Following its enforcement action against Impact Theory, LLC, the US Securities and Exchange Commission (SEC) commenced an administrative proceeding charging Stoner Cats 2, LLC (SC2) with conducting an unregistered offering of securities in the form of non-fungible tokens (NFTs) in violation of the Securities Act of 1933.

This public offering purportedly raised approximately $8.2 million from investors to finance Stoner Cats, an adult animated television show featuring house cats that gain sentience after exposure to their owner’s medical marijuana. The offering occurred on July 27, 2021, and resulted in the sale of 10,320 NFTs for 0.35 ETH (approximately $800) each. This sale was complete in just 35 minutes.

This dispute marks only the second SEC enforcement action targeting an NFT project, as opposed to cryptocurrency, which has been the primary focus of SEC enforcement activity in the digital asset space until recently. In anticipation of the proceeding, SC2 settled the case and consented to the SEC Order Instituting Cease-and-Desist Proceedings, Making Findings, and Imposing A Cease-and-Desist Order, without admitting or denying the findings (referred to as the settlement order).

Where Stoner Cats Went Wrong

As outlined in the settlement order, Stoner Cats NFTs are ERC-721 tokens recorded on the Ethereum blockchain. Each token is linked to a unique image of one of the Stoner Cats television characters. The tokens were randomly allocated among purchasers, meaning that buyers could not select their Stoner Cats NFTs, and the NFTs could be traded on a secondary market. Unlike some other projects, ownership of the Stoner Cats NFTs did not grant any rights to the underlying intellectual property.

Secondary Markets

Through what the SEC found was an “extensive media campaign” promoting Stoner Cats NFTs, SC2 claimed that in financing the production of the television series by offering and selling NFTs to the public, it could revolutionize the financing and production of entertainment content.

Immediately after being minted, the NFTs were traded in secondary markets, with over 10,000 secondary market transactions occurring between July 27, 2021, and June 2, 2022. Strikingly, the majority of NFTs purchased in the offering were resold in secondary market transactions before the release of the second episode of Stoner Cats on November 15, 2021. Per the settlement order, more than 62% of the purchasers in the offering bought more than one Stoner Cats NFT, and at least 20% of the Stoner Cats NFTs purchased in the offering were resold in the secondary market before the first episode of the Stoner Cats series aired.

In addition to the NFTs sold through the offering, SC2 minted an additional 100 Stoner Cats NFTs, retaining some of them thereafter and transferring others to third parties. Overall, purchasers spent over $20 million worth of ETH in secondary market transactions, with SC2 collecting a 2.5% royalty on each transaction.

The significance of marketing the Stoner Cats NFTs on secondary markets was reflected in the findings in the settlement order, which emphasized the value of these sales. The SEC noted that SC2 informed investors that these NFTs were comparable to “tickets” and that these tickets could be sold elsewhere if “people didn’t appreciate them.” Beyond the “ticket” analogy, the SEC stated that following the initial Stoner Cats NFTs offering, SC2 frequently touted the sales of their NFTs in secondary markets on Twitter, pointing to specific dollar amounts earned from secondary market sales, and insisting that the “smartest thing to do during a dip in the crypto markets would be to buy more ETH & sweep the Stoner Cats floor.”

Managerial and Entrepreneurial Efforts

The settlement order emphasizes that SC2 informed potential purchasers of Stoner Cats NFTs that it would develop the Stoner Cats web series through its own managerial and entrepreneurial efforts, and that investors would have a reasonable expectation of turning a profit based on these efforts. Indeed, SC2 promised purchasers that, in return for their investment, they would be granted exclusive access to the relevant web series, an online platform, and unspecified future entertainment content. The funds provided by purchasers were used to create entertainment content, as set forth in the SEC’s order.

Further, the SEC’s order detailed that as part of its marketing campaign, SC2 professionals highlighted their expertise as Hollywood producers, their knowledge of crypto projects, and the involvement of actors – such as Ashton Kutcher and Mila Kunis – in the web series. These advertisements, per the SEC’s findings, led investors to expect to turn profits upon resale of the Stoner Cats NFTs through secondary market transactions. Importantly, acting professionals such as Ashton Kutcher and Mila Kunis were compensated with the offering proceeds and the royalties generated from secondary market sales.

Next Steps

Similar to the settlement order in the Impact Theory action, SC2 is required to destroy all Stoner Cats NFTs and publish a notice of the SEC's order on the SC2 website. SC2 also agreed to pay a civil money penalty of $1 million to the SEC and establish a fair fund to allow injured investors to recoup their losses.

While the Stoner Cats action is novel in that it involves NFTs as opposed to cryptocurrency, when considered alongside the Impact Theory enforcement settlement, it indicates that the SEC is focused on the offer and sale of NFTs which it believes are securities offered and sold in violation of the registration requirements of the federal securities laws. As we have mentioned in prior alerts, the inquiry into whether a token or collectible is a security is highly fact-specific, making it difficult to predict how a court might rule on a case-by-case basis. Nonetheless, the SEC appears undeterred in pursuing enforcement investigations and cases in the NFT and cryptocurrency arena.

It should be noted that SEC Commissioners Hester Peirce and Mark Uyeda again issued a dissenting opinion and called for the SEC to establish clear guidelines for the sponsors and promoters of NFTs, referring to the enforcement action as involving “activity that we believe constitutes fan crowdfunding.” Peirce and Uyeda further wrote that the SEC’s application of securities laws serves to contribute to “legal ambiguity” within the creative community. However, the majority of the SEC Commissioners seem to be content with letting the law evolve through the enforcement process. Thus, sponsors of NFTs, as well as contributing artists and endorsers, are advised to tread carefully for the foreseeable future.

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