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Are Non-Fungible Tokens (NFTs) Subject To Securities Law?

Non-fungible tokens, or NFTs, are the latest trend to hit the digital market space. These popular digital items appear in numerous forms like drawings, music, and downloadable images that serve as collector items. This art form has recently gained so much popularity with art collectors, given that blockchain is utilized to determine and maintain authenticity regarding the ownership and utilization of the artwork. The popularity of NFTs rendered it a hot investment in recent years that many cryptocurrency transactions and amounts are tied exclusively to NFTs. This phenomenon spurred an inquiry to the Securities and Exchange Commission (SEC) to determine whether NFTs are subject to securities law regulations.

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What are Non-Fungible Tokens or NFTs?

Non-fungible tokens, more popularly known as NFTs, are units of financial security comprised of digital data stored in a blockchain. Each NFT is recorded in the blockchain, serving as a certificate of authenticity. The blockchain verifies that the holders of the NFTs indeed have ownership of the asset and are licensed to utilize that asset. The blockchain also allows the transfer of the NFT, whether to be sold or traded.

NFTs are typically digital images or files that are generally represented by photos, videos, or audio files. Since NFTs are comprised of digital images, they are uniquely identifiable and thus considered non-fungible.

Are Non-Fungible Tokens Subject to Securities Law?

Since NFT transactions are still new in the marketplace, albeit they are popular and have generated a significant amount of money and transactions, they have yet to be determined whether they are subject to securities law regulations.

Given the sudden take-off of NFTs transactions and its utilization of cryptocurrency, which is a new form of currency still being reviewed by the SEC on a case-by-case basis, the inquiry into whether NFTs are subject to securities law seems to be a natural next step.

Similar to cryptocurrency reviews, NFTs are subject to the four-prong Howey Test to assess whether they qualify as a security. If they are determined to be a security under this test, they would be subject to disclosure and regulation under securities law.

What is the Howey Test and How is it Applied?

The Howey Test was derived from a US Supreme Court case SEC v. WJ Howey Co. This case presented what is now known as the Howey Test. This test is essential in determining whether there is an “investment contract” under the Securities Act and whether the transaction involves an investment of money in a common enterprise with profits to come exclusively from the efforts of others.

The Howey Test comprises four elements, which all have to be met by a transaction to qualify as a security. These four elements to be completed are as follows:

  • Investment of money
  • In a common enterprise
  • A reasonable expectation of profit
  • Derived from the efforts of others

If such transaction is determined to have an investment contract defined by the Security Act, then such transaction qualifies as an “investment contract.” It is also essential to know that if a transaction is determined to be an “investment contract,” then it is immaterial whether the enterprise is speculative or non-speculative or if the sale of the property is with or without intrinsic value.

This test applies to any contract, scheme, or transaction. This test is also vital in assessing blockchain, cryptocurrency, and other digital currency; thus, it is used to evaluate NFTs.

So Are Non-Fungible Tokens Subject to Securities Law or Not?

As of today, the determination of whether a non-fungible token (NFT) is subject to securities law is still pending. However, one thing is sure, NFTs are receiving increasing attention and scrutiny from federal and state regulators. These regulators seek regulation rules for NFT transactions and call for SEC involvement, investigation, and enforcement against all NFT players.

Given the increasing popularity and transactions involving NFTs, it is only a matter of time until the SEC, as well as state and other federal regulators, along with the courts, establish a hard rule to determine if NFTs, or at least some form of NFTs, are subject to securities law.

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Legal Favor

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Sources

  • Insider, T. (2021, July 16). Digital Art may be next in the SEC’s crosshairs. Forbes. Retrieved June 26, 2022, from https://www.forbes.com/sites/insider/2021/07/15/digital-art-may-be-next-in-the-secs-crosshairs/?sh=5fde1edb32df
  • Securities Exchange Commission. (n.d.). Framework for “investment contract” analysis of Digital assets. SEC DLT Framework. Retrieved June 26, 2022, from https://www.sec.gov/files/dlt-framework.pdf
  • Securities Exchange Commission. (2019, May 9). How We Howey. SEC Speech. Retrieved June 26, 2022, from https://www.sec.gov/news/speech/peirce-how-we-howey-050919