Fractionalized non-fungible tokens (NFTs) have become increasingly popular within the ever-developing field of cryptocurrency, particularly in the distribution of digital art. NFTs use the same technology behind cryptocurrencies to create a certificate of ownership for a specific digital file that cannot be copied or forged. Each NFT is unique in value, granting the holder exclusive rights to a piece of a larger artwork. While some view NFTs as an avenue to be part of an exclusive group of digital art purveyors, some see potential investment in speculative blockchain technology, blurring the line between a “collectible” and a “security.”

On March 11, 2021, an anonymous cryptocurrency entrepreneur paid $69.3 million for a digital piece of art, the third-highest price ever paid for a work by a living artist. In previous months, the entrepreneur had purchased 20 digital artworks by the same artist, each time dividing up the portfolio of NFTs into blockchain-based tokens to sell fractionalized interests in the market. As the auction around the most recent art piece intensified, more people rushed to buy the tokens, increasing their value to $51 million by March 11.[1]

While it is not currently against the law for someone to buy, resell and promote the value of digital assets, Securities and Exchange Commission (SEC) Commissioner Hester Peirce warned that issuing fractionalized NFTs could be considered investment contracts under U.S. securities law. At a recent conference, Peirce said, “You have to be very careful if you decide to take a bunch of NFTs, put them in a basket, break them up and then sell fractional interest[s], or you decide to take one NFT and sell it in parts.”[2] Peirce emphasized that the “definition of security can be pretty broad” and that certain fundraising efforts related to NFTs may “raise the same kinds of questions that ICOs [initial coin offerings] have raised.”[3] This is especially true because the value of an NFT is based entirely on demand for the token rather than fundamental economic principles that typically influence market prices.[4]

SEC Staff published a framework analysis outlining characteristics that are more likely to subject digital assets to U.S. securities law under the traditional Howey test.[5] For a financial instrument to be classified as an investment contract, and therefore a security, the Howey test requires an investment of money in a common enterprise with the expectation of profits from the investment derived from the efforts of a promoter or third party.[6] While the framework provides many examples of managerial or entrepreneurial efforts that could create a reasonable expectation of profits, there is currently little Commission-approved (or official) SEC guidance regarding digital assets under the Howey test save for the DAO Report,[7] No Action Letters and enforcement actions. Ultimately, the conclusion of whether a digital asset is a security depends on the economic reality of the transaction and the manner in which the digital asset is offered and sold, including marketing efforts.

While the rise in popularity of digital art has allowed some artists to capitalize on the frenzy, prospective buyers should be aware that they may be holding a security if, among other things, any of the following apply:

• Digital art sales are marketed as a fundraising effort that pools investor funds to build a platform or enterprise.
• Promoters’, sponsors’ or any active participants’ marketing efforts are intended to increase the value of the digital art tokens.
• The digital art is created and sold as a way for the public to earn investment returns.

Authorship Credit: George Stamboulidis and Christina Gotsis

[1] Gerrit De Vynck and Douglas MacMillan, He just spent $69 million on a digital piece of art. It’s not his first Beeple. The Washington Post, Mar. 18, 2021, https://www.washingtonpost.com/technology/2021/03/17/nft-beeple-metakovan-christies/.
[2] Elenora Spagnola, Hester Pierce (SEC): NFTs are not investment products, The Cryptonomist, Mar. 26, 2021, https://en.cryptonomist.ch/2021/03/26/hester-pierce-sec-nfts-are-not-investment-products/.
[3] Sophie Kiderlin, The SEC’s ‘Crypto Mom’ Hester Peirce says selling fractionalized NFTs could be illegal, Markets Insider, Mar. 26, 2021, https://markets.businessinsider.com/currencies/news/sec-crypto-mom-hester-peirce-selling-nft-fragments-illegal-2021-3-1030250153.
[4] Robyn Conti and John Schmidt, What You Need To Know About Non-Fungible Tokens (NFTs), Forbes, May 14, 2021, https://www.forbes.com/advisor/investing/nft-non-fungible-token/.
[5] SEC, Framework for “Investment Contract” Analysis of Digital Assets, Apr. 3, 2019.
[6] SEC v. W.J. Howey Co., 328 U.S. 293 (1956).
[7] SEC, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Jul. 25, 2017.