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In my lastarticle, we reviewed the ways in which the meteoric rise of NFTs over the past few years has changed not only who can own art, but the definition of art itself. In this article, we are going to review how certain market participants are erroneously offering NFTs with securities features without proper compliance—and accordingly getting both issuers and investors in trouble.

Brief Background

NFTs are usually not securities, however, depending on their structure and nature, they can trigger various securities (SEC), commodities (CFTC) and money transmitter (FinCEN) rules and regulations. This is the case when they include characteristics of equity or an investment contract, as in the case of fractional NFTs, loans backed by meta-assets, digital assets staking backed by loans, copyright-backed NFTs and music copyrights as collateral.

If an NFT constitutes a “security,” it must be registered with the SEC or be exempt from registration. Regulation crowdfunding is one suchexemption. For example, regulation crowdfunding could take membership interests that are part of an LLC for a creative project and put them into an NFT. As such, the NFT represents a sale of equity, and is therefore a security. For any project, the critical considerations are what rights are included in the NFT and what the documentation is for those rights (for example, is it an LLC operating agreement, a corporation's certificate of incorporation, some other rights holders’ contract, etc.).

Securities Regulations

The SEC has issued statements that indicate that "tokens, coins, or other digital assets issued on a blockchain may be considered securities under U.S. federal securities laws"—this means the NFT must meet a legal analysis performed by a qualified securities attorney.

One question that has plagued the SEC, for example, is whether NFTs constitute securities under the four-prongedHowey test: Is this an investment of money? Is it a common enterprise? Is there the expectation of profit? And is that profit derived from the efforts of others? One potential example of a “security” could be a "fractional" NFT (S-NFT), where an investor would share a partial interest in an NFT with others. Depending on the facts and circumstances, S-NFTs could potentially be considered an "investment contract" under the Howey Test because of there being a common enterprise, with the expectation of profit derived from the efforts of others. Still, it comes down to the questions ofwhat are the rightsandwhat grants those rights? Frequently these offerings are further obscured when the rest of the NFT offers clever functionality and perks, but those items are not particularly material.

Current Conditions

At this time, unfortunately, I think we are seeing a replay of those 2016-2019 initial coin offerings (ICO) times when securities were erroneously sold as utilities, resulting in legal consequences for all parties involved. While with mature management teams and A-grade investors, it is quite possible that these market-participants are not listening to their lawyers’ advice or potentially were advised of the risk and chose to move forward anyway. After all, it is certainly fine to sell NFTs with benefits for buyers, as that in and of itself does not make them securities. These players may be willing to gamble that the financial returns of the NFT sale, or the foundation they are building for themselves in a nascent market, may be worth the potential lawsuit by the SEC or investors if they are found to be selling securities without licensing and properly following SEC’s compliance process. As expected during the early part of 2022, the SEC has reportedlysent subpoenasand opened an investigation into offerings from a handful of NFT creators.
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What makes it a security transaction is that it is coupled with an investment contract to share in the revenues from a royalty asset owned by the issuer, for which NFT buyers are reliant on the efforts of the issuer to administer. The investment contract, not the NFT, is the security; the issue is the bundling of the transaction, which then undermines the structure of this program and the free transferability of the tokens from wallet to wallet.

Royalties are a gray area to begin with. They meet several investment contract criteria but have been excluded from the definition of securities by case law and SEC practice. However, fractionalization changes the analysis in the following way:

1. When otherwise unaffiliated parties (i.e., an artist, producer, record label or publisher) come together to create a revenue-generating asset (a song or musical composition), there is no investment contract because of the collective effort of the parties involved (and no reliance on the efforts of others);

2. When that revenue-generating asset comes into existence, there is similarly no ongoing reliance on the efforts of others if that asset revenue is effectively on autopilot and the rights to that revenue stream are sold off to another party (even if it’s just the artist’s portion of the royalty rights that is sold off, while the producer, label or publisher retain their interests);but

3. When one party that acquires that royalty right and fractionalizes it, it is essentially creating a program around the asset that results in the creation of its own investment contract (separate and apart from the royalty stream created in the first point or sold in the second point), with reliance on the efforts of the party that fractionalized the right.

For example, in October 2021, the SEC qualified thefirst such offeringfor the song "Hit the Quan," performed by ILOVEMEMPHIS. For $16, fans could purchase a fraction of songwriter and producer Buck Nasty’s royalties via a marketplace called SongVest, thus giving them opportunities usually limited to institutions or those in the music industry.

What is the takeaway from all the debate and ambiguity? To maximize the benefits of NFTs and minimize the risks, entertainers, athletes and other creators who are working with platforms should make sure they know the ins and outs of the NFT ecosystem, but also foresee the changes coming down the pike.