The SEC issues its first fine to the NFT industry; what kind of NFT is considered a security?

Written by: Will 阿望

Source: Web3小律

On August 28, 2023, the U.S. Securities and Exchange Commission (SEC) took its first regulatory enforcement action against the NFT industry, accusing a Los Angeles-based entertainment company, Impact Theory, LLC, of selling unregistered securities, ultimately reaching a settlement with the SEC.

This is the SEC's first regulatory enforcement action against the NFT industry. Impact Theory promised investors that the value of the NFTs, the company, and shared wealth would increase, which is key to classifying NFTs as "securities." This article will analyze the SEC's regulatory enforcement against Impact Theory and the dissenting opinions of SEC commissioners to understand what types of NFTs may be deemed "securities" by the SEC.

1. Background of the Impact Theory NFT Case

According to the SEC, Impact Theory offered and sold three different types of NFTs from the Founder's Keys series to investors between October and November 2021. Before the NFT sale, Impact Theory held online events on Discord and shared promotional information on its website and social media channels.

The SEC claims:

(1) Impact Theory indicated to investors that purchasing NFTs was an investment in the business of Impact Theory, and if Impact Theory succeeded, it would bring profits to investors;

(2) Impact Theory told potential investors that it was "trying to build the next Disney," and the value of the NFTs would increase as a result;

(3) Impact Theory also stated that the fate of NFT investors was closely tied to that of Impact Theory and its founders.

(https://opensea.io/collection/impact-theory-founders-key)

Impact Theory sold 13,921 NFTs and raised over $29 million worth of ETH from the sales. Additionally, Impact Theory earned a 10% royalty on each resale of the NFTs, generating approximately $978,000 worth of ETH for the company.

Based on these facts, the SEC concluded: "Both potential and actual investors in Impact Theory NFTs believe that the NFTs are an investment and will appreciate in value." The SEC accused Impact Theory of violating Sections 5(a) and (c) of the Securities Act, which prohibit the issuance of unregistered securities.

Before settling with the SEC, Impact Theory took some remedial actions, such as repurchasing NFTs worth approximately $7.7 million from investors. As part of the settlement with the SEC, Impact Theory agreed to (1) destroy all NFTs it owns or controls within 10 days of the order being issued; (2) publish a notice of the regulatory enforcement on its website and social media; (3) modify the NFT contracts to eliminate its royalties; and (4) pay disgorgement and fines totaling approximately $6.1 million.

2. What is a "Security"? ------ Howey Test

Following the SEC v. Ripple case, U.S. regulators apply the Howey Test standard to determine what constitutes a "security." Although the SEC did not explicitly explain how the NFTs in this regulatory enforcement action met the Howey Test criteria, we can still infer the SEC's logic in classifying NFTs as "securities" from the facts surrounding Impact Theory's issuance and sale of NFTs.

This article will not elaborate on the Howey Test; for reference, see previous articles: Interpreting the SEC v. Ripple case, further clarifying regulatory ambiguities, Not all NFTs can be classified as securities, starting from SEC v. Yuga Labs.

In this case, we indeed see that Impact Theory's NFTs superficially meet the Howey Test criteria: (1) Investors made monetary (ETH) contributions; (2) The purchased NFTs were for a "common enterprise," linking the investors' wealth to that of Impact Theory; (3) Investors expected to profit from Impact Theory's efforts to create "the next Disney."

Among these, Impact Theory's promise to investors that the value of the NFTs and the company, and their shared wealth, would grow is key to classifying them as "securities."

3. Dissenting Statements from SEC Commissioners

After the regulatory enforcement order was issued, SEC commissioners Hester Peirce and Mark Uyeda immediately issued dissenting statements, indicating that this first regulatory enforcement action against the NFT industry still had many issues that needed clarification before the next regulatory enforcement case emerged.

First, they believe that Impact Theory's vague promises to NFT investors do not meet the Howey Test criteria. The full disclosure principle of the U.S. Securities Act requires issuers to have a relatively clear and specific plan for the use of funds raised from their securities offerings and profit expectations, similar to the prospectus in an IPO or the white paper in an ICO. Peirce and Uyeda further pointed out: "The SEC would not take enforcement action against someone selling watches, paintings, or collectibles, even if they made some vague promises about value appreciation, such as gradually building brand recognition to enhance the resale value of these tangible items."

Additionally, due to Impact Theory's extravagant promotions and vague statements, investors were misled into a false impression. As Peirce and Uyeda noted: "In reality, this NFT has no relation to company equity or the company's value, could this illusion/misleading also constitute fraud charges?"

Secondly, Peirce and Uyeda stated that even if the Howey Test requirements were met, whether the SEC needed to take such regulatory enforcement action was debatable. Violations of unregistered securities offerings can typically be resolved through rescission offers, and Impact Theory has already proposed such an offer through its repurchase plan.

Finally, Peirce and Uyeda raised several questions they believe the SEC should consider before conducting future regulatory enforcement actions in the NFT industry, mainly including:

1. Is the Securities Act suitable as the regulatory law for NFTs? Is there a feasible regulatory path for NFTs under the Securities Act?

2. Besides the NFT assets themselves having securities attributes, do the methods of NFT issuance and secondary market royalty transactions also constitute "securities"?

3. Regarding the compliance measures required for the aforementioned regulatory enforcement settlement, such as destroying NFTs and modifying to zero royalties, will these become standards for subsequent regulatory enforcement cases, and are they appropriate?

(https://metanews.com/sec-says-nfts-sold-by-impact-theory-are-securities-in-landmark-case/)

4. What Types of NFTs Will Be Classified as Securities?

First, let's attempt to answer Peirce and Uyeda's question about how NFTs should be regulated, which is fundamental.

4.1 How Should NFTs Be Regulated?

NFTs are essentially a type of token, and the value captured depends on the value of the underlying assets they are anchored to. The sources of value can vary, and the specific asset value attributes of NFTs are linked to the value attributes of their underlying assets.

Referring to the warning issued by the Hong Kong Securities and Futures Commission (SFC) on June 6, 2022, regarding NFT risks, the notice indicated that if NFTs are genuine digital representations of collectibles (art, music, or films), the related activities do not fall under the SFC's regulatory scope. However, some NFTs cross the boundary between collectibles and financial assets and may possess attributes of "securities" regulated under the Securities and Futures Ordinance, thus subject to regulation.

Therefore, NFTs can be categorized into three situations based on the attributes of their underlying assets:

(1) NFTs with underlying assets that are securities will be regulated under relevant securities laws and regulations;

(2) NFTs with underlying assets that are commodities will be regulated under relevant commodity/virtual asset laws and regulations;

(3) If the underlying assets are various rights, they will be assessed on a case-by-case basis according to the attributes of those rights.

Similarly, how NFTs should disclose information also needs to be determined based on the attributes of their underlying assets.

(https://cointelegraph.com/news/sec-investigating-nft-market-over-potential-securities-violations-reports)

4.2 Besides the NFT assets themselves having securities attributes, could the methods of NFT issuance and sales (secondary market transactions) also constitute securities offerings?

Based on the economic substance of the transactions, there are two ways NFTs may fall under "securities" regulation:

(1) The underlying assets being issued are securities, such as turning company equity into NFTs;

(2) Regardless of whether the underlying assets are securities, the method of NFT issuance constitutes a "securities" offering.

In regard to (2), in the SEC v. Ripple case, the court found that most "investment contracts" have underlying subjects that are merely commodities (Standalone Commodity) and do not necessarily meet the definition of "securities," similar to the orchards in SEC v. W.J. Howey Co. Other "investment contracts" may have underlying subjects like gold, crude oil, etc. Determining whether a transaction constitutes an "investment contract" requires assessing the economic substance of the underlying transaction to see if different methods of issuance constitute "securities" offerings.

In the SEC v. Ripple case, the Ripple token XRP does not necessarily meet the definition of "securities," but the facts of its promotion and sale to early investors constituted an "investment contract," thus falling under the definition of "securities."

In this case, the NFTs themselves do not possess "securities" attributes, but Impact Theory's marketing and promotion, telling potential investors that it was "trying to build the next Disney," indicated that the value of the NFTs would increase. Thus, the issuance of NFTs has the potential to be classified as an "investment contract," thereby falling under the definition of "securities."

In summary, "securities" refer to situations where investors passively participate in the business of a third party solely through monetary investment, expecting to gain profits from the efforts of that third party. If there are no efforts from the third party or if those efforts fail, investors face the risk of losing their invested amounts.

5. Conclusion

Although the SEC's regulatory enforcement does not have the effect of judicial adjudication, this outcome is still significant, as it marks the first finding that the issuance of NFTs violates the Securities Act's provisions regarding the sale of unregistered securities.

In an unclear regulatory environment, the SEC, CFTC, and other regulatory bodies continue to challenge the crypto industry and are delving deeper. Following the SEC's lawsuits against crypto giants Binance and Coinbase, this first case of regulatory enforcement against the NFT industry indicates that the SEC is not slowing down.

Previously, in the article "Legal Compliance Issues for Brand NFT Projects Operating Overseas," we covered some compliance points for NFT projects. However, it is evident that with the increasing regulatory scrutiny, companies in the crypto industry need to continue collaborating with experienced lawyers to discuss how to respond to lawsuits, regulations, and compliance.