The Nonfungible Token
A recent Bloomberg article reported that average prices for nonfungible tokens, or NFTs, are down approximately 70 percent from recent highs. NFTs are the latest innovation in digital assets and encompass digital representations of unique works of art, music, or other goods and experiences stored on blockchain. Unlike other digital assets such as bitcoin, in which each bitcoin is the same as every other one (and thus “fungible”), each NFT is theoretically unique and different from every other one (and thus “nonfungible”). A wide range of NFTs have begun to enter the marketplace over the past several months. A digital work of art represented by an NFT recently sold at auction for over $69 million, and even a professional sports league has begun to issue NFTs. A fascinating debate about the social and economic utility of NFTs has emerged, but what are some of the legal issues associated with this new digital asset class?
As with any digital asset, the analysis begins with the Howey test and the various factors the SEC considers in applying the test. Surprisingly, to date the SEC and its staff have said almost nothing publicly about the proliferation of NFTs and the agency’s position, but there are a number of similarities between the recent NFT proliferation and the past ICO craze, and it is probably only a matter of time before the agency brings its first enforcement case against an issuer of an NFT. As is always the case in applying Howey to a novel digital asset, the outcome is heavily dependent on the facts and circumstances surrounding its issuance and the intended use by the resulting digital ecosystem.
With NFTs, the Supreme Court’s opinion in Forman can be instructive. There, the Court held that when an asset’s primary purpose is a consumptive one, no security is present. Accordingly, to the extent an NFT is simply a digital representation of a real-world asset that would not ordinarily be considered a security (such as a song, photograph or unique work of art), the likelihood of finding an NFT to be a security is low. An NFT that represents the digital equivalent of a trading card would also seem to pose low risk. On the other hand, to the extent the NFT has attributes that the SEC has otherwise considered indicative of securities with respect to other digital assets—e.g., use for seed capital or other critical financing, widespread secondary trading, marketing or trading via crypto exchanges, or bulk presales at a discount—there is a greater likelihood that a security is present. Many NFTs incorporate multiple features, so one must balance Howey and Forman.
Some NFTs also incorporate a royalty mechanism for subsequent resales, which makes perfect sense in the case of a license of intellectual property. But there is also a risk that the SEC or a private plaintiff may characterize the royalty as interest and assert that the NFT is therefore more akin to a debt security, depending on the circumstances. Enterprises that regularly license their intellectual property in the ordinary course of business seem less at risk under this scenario than those that have never done so before issuing an NFT.
Even if an NFT is not a security, various other regulatory regimes may come into play. For example, the CFTC actively monitors the marketplace for non-security tokens and has frequently brought enforcement cases under its antifraud authority. The CFTC also recently brought its first market manipulation case involving digital assets, and it could apply the same principles to trading NFTs against those who seek to use non-market forces to influence NFT prices.
To the extent an issuer of an NFT accepts bitcoin or other virtual currency in payment, it must consider whether state or federal registration as a money transmitter or money service business is necessary. Even for entities not subject to these regulations, state and federal laws against money laundering may apply. Moreover, the Office of Foreign Asset Control has also begun to focus on digital assets and the possibility of specially designated nationals and blocked parties using transactions in digital assets to avoid US sanctions, bringing several recent enforcement cases. The Federal Trade Commission also polices the digital asset space for misleading marketing and potential pyramid scheme activity. As previously noted, the specific structure of the NFT could implicate other regulations as well.
If groups of purchasers pool funds to purchase one or more NFTs, one must apply the Howey test to the pooled investment vehicle, even if its underlying asset is not a security. Potential investment adviser and broker-dealer registration issues under SEC rules could arise whenever a private pool of capital is created. Likewise, the CFTC regulates commodity pool operators. Again, the specific features of the pooled investment vehicle will be determinative.
In sum, as with other digital assets, a wide range of legal issues can come into play depending on the structure of the asset and intent of the parties involved. A thorough analysis of those issues is warranted before issuance of any NFT.