Introduction

The Securities and Exchange Commission (“SEC”) issued a cease-and-desist order on August 28, 2023, charging Impact Theory, LLC (“Impact Theory”) with conducting an unregistered offering of crypto asset securities in violation of the Securities Act of 1933 (“Securities Act”).¹  Without admitting or denying the SEC’s findings, Impact Theory accepted the order and agreed to pay more than US$6.1 million in civil penalties, disgorgement and prejudgment interest.²  The order marks the first time that the SEC has applied the seminal “Howey test” to non-fungible cryptocurrency tokens (“NFTs”). In a dissenting opinion two SEC Commissioners rejected the SEC’s application of the Howey test and raised several questions for future cases involving NFTs.

Background

Courts generally apply the “Howey test” to determine whether a digital asset constitutes an “investment contract,” and consequently a security under U.S. securities laws.³  Under the Howey test, a digital asset is an investment contract if the following elements are present: (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits to be derived from the efforts of others.

Impact Theory, a Los Angeles-based entertainment media company, offered and sold NFTs, known as Founder’s Keys (“KeyNFTs”). NFTs are digital asset tokens similar to cryptocurrency. However, each NFT possesses unique characteristics that distinguish NFTs from each other, such as being tied to ownership of a specific piece of art. Many NFTs operate on the Ethereum (“ETH”) blockchain.

KeyNFTs were divided and sold into three classes, titled “Legendary,” “Heroic,” and “Relentless.” Impact Theory raised around US$29.9 million worth of ETH from the sale. As part of the remedial actions Impact Theory undertook, and which the SEC considered in arriving at the resolution, it agreed to revise the KeyNFTs’ smart contracts to eliminate royalties that Impact Theory would have received for any future secondary market transactions.

The Order

The SEC analyzed Impact Theory’s KeyNFTs under the Howey test and determined that they constituted investment contracts, stating that “[p]urchasers in the KeyNFT offering had a reasonable expectation of obtaining a future profit based on Impact Theory’s managerial and entrepreneurial efforts.” In arriving at this conclusion, the SEC did not conduct a fact application; instead, it highlighted several key facts that lead to its position.

First, the SEC established that an investment of money was present. Specifically, Impact Theory sold (i) Legendary tier KeyNFTs to investors for between 1.5 to 3 ETH per token; (ii) Heroic tier KeyNFTs for 0.75 to 1.5 ETH per token; and (iii) Relentless tier KeyNFTs for 0.05 to 0.1 ETH per token.

Second, the SEC provided facts purporting to show that the sale of KeyNFTs constituted a “common enterprise” or “scheme” between investors. Specifically, according to the SEC, Impact Theory claimed that a purchase of a KeyNFT constituted an investment in what would be a “thriving community” in Impact Theory’s vision.

Last, the SEC claimed that investors possessed an expectation of profits to be derived from the efforts of Impact Theory because the company repeatedly told investors that their money would be put into development efforts and create additional projects to add value to the company. Per the SEC, Impact Theory expressed that such development efforts would enrich investors, including statements that NFTs were the “mechanism by which communities will be able to capture economic value from the growth of the company that they support” as well as claims that investors would be ecstatic that they would be “getting all this value” from their investment.

As a result of these findings, the SEC concluded that investors “understood Impact Theory’s statements to mean that the company’s development of its projects could translate to appreciation of the KeyNFTs’ value over time.”

The Dissent

SEC Commissioners Hester M. Peirce and Mark T. Uyeda released a joint dissenting opinion disagreeing with the SEC’s application of the Howey test.⁴  The dissent acknowledged the matter’s routine facts, which are typical of many similar cases. But, importantly, the dissent also contested the SEC’s position that the facts provided a sufficient basis for the SEC to bring an enforcement action.

The dissenting Commissioners began by noting that the offer and sale of KeyNFTs were not the sale of shares of a company, did not generate any type of dividend, and did not involve the type of promises on the part of Impact Theory traditionally present in Howey test analyses.

The dissenting Commissioners were sympathetic to the SEC’s concern that investors may buy into the “hype” of NFTs without a clear understanding of how to use or profit from such investment, but contended that such concern, though legitimate, does not “pull the matter into our jurisdiction.” The dissent further observed that even if the KeyNFTs are investment contracts under the Howey test, Impact Theory already proffered remedial efforts and as such should not be subject to an enforcement action.

The dissent concluded by positing several issues worthy of consideration before the SEC delves into matters relating to the offer and sale of NFTs. We highlight a few of these below and note that in making these observations, the dissenting Commissioners provide a helpful and potentially effective roadmap to push back on the SEC’s position on NFTs, should more enforcement actions be in the pipeline.

• Given the nebulous and difficult-to-define characteristics of NFTs as a group, are there useful ways for the SEC to categorize NFTs for purposes of contemplating whether and how the securities laws apply to their offers and sales?
• What regulatory frameworks, including existing cryptocurrency programs and ongoing legislative efforts regarding cryptocurrency, may be helpful to apply to NFTs?
• Does the Impact Theory enforcement action reflect a view that both current and prior NFT offerings and sales fall under the Howey analysis such that issuers of such offers and sales need to come into compliance with the position set forth in this action?
• What impact, if any, will undertakings to destroy NFTs or revise smart contracts have for future NFT cases?
• What is the status of secondary investments in NFTs that are said to be investment contracts? Do such secondary offerings also, by definition, constitute investments?

Takeaways

The Impact Theory action represents the first shot across the bow by the SEC regarding the world of NFTs. As the dissent highlighted, it also foreshadows that this action might be the SEC’s first move towards bringing NFTs into the larger fold of its digital asset enforcement policies. Should the SEC be setting its sights on NFTs more broadly, then it is reasonable to expect more enforcement actions against other varieties of NFTs both past and present.

As the SEC continues its march to gain increasing jurisdiction over the digital asset ecosystem, market participants are increasingly finding themselves in a position of having to make a difficult decision: Push back against the SEC’s theories of enforcement or fall into compliance. Pushing back can be done in two ways: Defend against an enforcement action brought by the SEC or initiate a pre-enforcement challenge in federal court that forces the SEC to defend its position and asks a neutral federal judge to endorse or reject the SEC’s theory of liability before the SEC brings an enforcement action.

Given the aggressive enforcement climate against digital assets, market participants and observers can expect that the SEC is likely not done with NFTs; instead, the SEC is likely to provide further guidance or other indications regarding its position on NFTs. Of course, entities considering whether to offer and sell NFTs should consider the costs associated with operating in a manner consistent with the Impact Theory order as well as the risks of not doing so. In addition, market participants that have already sold NFTs to investors should consult with counsel to determine the best path forward in light of the SEC’s order, including implementing remedial actions such as those undertaken by Impact Theory.

Footnotes

1. Impact Theory, LLC, Release No. 33-11226 (Aug. 28, 2023).
2. Press Release, SEC Charges LA-Based Media and Entertainment Co. Impact Theory for Unregistered Offering of NFTs (Aug 28, 2023).
3. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
4. NFTs & the SEC: Statement on Impact Theory, LLC, Hester M. Pierce and Mark. T Uyeda, (Aug 28, 2023).