NFT Securities Issues and SEC Scrutiny.

The issuance of an “NFT” is not inherently a “securities offering,” and it can present numerous potential securities law issues as a whole. With respect to an NFT “investments,” courts focus on the transaction’s economic characteristics under the Howey test, and labels like “NFT” are not dispositive.

A transaction qualifies as an investment contract under the Howey test if: (i) there is an investment of money, (ii) in a common enterprise, (iii) with an expectation of profit, and (iv) that profit is solely or predominantly based on the efforts of others.

The Securities and Exchange Commission (SEC) cannot assert jurisdiction or authority in cases where no securities issues are involved. Howey test analysis determines securities status, and generic terminology like “NFT,” “web3,” and “digital assets” does not create jurisdiction where none exists.

As Reuters recently noted, there is debate over when an NFT constitutes “an investment contract under the Howey test” (October 23, 2024). The SEC’s Commission-level guidance and enforcement priorities are not substitutes for the federal securities statutes or binding judicial precedent. The Howey test is not “outdated” and it remains applicable to NFTs.

However, once an NFT is deemed to be a security under the federal securities laws, its issuance is subject to registration requirements, which will almost certainly be violated as no NFT has yet been registered with the SEC under the Securities Act of 1933 (the “Act”). Issuances will likely constitute unregistered broker, dealer, and investment advisor transactions. Additionally, fraudulent, misleading, or false advertising and sales practices may also trigger federal securities fraud liability and enforcement action. The risks of offering and trading NFTs as securities are substantial.

When does an NFT Sale Pass the Howey Test?

As discussed, determining whether an NFT sale constitutes an investment contract offering under federal law requires conducting a Howey analysis. Our federal attorneys use this analysis to determine the extent of our clients’ liability in NFT enforcement cases, Howey analysis is well-established and continues to be applied across various contexts. With respect to the Howey elements, our attorneys focus on whether:

• Investors are investing money in a common enterprise, and

Are Consumptive NFT Transactions Excluded?

While buyers will certainly use the “consumptive” nature of most NFTs as a defense to howey analysis, this only addresses a single element of the test. Howey’s investors must have an expectation of profits derived from the efforts of others. For example, while purchasing land is generally a consumptive act, purchasing land in order to secure profits from the developer’s efforts is an investment. The following factors can make an NFT buyer qualify as an investor:

• Promising a Future of Financial Success, The promise that the issuer will take actions to increase the value of the NFT (by enhancing utility, driving demand, or promoting the NFT directly) can make the NFT buyer qualify as an investor and the efforts of the issuer will drive the expectation of profit.
• Fractionalized NFT Interests, Even if the underlying NFT itself does not constitute an investment contract, a sale of interests in an NFT can, and does, present securities law issues separate from those of the underlying NFT.
• Revenue-Sharing and Royalty Rights, While investors can expect profits from purchasing NFTs with revenue-sharing or royalty rights, these are not necessarily investment contracts. However, such rights provide financial incentives for buyers that can easily be construed as an expectation of profit derived from the efforts of the issuer.
• Governance Rights, As SEC has stated in its digital asset enforcement priorities, including governance rights in the sale of a digital asset does not necessarily remove its investment contract status.
• Staking and Other Incentive Programs, Staking and other reward mechanisms also require separate analysis from the underlying NFT, although it is possible they present securities law risks in the contexts discussed above.

The Federal SEC has recently been investigating both platforms and issuers of NFTs, and in many instances the focus of the SEC’s investigations has been marketing and offering of NFTs under investment-contract theories.

Are NFTs “Exchangeable” Under the Securities Exchange Act?

Once Howey analysis establishes whether an NFT is a “security,” the issuer and any other entity with involvement in a transaction with the security must then address other questions, such as how the securities are being exchanged. Broker, dealer, and investment advisor registrations will be required depending on the extent to which a transaction involves deforming or investing in an NFT for profit, and it will be required under various circumstances where the Howey test may not apply. For example, certain investment arrangements will trigger registration requirements regardless of the subject matter’s “investment contract” status and may include any unregistered offers or sales of “equities” or “debt instruments.”

What are the Implications for NFT Investors, Issuers, and Intermediaries?

Based on how brokers, platforms, and other intermediaries market their NFTs, and with specific considerations of the Howey test in each case, it is likely that NFT-related securities liability is an issue for a broad spectrum of NFT issuers, intermediaries, and NFT investors. In such cases, it is important for involved parties to quickly assess their risk exposure, and identify any necessary registrations.

What do NFT Enforcement Cases Actually Prove?

In 2023, Impact Theory became the SEC’s first NFT registration enforcement action. Two Commissioners, Hester Peirce and Mark Uyeda, wrote powerful dissents, arguing that the SEC’s administrative order did not meet its burden of showing that Impact Theory’s NFT offerings were actually securities under the Howey test.

Similarly, in the SEC’s action against the creators of the “Stoner Cats” NFTs, the SEC alleged that the issuance of the NFTs constituted an unregistered offer and sale of investment contracts. Specifically, the SEC’s enforcement action focuses on the fact that “owners” were promised a 2.5% royalty from secondary transactions. The case is currently ongoing.

Most recently, in September 2024, in a first-of-its-kind action alleging that the “Flyfish Club” NFTs provided access to a planned private dining club, Flyfish Club agreed to pay a $750,000 penalty and ceased its offering of “exclusive membership NFTs.” The SEC alleges, though it agrees to settle on a neither-admit-nor-deny basis, that the Flyfish Club NFTs offered prospective “exclusive club membership” with an expectation of profits based on the efforts of Flyfish Club.

These are not administrative settlements or determinations by federal courts. Rather, they represent the SEC’s first steps into taking the Howey test and the Securities Act out of textbooks and apply them to a specific, evolving technology. While SEC administrative settlements do not create binding judicial precedent that resolves the legal questions posed by the Howey test, the SEC’s enforcement actions are an extremely clear signal of its digital asset enforcement priorities for the current administration.

How Have Courts Handled Non-Administrative NFT Securities Litigation?

To date, the federal courts have not issued any opinion on the applicability of the Howey test in cases involving the sale of “collectible NFTs.” In Friel v. Dapper Labs, plaintiffs alleged that NBA Top Shot NFTs constitute “unregistered securities,” and they sought to enforce this allegation by challenging the transaction and seeking monetary damages. While the court ultimately denied Dapper Labs’ motion to dismiss, it did not finally determine that NBA Top Shot NFTs constitute “investment contracts” or are issued as “securities.”

The fact that Dapper Labs owns and manages the Flow blockchain, a private Ethereum-like blockchain on which NBA Top Shot NFTs reside, and that Dapper Labs controls the marketplace, were both important factors in the plaintiffs’ claims. Friel’s analysis of the Dapper Labs case demonstrates that, while not controlling, the transaction economics can be important for an NFT sale to be construed as offering a security.

Similar to the SEC’s administrative action in the Flyfish Club case, the Friel case is an example of how the court can find an NFT issue-based security violation by analyzing a specific issue (i.e., whether purchasers’ investment in an NFT entitles them to profit from the efforts of another). As we discuss in detail below, this logic can be applied broadly to most NFTs that have an investment purpose.

If you are facing this situation, Spodek Law Group handles federal criminal defense matters nationwide, from offices in New York and Los Angeles.

Does my NFT Marketplace Need Securities Registration?

If an NFT represents a security, the marketplace hosting the transaction will most likely need to register as an “exchange.” With respect to determining if a marketplace is an exchange, the SEC defines a marketplace as having “exchange-like services” if it is a system that “facilitates” securities transactions. The SEC’s Rule 3b-16 defines an exchange or an entity providing exchange-like services when, “as a result of its offerings, transactions and, or otherwise, a substantial amount of trading in securities occurs on an exchange,” which includes a platform that “serves to facilitate” the trading of “securities.”

Under the rules that govern exchanges and Alternative Trading Systems (“ATS”), platforms providing ATS services can only do so through the intermediation of a registered broker-dealer. Since ATS are generally subject to federal securities registration, they are subject to registration as well. Therefore, if an NFT is a security, the marketplace hosting the transaction may need to register as an exchange, as an ATS, and as a broker or dealer.

Registration for NFT Brokers, Dealers, and Investment Advisors

Exchange Act Section 15(a) requires any entity engaged in the business of “effecting transactions in securities for the account of others” to register as a broker or dealer with the SEC. Broker-dealers are generally required to register with the SEC in order to offer, sell, and facilitate securities transactions. While this is generally viewed as a violation, broker-dealers and investment advisors can facilitate and manage securities transactions if appropriate safeguards are in place.

In addition to facilitating securities transactions, the Exchange Act also addresses the role of broker-dealers as custodians of clients’ assets. Under Rule 15c3-3, broker-dealers are required to promptly obtain and maintain physical possession or control of customers’ fully paid and excess margin securities, and they may not use those securities in the firm’s own business. While the security deposit obligation in the blockchain ecosystem remains an extremely complex issue, this is one of the few issues the SEC addressed in its SEC v. Coinbase lawsuit.

Transfer Agents and Investment Advisors

In addition to broker-dealers, transfer agents registered under Section 17A of the Exchange Act are generally involved when securities are registered under Section 12. With respect to investment advisors, these entities are required to safeguard clients’ securities under Advisers Act Rule 206(4)-2, which prohibits investment advisors from commingling clients’ assets with their own.

Issuer Control Over Resale Infrastructure and Other Factors Influencing Howey Analysis

The degree to which an issuer controls an NFT’s resale infrastructure may be a key factor in whether the NFT offering constitutes a “security” under the Howey test. While purchasers’ expectation of profit can result from various factors, one factor that is particularly relevant for NFTs is the purchaser’s expectation that “the profits of the transaction are primarily the result of the efforts of the issuer or others.”

Therefore, the more that an issuer controls the resale infrastructure through which a purchaser can transfer an NFT, the more likely it is that the purchasers’ expectation of profit results from the efforts of the issuer, and the more likely it is that the NFT will satisfy the Howey test.

Can NFT Issuers Use Exemptions and Permit Resales?

Qualifying transactions undertaken by issuers of “NFT securities” may be exempt from securities registration under Section 4(a)(2) of the Securities Act of 1933 (the “Act”), which exempts “all transactions by an issuer, underwriter, or dealer.” With respect to exempt private offerings, the federal securities laws afford issuers of unregistered “NFT securities” relief through the following safe harbors, among others:

• Regulation D Rule 506(b), Under Rule 506(b) of Regulation D, an issuer may avoid securities registration if it limits its offering to accredited investors and does not rely on a “general solicitation” of “non-accredited investors.” Reliance on Rule 506(b) is one of the most commonly used methods for making a compliant offering of an unregistered private security. However, this exempt private offering provision is not suitable for issuers that plan to allow prospective purchasers to transact on a marketplace, as this would trigger the requirement to avoid a general solicitation of non-accredited investors.
• Regulation D Rule 506(c), Regulation D Rule 506(c) allows issuers of unregistered private securities to engage in a general solicitation, provided that all purchasers are verified as “accredited investors.” While Rule 506(c) allows issuers of unregistered “NFT securities” to facilitate investors’ purchase of unregistered shares on marketplaces, this exemption only works for registered “accredited investors.”
• Regulation Crowdfunding, Regulation Crowdfunding allows eligible issuers, that include many newly formed issuers of unregistered securities, to raise up to $5 million during any 12-month period from crowdfunding platforms through other methods of offering. Regulation Crowdfunding requirements for registered issuers of “NFT securities” include those similar to that of registered securities offerings.
• Regulation A, Regulation A is a method of registering an unregistered private securities offering with the SEC and with state securities commissions that meets numerous conditions, including the qualified nature of the offering. Regulation A has two tiers. Tier 1 offerings are subject to a $20 million maximum within a 12-month period, and Tier 2 offerings are subject to a $75 million maximum within a 12-month period.

The foregoing safe harbors all afford opportunities for issuers to conduct nonpublic unregistered private offerings. However, each method has its own set of requirements and limitations, and all registered securities offerings will still be subject to federal antifraud provisions. All registered securities offerings must be conducted in compliance with federal and state securities law, and issuers will be liable for violations under both statutes.

Are All Secondary NFT Securities Sales Subject to Registration?

Each secondary NFT securities sale requires either registration or an exemption from registration. The primary exempt private offering that may facilitate the resale of “NFT securities” to non-accredited investors is Section 4(a)(1) of the Act. Section 4(a)(1) is a safe harbor that applies to transactions by individuals other than issuers, underwriters, or dealers (which may include brokers, transfer agents, and other investment intermediaries).

When attempting to sell restricted “NFT securities” to investors, the most common and applicable exemption is Rule 144. Securities Act Rule 144 provides a safe harbor for transactions that fulfill three conditions:

• The securities are registered under Section 12 of the Exchange Act, or the securities are “unregistered restricted securities”;
• The amount of securities sold does not exceed the specified limit; and
• The registration statement for the securities has been effective for the time required, and a specific holding period has passed.

What Happens if the SEC Treats My NFTs as Securities?

When assessing liability in an NFT-related securities enforcement action, two primary theories of liability are registration violations and securities fraud. While the SEC will frequently pursue both theories concurrently, these are distinct theories of liability, and they involve separate legal questions and defenses.

It is important to note that SEC civil scrutiny does not necessarily lead to prosecution. While parallel SEC and DOJ investigations can trigger a government-initiated criminal prosecution, they may lead only to a civil enforcement action if prosecutors are unwilling or unable to prove a willful and fraudulent intent to commit a crime.

Statutory Framework of the Securities Act

The Securities Act of 1933 (the “Act”) establishes the federal registration framework for offering and selling securities in the United States. The registration framework includes:

• Section 5, This section establishes the primary registration requirements of the federal securities laws. It imposes civil liability for offering unregistered securities and selling unregistered securities.

Anti-Fraud Provisions of the Federal Securities Laws

Along with registration requirements, the Securities Act establishes antifraud provisions to deter fraudulent securities offerings. Section 17(a) of the Act prohibits issuers of “NFT securities” from:

• Employing a device, scheme, or artifice to defraud;
• Engaging in any act, practice, or course of practice which would operate as a fraud or deceit;
• Obtaining money or property by means of an untrue statement of a material fact or omission of a material fact; and
• Failing to disclose material information and misleading prospects by providing deceptive statements.

Statutory Remedies in Unregistered Securities Transactions

For investors and other parties, unlawful unregistered NFT offerings trigger statutory remedies under the Securities Act. For example, Section 12(a)(1) of the Act provides the right to rescind any transaction in which an unregistered security is offered or sold to the buyer. Investors can seek rescission of unregistered “NFT securities,” or they can file for damages. Similarly, an unregistered broker, dealer, or investment advisor may also be subject to rescission of a securities transaction when they facilitate the purchase of restricted or unregistered securities.

Section 21(d)(7) Disgorgement Remedies

With respect to the SEC’s authority, Section 21(d)(7) of the Securities Exchange Act of 1934 (the “Exchange Act”) expressly authorizes the SEC to seek disgorgement of “any property obtained by the defendant” as a result of a violation of the federal securities laws. While Section 21(d)(7) is a provision of the Exchange Act, the SEC frequently applies it in enforcement actions brought under the Act and the Howey test. This provision, however, is subject to a statute of limitations.

Officer-and-Director Bar for Unregistered Offerings

Section 20(e) of the Securities Act authorizes the SEC to issue an “officer and director bar” if the violation of the Act is “egregious.” While Section 20(e) bars an individual from acting as an officer, director, or control person of a public company, it may lead to civil prosecution for those involved in registered private offerings.

Get Advice on Your Situation

If you want someone to look at the specifics of your case, Spodek Law Group handles federal criminal defense nationwide from New York and Los Angeles. The firm has been practicing since 1976 and its motto is simple: we owe loyalty to only you. Call 212-300-5196.