NFTs: But is it Art (or a Security)?

Latham & Watkins LLP
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Latham & Watkins LLPAs the market for NFTs heats up, market participants should remain mindful of the regulatory implications of complex schemes.

As the current crypto boom has progressed, it seemed Decentralized Finance (DeFi) had cemented its position as the dominant new narrative of this cycle. This view is supported by the tens of billions of dollars that have flowed into DeFi protocols over the past twelve months. Yet, amid renewed public interest, non-fungible tokens (NFTs) show signs that they should not be overlooked in discussions regarding the hottest new developments in the crypto space. As with any fast-moving market driven by explosive consumer interest and waves of money, regulators will likely take an interest and scrutinize market practices against existing regulations.

Background

NFTs entered public awareness during the crypto boom of 2017-18 and have recently experienced a resurgence, eclipsing the popularity they achieved in the previous market cycle. As widely reported, some recent issues of NFTs have sold out in seconds and can command seven or eight-figure purchase prices per unit.

NFTs are essentially unique digital assets with blockchain-based authenticity, ownership, and transferability features. They differ from other blockchain-based assets such as Bitcoin, Ether, and stablecoins that are identical and interchangeable (i.e., fungible). Most NFTs are currently issued on Ethereum; however, other blockchain platforms are also vying for market share in the space, with new NFT-focused protocols even being launched. NFTs can be purchased and sold peer-to-peer or on dedicated marketplaces online.

Are NFTs Securities?

In the case of NFTs that constitute art or collectibles, on the surface of things, such NFTs should arguably not be deemed to be securities. (Needless to say, any given NFT would have to be analyzed on its specific facts.) These NFTs are essentially finished products whose value is determined at a sale that is made directly to a buyer. For such NFTs to maintain or appreciate in value, there is typically no expectation or need for third parties to extend managerial efforts that will enhance the value of the NFT. As noted by the SEC staff in its 2019 Framework, “Price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.” In other words, an NFT is not a security simply because it can increase in value.

However, NFTs that constitute art or collectibles may only be the tip of the iceberg. Many industry participants think the technological developments being driven by the demand for NFTs could lay the groundwork for expansion into an enormous variety of digital property rights. The analysis becomes more complex when considering the emerging trend towards these other areas, including the financialization of NFTs.

For example, certain projects propose to issue insurance policies in NFT form. This approach is based on the idea that each insurance policy is unique given such variables as the type of risk covered, extent of coverage, and premiums payable. In such structures, insurance writers contribute to a protection pool and receive a share of premiums from insurance buyers commensurate to their contribution to the protection pool. Such systems contemplate that the insurance writers will also be able to trade their share of the protection pool and accompanying rights to premiums on secondary markets.

Similarly, it is possible to mint NFTs in such a way that the original NFT issuer would receive a share of proceeds each time their NFT was sold — even long after their initial sale of the NFT. One can envision a scenario in which an artist could decide to sell such rights to future proceeds on a secondary market, perhaps even packaging them with rights to proceeds from other NFTs they created. Finally, platforms are emerging where NFTs can be used as collateral to borrow other cryptoassets.

In any of the foregoing scenarios, careful consideration would need to be taken to ensure that the underlying tokens being traded are not securities, so as to avoid the accompanying regulatory burden. If deemed to be a security, every sale of the token would need to be registered or exempt from registration under US securities laws. Furthermore, platforms dealing in the token would be required to register as a securities exchange or alternative trading system and broker-dealer.

Considerations for NFT Issuers

NFT issuers are advised to avoid marketing NFTs as an investment that can reward holders with appreciation, profit, or dividends. The concern here is that such marketing could transform a non-security into a security, such as in the Gary Plastic case, in which a secondary market for the instruments was touted. (For additional details, see page 102 of this Latham-authored analysis.)

In addition, issuers should avoid:

  • Marketing NFT sales as a fundraising effort to build a platform for future sales
  • Employing promoters, sponsors, or third parties whose marketing efforts are intended to drive the NFTs’ appreciation
  • Giving NFT buyers the impression that they can reasonably expect capital appreciation of the digital asset or to derive profits or from their asset as a result of the creator’s efforts or the efforts of any third party

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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