Blockchain technology opened the world to a variety of new technological advances that reshaped the way humans interact and transact with one another. One of the most recent and trending applications of blockchain technology is non-fungible tokens or “NFTs.” NFTs are unique digital tokens encoded on a blockchain that represent ownership of specific digital assets such as artwork, collectibles, videos, domain names, and so forth.1 NFTs can be thought of as certificates of authenticity. Although NFTs resemble cryptocurrencies, NFTs are non-fungible. This means that no two tokens are identical, and they are not interchangeable with one another. They are valuable because each comes with a unique digital signature or ledger that allows it to be easily authenticated, verified, and transferred. This has completely revolutionized the way people trade different assets, and many NFTs are sold online for millions of dollars.2 Additionally, NFTs can come in different forms, ranging from whole NFTs of digital artwork or real property to fractionalized NFTs (“f-NFTs”) that break up ownership of an NFT into multiple “shards” so a larger number of people can own a piece of a single digital asset.3
NFTs are a new and influential technology that can have far-reaching implications for current securities law, intellectual property law, and other legal areas. In securities law, NFTs have established a new way for people to invest and gain returns from digital assets. This has disrupted the legal and financial sectors and created new risks for investors such as fraud and hacking.4 With the recent rise of NFTs as potential investment assets comes the possibility of government regulation to protect investors. The growing use of NFTs alerted many regulators, such as the Securities and Exchange Commission (“SEC”), to the possibility of regulating these digital assets as some type of security.5 However, regulatory and securities laws struggle to keep pace with emerging innovations and financial technologies like NFTs. Much of the SEC’s limited guidance focuses on cryptocurrencies and blockchain technology generally, with little guidance specifically on NFTs as a security. Leaders in the industry have requested no-action letters, although the SEC remains silent.6 Leaders believe “it would be a lot easier to operate in an environment where sensible ground rules are laid out that allow for innovation.”7 NFT creators, buyers, and exchange platforms must rely on general SEC regulations of other digital assets to guide their decision-making and avoid regulation. Given these issues, it is important for the SEC to provide guidance on NFTs to protect and inform potential investors, while also ensuring issuers can properly develop NFTs and NFT platforms without the fear of strict regulation.
This lack of guidance stems from the fact that many regulators are divided on whether NFTs can be classified as an “investment contract” security or regulated by the SEC. The Securities Act of 1933 defines a “security” as “any note, stock, . . . bond, debenture, . . . [or] investment contract.”8 In 1946, the U.S. Supreme Court developed a four-pronged test in SEC v. Howey to clarify whether an asset is an “investment contract” security.9 The Howey test holds that a contract, transaction, or scheme is an “investment contract” when an individual (1) makes an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit (4) derived from the efforts of others.10 While some argue that NFTs are not an “investment contract” security under the Howey test because they do not satisfy either the second or fourth prong, others believe that fractionalized NFTs could pass all four prongs.11 There has been little in-depth legal research and analysis that focuses specifically on f-NFTs as securities and the potential regulatory framework that could control this digital asset.12 The legal field must catch up with rapid technology developments and take a revised look at current regulations to see how they can be applied to NFTs. To analyze if the SEC can regulate NFTs, two main questions need to be addressed: (1) whether certain NFTs can be classified as a security under federal law; and (2) if NFTs are securities, how SEC requirements can be applied to best protect the public’s interests.
To answer these questions, this Note will apply the Howey test to f-NFTs and identify the risks and opportunities of regulating them as securities to better understand how to protect investors while also allowing for the innovation of digital assets. This Note will first conclude that NFTs can be “investment contract” securities and satisfy the four Howey prongs if they are fractionalized. First, when purchasing f-NFTs, buyers make an investment using digital currency that is considered “money.” Second, having an NFT tied to the success of a company or celebrity, or having multiple fractional interests in an NFT that are shared by a pool of investors, are investments in the “common enterprise” of that individual company, celebrity, or whole NFT. Third, f-NFTs have a “reasonable expectation of profit” given that they are easily traded on secondary markets and promoted as a unique way to “unlock liquidity.” Lastly, an f-NFT’s financial return can be derived from the efforts of platforms or issuers to maintain or improve the f-NFT market and support the popularity or price of the digital asset. This Note will then explain that even if f-NFTs are deemed securities, the SEC will need to adopt a clearer regulatory framework for f-NFT issuers, buyers, and platforms by modernizing established regimes of other digital assets. The SEC may have trouble regulating issuers or buyers of f-NFTs because the decentralized networks of f-NFTs already provide a form of digital “registration” that gives sufficient information to investors and prevents fraud through the easily verifiable digital ledgers of an f-NFT’s transactions. However, a platform that creates and trades f-NFTs may be a security “exchange” under federal law, and thus the SEC may be able to place some modified regulations on these f-NFT platforms, such as notice and disclosure requirements or compliance with capacity, integrity, and security standards, which ensure f-NFT and investor protection.
Part I provides a general overview of NFTs by explaining the blockchain technology that powers them. This Part illustrates what NFTs are, how they work, the concept of fractionalizing NFTs, and the principal applications and potential importance of NFTs in the financial markets. Part II lays out the underlying securities law—in particular SEC v. Howey—and the SEC’s current regulatory framework for other blockchain-based financial assets such as cryptocurrencies and digital tokens. Part III applies the Howey test to f-NFTs to show that they can be classified as securities and bolsters this argument by comparing f-NFTs to a digital asset (DAO Tokens) that the SEC has previously determined to be an “investment contract.” Part IV analyzes the pros and cons of regulating certain NFT issuers, buyers, or exchange platforms and provides recommendations for an NFT regulatory framework using comparisons to other developed digital asset platforms. Part V provides a preliminary exploration of existing regulatory models like those that govern traditional stocks and Real Estate Investment Trusts (“REITs”) and how they can be applied to f-NFTs.
I. NFT BACKGROUND: A TECHNICAL OVERVIEW OF NFTS
A. TECHNICAL ASPECTS OF NFTS
An NFT is a cryptographic unit of data or digital signature stored in a “blockchain” that represents the ownership of a unique digital asset or real-life object.13 Since they use blockchain technology, NFTs are typically bought and sold online with cryptocurrency.14 NFTs are similar to cryptocurrencies such as Bitcoin and Ethereum because they all use blockchain technology to create a digital object (currency or token) using units of data on a digital ledger. The only difference is that digital currencies are meant to be fungible, in that one Bitcoin is the same as and interchangeable with another Bitcoin, while an NFT is meant to be non-fungible, in that each one is one-of-a-kind and not exchangeable with another NFT.15 The underlying data of an NFT is unique because there can only be one owner, and that person is the only one who can access or transfer that NFT. This non-fungibility and use of blockchain allow NFTs to have a built-in proof of ownership that is easily authenticated, create exclusivity, and allow for verified transfers.
B. BLOCKCHAIN TECHNOLOGY
NFTs rely on blockchain technology, which creates a secure, decentralized network for transactions of various digital assets. The blockchain is essentially a “chain” of “blocks,” each containing specific information regarding a digital asset and its transactions that is then stored on a digital, secure, peer-to-peer ledger.16 An NFT is a digital database that stores data in the form of a “smart contract” and a unique identification hash bundled together in “blocks” that are all “chained” together in a distributed network. A smart contract is defined as “a computerized transaction protocol that executes terms of a contract” and is meant to minimize fraud and transaction costs.17 In other words, smart contracts are programs stored on a blockchain that automatically execute certain terms of a contract once certain predetermined conditions are met.18 Each blockchain “block” contains three components: (1) data, (2) the hash of the block, and (3) the hash from the previous block.19 The hash is a digitally generated string of digits and letters used to identify each block in a blockchain structure and acts as a type of unique fingerprint.20 The data for an NFT “block” includes a “smart contract” that points to where an NFT is located on the internet and how to retrieve it, dictates the terms of a transaction, provides a verification of ownership, and holds a ledger of the token’s ownership history and transaction record.21
FIGURE 1: NFT Blockchain Sequence Diagram
An issuer creates an NFT by deploying a code to develop a specific type of “smart contract” that contains a blockchain address, typically on the Ethereum Blockchain, where the smart contract resides.22 Later, when someone buys or sells an NFT, the blockchain automatically creates a new “block” and a new hash for this block to add this new transaction to the “chain.”23 The blockchain is essentially recording a “change of state” to the NFT in which the “smart contract” updates its internal ledger and changes the structure of the NFT’s underlying blockchain to reflect the transfer of the NFT to and from different addresses.24 In short, whenever an NFT is sold, this new ownership is noted as a “new block” in the blockchain ledger, and the digital hash of that NFT is changed.
When purchasing an NFT, you are only buying exclusive access to the unit of data that contains the NFT’s location and are relying on the issuer’s obligation to ensure authenticity.25 You do not gain any property rights of the actual digital asset, such as intellectual property rights (right to copy, right to destroy, and so forth.). Similar to buying a painting, when buying an NFT, you are only buying display rights or the right to say that you own it, but nothing else. You are mostly buying a digital certificate of ownership and authenticity or unique access to a digital object, not the actual digital object itself.26 In other words, you own the one-of-a-kind map of where the NFT is located and are the only one who has access to it. The underlying NFT is typically hosted or located on a regular Hypertext Transfer Protocol (“HTTP”) Uniform Resource Locator (“URL”) web address on the internet or on an InterPlanetary File System (“IPFS”) hash, which is a “system designed for hosting, storing, and accessing data in a decentralized manner.”27 Using a regular HTTP web address is typically very risky given that a server owner could easily change the underlying content of that particular address and completely erase the actual NFT content that was originally purchased.28 However, when housing an NFT on IPFS, the NFT gets assigned a unique content identifier (“CID”) hash that links to the data in the IPFS network.29 Using an IPFS CID hash, as opposed to an HTTP URL, allows someone to find the NFT based on its content rather than by its location on a server. Thus, if the content of the NFT is changed, the original CID link would break and create a new one.30
Even though NFTs only give a type of “bragging rights,” they provide various advantages that have changed the tech and financial markets. The benefits of an NFT are that it is easy to authenticate its originality, establish its exclusivity, and transfer the asset.31 The permanent digital ledger inherent in an NFT acts as a record of ownership and allows for easy traceability across the blockchain network so that the original creator or past owners can be easily traced through their past transactions.32 This has made NFTs a highly valuable avenue to establish verified ownership over assets such as digital artwork, digital trading cards, video highlight reels, social media posts, collectibles, and even real property.33 An NFT also has the unique capability to internally incorporate royalty agreements into its “smart contract,” where it automatically carries out an agreed-upon payment system whenever the NFT is licensed, resold, or used for some particular purpose.34 This has provided content creators with new ways to continuously and easily monetize their work through NFTs. Lastly, NFTs have created a new way for people to invest their money in digital assets. With billions of dollars recently being poured into the NFT market, many investors have flocked to these digital assets as a potential high-risk investment strategy.35 However, NFTs have become the target of some security breaches and hacking due to their novelty and outdated or inefficient security protocols.36 Additionally, the value of NFTs and their potential returns can be volatile and speculative because they are only worth as much as other people are willing to pay for them.37 An NFT’s appreciating value seems to be derived either from its creator or its scarcity.38 Thus, depending on these two factors, investors could either win the jackpot to resell their NFT for a large gain or end up with a worthless digital asset and a large loss.
C. FRACTIONALIZATION OF NFTS
One major innovation that has disrupted the way people view and use NFTs as investments is the concept of fractionalizing NFTs. Fractional NFTs, or “f-NFTs,” break an NFT into pieces, or “shards,” which can be subsequently traded and sold in the market at a lower price than the NFT as a whole.39 F-NFTs represent a fraction of the larger digital asset in which an investor can now share a partial interest in an NFT with other investors.40 Given that NFTs are routinely sold individually for thousands or millions of dollars, f-NFTs democratize these investments such that average investors can now purchase a smaller portion of a high-priced NFT.41 F-NFTs opened up access to NFT markets and allowed more people to invest in these new digital assets.
There are currently multiple platforms that facilitate the creation and trading of f-NFTs, such as Niftex, Fractional.art, and DAOfi. These f-NFT platforms allow owners to break NFTs into multiple shards and sell them at an initial fixed price.42 The shards can subsequently be traded in an open market on the platform. On Niftex, an f-NFT is created through a four-step process: (1) “Owners of NFTs create fractions (‘shards’) by choosing issuance and pricing”; (2) these fractions are then put on sale on the platform at a fixed price for two weeks or until they sell out; (3) once the fixed sale period ends, the fractions can be traded on a secondary market; and then (4) a whole NFT can be fully retrieved by purchasing all of the shards through the platform’s special “Buyout Clause.”43 This Buyout Clause is embedded within an f-NFT’s smart contract and gives f-NFT investors who own a particular percentage of an NFT’s shards the opportunity to purchase the remaining shards to now own the whole NFT.44 F-NFT platforms have also incorporated the ability to automatically give issuers a portion of the f-NFT created or to give some type of “curator fee.”45
NFT issuers and platforms have become very creative in the ways in which they utilize and develop this digital asset. One theory is that platforms could put numerous NFTs into one basket and sell f-NFTs of that basket as an investment product or security (“f-NFT bundles”).46 While some people do not think a traditional NFT could be a security, an f-NFT may be deemed a security under U.S. securities law. SEC Commissioner Hester Peirce warned issuers of f-NFTs that “the whole concept of an NFT is supposed to be non-fungible [meaning that] in general, it’s less likely to be a security,” but if issuers sell fractional interests in NFTs or NFT bundles, “you better be careful that you’re not creating something that’s an investment product—that is a security.”47 Peirce argued that “the definition of a security can be pretty broad,” and thus f-NFTs could fall within the SEC’s definition of a security and be subject to some form of regulation.48 With the high costs of a single NFT, the growing availability of blockchain platforms in the mainstream, and the large development of decentralized finance and decentralized applications, “the continued fractionalization of NFTs is almost inevitable.”49
II. LEGAL BACKGROUND: DEFINING “SECURITIES”
The main statutes governing securities regulation are the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). While the Securities Act mostly deals with the issuance of securities, the Exchange Act governs exchanges, brokers, and trading on secondary markets.50 Together, these statutes establish a registration and disclosure regime that requires any offer or sale of securities to register with the SEC and any issuers of securities to provide accurate and complete disclosures of material information regarding their securities offering or company. These requirements provide key information to investors so that they can make the most informed decisions. The consequences of being subject to these registration and disclosure requirements include filing documents with the SEC any time you sell securities, such as a Form S-1 registration statement, and filing continuous, periodic reports regarding the company’s business operations and financials, such as Form 10-K, Form 10-Q, or Form 8-K.51 These statutes, along with regulatory rules, provide definitions and tests to help determine whether an asset is a “security” or an organization is an “exchange” that is subject to federal regulation.
A. SECURITIES ACT OF 1933
The Securities Act makes it illegal for an issuer to offer or sell any unregistered security within interstate commerce unless the security is exempt from registration.52 This statute defines an “issuer” as “every person who issues or proposed to issue any security,” where “person” includes “an individual, a corporation, . . . [or] any unincorporated organization.”53 It also provides a broad definition of different types of assets that could be considered securities under U.S. federal securities law.54 This definition specifically includes “investment contracts,” which can be seen as a catch-all term for any type of asset that behaves and feels like a security. Thus, it is sometimes difficult to determine if something falls within the definition of a security.
B. SEC V. HOWEY
In SEC v. Howey, the U.S. Supreme Court created the Howey test to help clarify what an “investment contract” security is under the Securities Act. The defendant, W.J. Howey Company, sold real estate contracts for orange groves in Florida for a fixed price per acre.55 Howey then encouraged purchasers to set up service contracts in which they would lease the land back to the company to farm the orange groves, and in exchange the buyers would receive a share of the profits.56 The Supreme Court held that these orange grove service contracts were “securities,” because purchasers were buying shares in Howey’s profits from the orange groves through these service contracts, not the actual orange groves themselves.57 The Court developed a four-pronged test in which “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”58 There have since been a variety of cases that helped develop and clarify each of the four Howey prongs. The first prong of “an investment in money” does not need to be in the form of cash and can be satisfied using a different form of contribution or investment, such as cryptocurrency.59
The second prong of “in a common enterprise” requires that the fortunes of the investor be linked to the success of the overall venture or enterprise. “Fortunes” refers to the “profits” (and benefits) or “losses” (and costs) that occur from a certain asset and that affect a person’s position.60 There needs to be a kind of commonality or relationship, either among investors or between the “promoter” and investors, in which the investor depends on the actions and decisions of the promoter of the asset.61 A promoter is defined as any individual or organization that helps found and organize the business or enterprise of an issuer of any security or that receives ten percent or more of any class of the issuers securities or proceeds from the sale of such securities as consideration for their services or property.62 Federal courts have typically required that there be either “horizontal commonality” or “vertical commonality” for an asset to satisfy the “common enterprise” prong.63 Horizontal commonality is defined as the relationship between investors and a pool of other investors. There is commonality when an individual investor’s fortunes are tied to the fortunes of other investors in a common venture by the pooling of assets, usually combined with the
pro-rata distribution of profits.64 Vertical commonality is defined as the relationship between the promoter and the body of investors.65 Commonality exists when there is a connection between the fortunes (strict vertical commonality) or efforts (broad vertical commonality) of the promoter and the fortunes or efforts of the investors. This type of commonality does not require a pooling of funds.66
The third prong of “a reasonable expectation of profits” requires investors to realize some form of appreciation on the development of the asset or participate in the earnings resulting from the use of investors’ funds.67 The SEC defines “profits” as “capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds.”68 Courts also include “dividends, other periodic payments, or the increased value of the investment” in the definition of profits.69 However, the SEC notes that “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.”70 This prong is very fact-sensitive, and the SEC looks at several factors, like the trading of the asset on secondary markets, identity of the buyers, and marketing efforts, to determine whether an asset satisfies this prong.71
Finally, the fourth prong of “from the efforts of others” is satisfied when the promoter or issuer of an investment creates or supports the market for these assets or the value of the asset is dependent on the promoter’s efforts in generating demand.72 In Howey, the Supreme Court understood that the Securities Act’s definition of a “security” is broad, so it argued that “[f]orm was disregarded for substance and emphasis was placed upon economic reality.”73 Thus, when determining whether something can be considered a security, one needs to focus on the specific circumstances, facts, and economic impact of the particular asset.74 For an asset such as digital currencies or tokens, this test may consider factors such as the token’s design, issuance, and how it interacts with its platform or blockchain. Depending on how an NFT is created, structured, marketed, and sold or distributed, such NFTs could be deemed securities. This would mean that any sale of this NFT would be subject to the existing securities law framework.
C. CURRENT CASE LAW
D. SECURITIES EXCHANGE ACT OF 1934
Once an asset is deemed a “security,” the SEC and the Exchange Act impose numerous regulatory requirements on the “exchanges” or platforms that facilitate the trading of those assets. Section 5 of the Exchange Act makes it unlawful for any broker, dealer, or exchange to effect any transaction in a security unless the exchange is registered as a national securities exchange under section 6 of the Exchange Act or an appropriate exemption applies.82 Registration as a national securities exchange requires any person or entity that offers or sells securities to the public to provide “full and fair disclosure” through the delivery of a statutory prospectus that contains information necessary to give prospective purchasers the proper opportunity to make an informed investment decision.83 Under the Exchange Act, an “exchange” is defined as any organization or group of persons (whether incorporated or unincorporated) that maintains or provides “a market place or facilities for bringing together purchasers and sellers of securities” or conducts functions commonly performed by stock exchanges.84 The Code of Federal Regulations attempts to clarify when an entity must register as a national security exchange and provides a functional test to assess whether an entity meets the definition of an “exchange” under the Exchange Act. Rule 3b-16(a) states that an organization, association, or group of persons is considered to constitute or maintain an “exchange” if it (1) “brings together the orders for securities of multiple buyers and sellers” and (2) “uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other.”85 Rule 3b-16(b) then lays out what is excluded from the definition of an exchange.86 The SEC has argued that when analyzing whether a “system operates as a marketplace and meets the criteria of an exchange under Rule 3b-16(a),” one must look to “the activity that actually occurs between the buyers and sellers—and not the kind of technology or the terminology used by the entity operating or promoting the system.”87 Thus, any trading system that meets the definition of an exchange under
Rule 3b-16(a), and is not excluded under Rule 3b-16(b), must register as a national securities exchange or operate pursuant to an appropriate exemption.88
Exempted entities do not need to register as a national securities exchange under section 6.89 Rule 3a-1-1(a)(2) states that an organization, association, or group of persons is exempt from the definition of “exchange” if it is operating as an alternative trading system (“ATS”) and is in compliance with Regulation ATS.90 ATSs are SEC-regulated electronic trading systems that utilize the process of “dark pools” to match orders for buyers and sellers of securities.91 The SEC released a report regarding its adoption of new rules and amendments that allow ATSs to “choose whether to register as national securities exchanges, or to register as broker-dealers and comply with additional requirements under Regulation ATS, depending on their activities and trading volume.”92 ATSs typically face fewer and simpler regulations than national securities exchanges but still have some requirements, such as registering as a broker-dealer, giving notice of initial operations or material changes, providing fair access, keeping records, complying with capacity, integrity, and security standards, and other reporting requirements to safeguarding customer funds and securities.93
E. RULES, REGULATIONS, AND GUIDANCE FROM AGENCIES
In addition to statutes, issuers and platforms of digital assets also rely on statements, reports, and frameworks from the SEC and other regulatory bodies to guide their decisions. As digital assets grew in popularity, the SEC took notice and came out with formal and informal statements regarding its views on cryptocurrencies and tokens. In 2018, SEC Chairman Jay Clayton testified before a Senate committee arguing that cryptocurrencies could be structured as securities products subject to federal securities laws and warned that certain Initial Coin Offerings (“ICO”) structures could implicate securities registration requirements.94 More recently, at the Security Token Summit 2021, Peirce warned issuers of NFTs to be cautious when they create f-NFTs because when used in certain creative ways, they could create a security that is subject to regulation.95
The SEC created a branch in 2018 called the Strategic Hub for Innovation and Financial Technology (“FinHub”) to coordinate and respond to emerging financial technology (“fintech”); serve as a public resource by consolidating, clarifying, and communicating the SEC’s views and actions related to fintech innovation; and inform policy research in these areas.96 In 2019, FinHub published an SEC document called Framework for ‘Investment Contract’ Analysis of Digital Asset, which provided details on how the SEC applies the Howey Test to analyze whether digital assets could be considered an “investment contract” security.97 This is one of the few documents available to guide digital asset creators and platforms.
Although guidance from the SEC regarding digital assets is sparse, there is some case law and reports from the SEC. For example, the SEC issued an enforcement order against the creator of EtherDelta, which provides a marketplace for bringing together buyers and sellers of digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain.98 This case held that EtherDelta violated section 5 of the Exchange Act because it issued digital asset securities using blockchain technology as an unregistered exchange.99 This is one of the main cases analyzing whether a platform that houses digital assets can be an unregistered security exchange. Other regulatory bodies have provided reports of their research into the intersection of digital assets and securities law. For example, the Congressional Research Service (“CRS”) published a report containing a broad outline of how federal securities laws and regulations apply to cryptocurrencies, ICOs, and NFTs.100
The SEC also published the Decentralized Autonomous Organization (“DAO”) Report, which discusses U.S. federal securities laws and their applicability to the new paradigm of “virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities.”101 The purpose of this report of investigation is to “advise those who would use a [‘DAO Entity’], or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”102 Slock.it created The DAO, which is a “for-profit entity whose objective was to fund projects in exchange for a return on investment.”103 DAO Tokens represented a type of “crowdfunding contract” that would help raise “funds to grow [a] company in the crypto space.”104 The DAO offered and sold DAO Tokens in exchange for Ether (“ETH”), a virtual currency used on the Ethereum Blockchain, and the proceeds from these sales were used to fund projects.105 DAO Token holders had the right to vote on these projects and were entitled to any anticipated earnings from the projects it funded.106 The DAO platform also had a group of individuals called “Curators” who were given “considerable power” to perform “crucial security functions” and maintain “ultimate control over what projects would be submitted to, voted on, and funded by The DAO.”107 In applying the Howey test to the DAO Token, the SEC’s DAO report found that the tokens meet the criteria of a security and The DAO was required to register as an exchange under Rule 3b-16.108
Even though there is some guidance for blockchain technologies generally, the SEC has not yet provided any guidance regarding NFTs specifically. Given this small amount of advice, many people have requested that the SEC provide regulatory clarity with respect to NFTs so that they know how to proceed.109 These requests for guidance come in the form of “no-action” letter requests that encourage “the SEC to engage in a meaningful discussion of how to regulate FinTech companies and individuals that are creating NFTs that may be deemed digital asset securities and the platforms that facilitate the issuance and trading of NFTs.”110 The existing securities framework provides a “crude mechanism” for regulating NFTs, and the SEC needs to reevaluate or reapply these old frameworks to new financial technologies to establish sustainable guidance and prevent NFTs from becoming the “Wild West” of digital investments.111
III. HOWEY TEST: ARE F-NFTS SECURITIES?
Although there are few articles or regulations specifically addressing NFTs, the current view is that NFTs may not be an “investment contract” security that can be regulated by the SEC because an NFT may gain its value through its uniqueness, as opposed to “a common enterprise” (second Howey prong), and any profits realized through an NFT may be derived from regular supply and demand, as opposed to the “efforts of others” (fourth Howey prong).112 However, to determine an NFT’s ability to be categorized as a security, regulators need to focus on the “economic reality” and specific circumstances, such as how society defines the NFT’s value, how it is utilized, or how it is marketed. On one hand, if the purchaser is a collector and the NFT’s value comes from its uniqueness and artistry, the main purpose of buying the asset is to “consume” it by enjoying its aesthetics; the NFT may also be marketed as allowing buyers to join the ranks of premier owners and connoisseurs of unique digital objects. In such a scenario, an NFT is less likely to be a security. For example, some people may buy a Pudgy Penguins NFT from OpenSea (an NFT exchange website) because they think it is adorable and just want to look at it or display it as a profile picture on social media.113 On the other hand, if the purchaser is an investor and the NFT’s value comes from its ability to gain a return on investment, the main purpose of buying the asset is to sell it later for a profit; or if it is marketed as an asset that will appreciate in value to give a substantial return, then an NFT is more likely to be security. Some purchasers’ main goal in buying a Pudgy Penguin may be to increase their capital.114 In the end, NFTs may gain value from both their uniqueness and their ability to provide a return on investment.
Another prevailing view is that fractionalizing NFTs could create a type of security that is subject to regulation.115 F-NFTs could be an investment contract under the Howey test depending on the facts and circumstances of the particular f-NFT, such as if you put multiple NFTs into one basket and then sell f-NFTs out of that basket.116 Although the SEC has yet to initiate any enforcement action against creators or platforms that facilitate the offer and sale of f-NFTs, the SEC and courts have held in many cases that fractional interests in an asset can be a security even if the individual asset itself is not.117 This Part applies the four prongs of the Howey test to analyze whether an f-NFT can be an “investment contract” security and compares
f-NFTs to the DAO Token, which has already been deemed a security.
A. “MAKES AN INVESTMENT IN MONEY”
F-NFTs most likely satisfy the first prong of the Howey test given that people buy f-NFTs using cryptocurrency. The SEC argues that most digital assets, such as f-NFTs, pass the first Howey prong because they are purchased through an exchange for value.118 It does not matter that this exchange for value is in the form of digital currency such as cryptocurrency. Courts have held that an “investment of money” does not need to be in the form of cash, and thus purchasing something with cryptocurrency, as is the case with NFTs or f-NFTs, would satisfy this definition.119 When comparing f-NFTs to the DAO Token, both of these digital assets make an “investment in money” because both purchasers of the DAO Token and f-NFTs use ETH, the digital currency used on the Ethereum blockchain, to buy their respective digital assets.
B. “IN A COMMON ENTERPRISE”
A traditional NFT may not pass this second Howey prong because its value stems from its uniqueness—not a common enterprise—and there may not be a relationship between the seller or promoter of an NFT and a buyer or investors in that NFT. However, the SEC’s FinHub stated that a “common enterprise” typically exists for investments in digital assets because the fortunes of individual purchasers of digital assets are tied to other investors or tied to the success of the promoter’s efforts to expand a digital asset platform.120 Also, courts have determined that the “common enterprise” prong is a distinct element of an investment contract analysis and “does not require vertical or horizontal commonality per se.”121 Thus, there are some arguments that f-NFTs may pass the second prong and have a common enterprise.
Horizontal commonality can be shown for f-NFTs through the fact that if a person owns a partial ownership interest in an underlying NFT, the value of this shard is tied to the fortunes of all the owners of the other shards of that fractionalized NFT.122 If the value of the underlying NFT increases, the value of each of its shards also increases. Thus, a common enterprise can be found through the relationship between an investor of an f-NFT and the pool of other investors who share ownership of the same fractionalized NFT. One of the very reasons to fractionalize an NFT is to enable smaller investors to “pool resources” together to purchase a smaller interest in an NFT and share in the returns of the whole NFT.123 This is similar to the investors in the DAO Token who pooled together ETH to help The DAO fund large projects with the hope of a return on their investments.124 Both the DAO Token and f-NFTs can satisfy horizontal commonality by pooling investors’ assets and tying their interests together. Also, an NFT can be part of a series of similar NFTs, like a collection of artworks by the same person, where the value of one will rise and fall along with the value of the others in the series.125 The fortune of one NFT investor in the series may be tied to the increase and decrease in fortune of the other NFT investors in the same collection.
F-NFTs may also satisfy the vertical commonality requirement, given the relationship between the original issuer of the f-NFTs (promoter) and all the purchasers of the f-NFTs (body of investors). A common enterprise exists under broad vertical commonality when the investors are dependent on the promoter’s efforts or expertise for their increased returns.126 For f-NFTs, a common enterprise may exist because the success of f-NFT investors gaining returns is dependent on f-NFT companies making the effort to fractionalize or bundle different NFTs and maintain the platform to protect f-NFTs and keep trading running. Additionally, strict vertical commonality can be established if f-NFT platforms gain some type of fee percentage from their efforts in fractionalizing and selling f-NFTs. Thus, if f-NFT platforms actively manage or charge fees for handling these assets, then the fortunes of f-NFT platforms are connected to the fortunes of the f-NFT investors. When f-NFT investors succeed, so does the f-NFT company.
Even certain, whole NFTs may pass the vertical commonality test. For example, many college and professional athletes have been creating NFTs of themselves through digital artwork, highlight reels, and other digital assets.127 These NFTs may satisfy the “common enterprise” requirement because the value of the NFT would depend on the rise and fall of the athlete’s career and how much effort that athlete put into increasing their popularity. If the particular athlete who is issuing an NFT does better professionally in their sport or increases in popularity, then the value of their NFT may also increase. In other words, the fortunes of the owners of the athlete’s NFT would increase in correlation with the fortunes or the career of the athlete also increasing. The same argument can also be made for NFTs from specific artists or celebrities, such as Beeple or Martha Stewart.128 Investors of Beeple’s NFTs have their fortunes tied to the efforts of Beeple and his other artworks. The value of an investor’s Beeple NFT will benefit from Beeple and his other artwork becoming more popular or valuable. Thus, there are good arguments that f-NFTs fulfill the second Howey prong.
C. “WITH A REASONABLE EXPECTATION OF PROFIT”
F-NFTs can satisfy the third Howey prong if purchasers buy f-NFTs with the expectation that they will realize some type of gain or profit. Given that this prong is heavily fact–sensitive, the SEC provided a list of characteristics that make it more likely for a digital asset to fulfill the “reasonable expectation of profits” prong.129 F-NFTs seem to satisfy three of the characteristics listed: (1) the digital asset is “transferable or traded on or through a secondary market or platform,” (2) the issuer continuously “expend[s] funds from proceeds or operations to enhance the functionality or value of the network or digital asset,” and (3) the digital asset is marketed or promoted in a way that would cause a purchaser to have an expectation of profits. To determine whether an f-NFT can be classified as a security under this prong, one needs to focus on the transaction itself and the way the digital asset is offered and sold.130
The first characteristic that increases the likelihood of f-NFTs fulfilling the third Howey prong is the fact that investors can transfer or trade these assets on secondary markets or online blockchain platforms.131 The ability to sell or buy NFTs or f-NFTs on secondary markets such as OpenSea provides proof that the investor may expect to realize some type of return or appreciation on the digital asset through secondary trading. This is much like how DAO Token holders were able to monetize their investments in DAO Tokens by reselling and trading them on various secondary trading platforms and markets.132
The second characteristic that leans in favor of f-NFTs satisfying the third prong is the fact that f-NFT platforms may “provide essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts.”133 The more likely that f-NFT issuers made efforts to increase the demand or value of the digital asset, the more likely the f-NFT will have a “reasonable expectation of profits.” Different cases have clarified that efforts to “increase the demand or value” include when issuers or platforms (1) create and manage an “ecosystem” for the digital asset which allows them to increase in value, (2) develop the network to inspire creative uses of its assets, or (3) add a new functionality using the proceeds from the token’s sales.134 First, f-NFT platforms like Fractional.art and Nitfex made “essential managerial efforts” to increase demand or value of f-NFTs by taking continuous, active steps to fractionalize NFTs and make them more accessible to more investors. This created a new ecosystem where average investors could pool their funds together to share in the gains of valuable NFTs. Second, fractionalization networks inspired new creative uses such as bundling various NFTs together and selling f-NFTs of this bundle. The value of these f-NFTs would be dependent on the values of all the individual NFTs that the issuer chooses to place in the basket. Lastly, f-NFT platforms created a new functionality for NFTs by adding the ability to fractionalize one NFT into multiple shards. This allows purchasers to buy smaller interests in many different NFTs to diversify their collection, thus minimizing the volatility of this digital asset and increasing the potential returns.
This view of f-NFTs can be compared to the DAO Token that satisfied the third Howey prong because the proceeds from selling the DAO Tokens were used to fund different proposed projects in which holders had the potential to gain a share of the profits from these projects.135 Also, much like how f-NFT platforms have created an ecosystem for the fractionalized assets, The DAO created a type of ecosystem for its “crowdfunding contracts.” While one may argue that f-NFT platforms are not using the proceeds from selling their tokens to directly improve their network, another may argue that f-NFT platforms collect fees from transactions that occur on their platform and then use these fees to maintain a secure network for f-NFT purchasers. Thus, this characteristic may depend on how the specific f-NFT platform is managed.
The third characteristic that makes f-NFTs more likely to provide a “reasonable expectation of profit” is the way in which f-NFTs are marketed to potential buyers. The SEC provided a list of ways a digital asset could be marketed that weigh in favor of the third Howey prong. F-NFTs may satisfy four of these methods: (1) the “intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset”; (2) a key selling feature of f-NFTs is the ability to readily transfer it; (3) “[t]he potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials”; or (4) there is an available market for trading the digital asset or the issuer promises to create or support a trading market.136 F-NFTs can satisfy these marketing characteristics, and many of them are also found in the DAO Token.
First, although current f-NFT platforms do not directly market that proceeds from f-NFT sales will be used to develop the network, one can assume that these platforms use the fees they collect from sales to maintain the network and allow for continuous fractionalization of NFTs. Second, the fact that f-NFTs are marketed as being easily transferable on platforms such as Niftex, Fractional.art, or DAOfi lean in favor of there being an “expectation of profit.”137 This is similar to the DAO Token, which was promoted as being readily available to buy and sell on “a number of web-based platforms that supported secondary trading.”138 Third, certain f-NFT platforms emphasize that these assets are a unique and better way to unlock liquidity, gain greater exposure and price discovery for your NFTs as fractions on the open market, trade NFTs with lower cost and greater diversification, get access to a variety of unique and iconic digital assets with low price thresholds, or provide liquidity for shard markets and earn transaction or curator fees.139 These platforms focus on f-NFTs’ ability to increase exposure of a particular NFT in a market and diversify one’s investments in NFTs to spread out the risk of a single NFT losing value. Increased exposure and diversification can increase an f-NFT’s profitability, and a platform’s emphasis on this promotes an f-NFT’s appreciation in value. However, f-NFTs may simply be marketed as an easier, more accessible way for the average investor to partake in the NFT market.140 If this is the case, it is less likely that f-NFTs satisfy the third Howey prong. The DAO platform emphasized its potential profitability by marketing it as an investment where purchasers could share in the profits of the proposed projects the DAO Token funded and thus gain a return on their initial investment.141 Although this is not exactly similar to how f-NFTs’ profitability were marketed, both seem to promise their purchaser some type of liquidity. Fourth, f-NFT platforms provide a readily available market for the trading of various f-NFTs. Creators or purchasers of f-NFTs can easily sell or buy these assets on different websites. These platforms support an f-NFT trading market by providing information regarding how the platform and fractionalization process operates and how the underlying technology works, a “frequently asked questions” section, a link to create or buy and sell f-NFTs, ways to “join the community,” and so forth.142 This is similar to the DAO Token issuers who supported a trading market for their token by developing a website, a link to detailed information regarding The DAO entity’s structure and source code, and a link to buy DAO Tokens; providing information on how The DAO operated; soliciting media attention; and posting on online forums.143
A counterargument is that traditional NFTs are less likely to be a security because purchasers of traditional NFTs buy them for their artistry or bragging rights, proving that NFTs gain their value from their uniqueness, scarcity, or collectable status—not from any expected profits. An NFT’s value may just be based on the normal market forces of supply and demand, which is not considered “profit.”144 The SEC also notes that digital assets are less likely to satisfy the Howey test if “[a]ny economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.”145 The intended functionality of an NFT may just be bragging rights or display rights, such as displaying a rare NFT artwork as your profile picture on your social media account. Thus, when an NFT increases in value, this may just be incidental to using the asset for its intended functionality of bragging rights. Also, if an f-NFT is marketed in a way that focuses on its role as a piece of digital artwork or a collectible, and not as an opportunity to gain any returns, this may work against f-NFTs being a security.146 For example, some platforms market f-NFTs as a way to create more accessibility to the NFT market and not necessarily as a way to increase one’s returns.147 Regulators will need to analyze the specific characteristics of certain f-NFTs and f-NFT platforms to determine whether they satisfy the third Howey prong.
D. “THROUGH THE EFFORTS OF OTHERS”
Some argue that although an NFT may provide the purchaser with a reasonable expectation of profits, this increase in financial returns is not derived from the “efforts of others” and instead comes from the NFT’s own scarcity and uniqueness. Thus, it may be more difficult to argue that an NFT satisfies the fourth and final Howey prong, which requires the asset’s increase in value to come from the “efforts of others.” While a traditional NFT may not fulfill this prong given that its value comes from its uniqueness, an f-NFT may be an exception because its value is derived from the efforts of the f-NFT platforms or issuers who support the f-NFT market. The fourth Howey prong is satisfied if an f-NFT issuer supports a market for f-NFTs or the value of these assets depend on the issuer’s efforts in generating demand.148 Thus, if an NFT issuer or exchange puts in the work to develop the platform and increase buyers, and the purchasers reasonably expect a return based on this work, then an NFT may pass this last prong.
The SEC Framework for “Investment Contract” Analysis of Digital Assets lays out two key questions to consider when determining whether a digital asset can satisfy the “efforts of others” prong: (1) does the purchaser reasonably expect to rely on the efforts of an “Active Participant,” and (2) are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”?149 To help answer these questions, the SEC provided a list of six characteristics that lean in favor of a digital asset fulfilling the fourth Howey prong. While none of the characteristics are dispositive, they provide a good framework to help determine when a digital asset gains its value through the “efforts of others.” F-NFTs may satisfy some of the characteristics and thus satisfy the last Howey prong.
The first characteristic is that an issuer is “responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an [issuer] to be performing or overseeing tasks.”150 Platforms that issue f-NFTs may have this characteristic because they are responsible for promoting the f-NFTs on their platforms, bringing more buyers onto their networks, and improving their networks by offering more products such as f-NFT bundles or automatic royalties embedded in smart contracts.151 These development efforts can increase the value of the actual platform and thus increase the value of the f-NFTs traded on that specific platform. Also, if a platform markets f-NFTs as producing profit based on royalty payments or f-NFT bundles, purchasers may expect that the issuers are putting in some type of managerial efforts to oversee the asset and increase its value. The value of an f-NFT could come from the efforts of a person or entity promoting, selling, choosing, developing, and managing different f-NFT royalties or bundles. This is similar to the DAO Token Curators who managed different projects for investors to create returns by deciding what projects would be submitted to, voted on, and funded by DAO Token holders.152 DAO investors relied on the “managerial and entrepreneurial efforts” of the Curators to manage The DAO network and project proposals because the creators of The DAO represented that they “could be relied on to provide the significant managerial efforts required to make The DAO a success.”153
The second characteristic is that the issuer performs essential tasks or responsibilities, as opposed to “an unaffiliated, dispersed community of network users (commonly known as a ‘decentralized’ network).”154 This reference to a “decentralized” network may work against f-NFTs being deemed a security because they are inherently run on a “decentralized” network. One can argue that the blockchain technology, smart contracts, and digital ledger perform the “essential tasks or responsibilities” for f-NFTs as opposed to the issuer or platform. However, the DAO Token was still deemed a security even though it utilized blockchain technology, and smart contracts performed tasks for the usage of the DAO Tokens.155 Although
f-NFTs are run on a “decentralized” network, issuers can perform essential tasks such as fractionalizing NFTs, using their expertise to bundle NFTs, or maintaining the network to ensure the f-NFTs are protected.
The third characteristic is that an issuer “creates or supports a market for, or the price of, the digital asset,” which can include (1) “control[ing] the creation and issuance of the digital asset,” or (2) “tak[ing] other actions to support a market price of the asset, such as by limiting supply or ensuring scarcity” through activities like buybacks.156 Issuers of f-NFTs, such as Niftex and Fractional.art, may embody this characteristic because issuers set the original fixed price of an f-NFT when they initially fractionalize an NFT, and many f-NFT platforms have some type of “buyout” provision which lets f-NFT investors purchase the remaining shards to gain ownership of the full NFT.157 This buyout provision is similar to a buyback because the original f-NFT issuer can buy back the whole NFT, which can subsequently support a market price of the f-NFTs. Also, as more NFTs are bought and sold on a platform, the rarity and scarcity of a specific NFT may increase, which then affects the price of that NFT.158 Thus, if f-NFT platforms support the growth of their platforms to include more f-NFTs or other products, then these platforms can create a market for and support the price of f-NFTs. A counter argument is that an NFT’s lack of exchangeability with other NFTs impedes its ability to be classified as a security. Traditional securities increase their value from price fluctuation and exchangeability, but due to its uniqueness, an NFT only increases its value through profit increases and not exchangeability.159 This issue may be limited with f-NFTs, whose value is tied to other types of price fluctuations.
The fourth characteristic is that the issuer has a “lead or central role in the direction of the ongoing development of the network or the digital asset.”160 By simply maintaining the f-NFT network, these platforms are providing an active management role that contributes to the development and stability of f-NFTs and f-NFT networks. Since the actual NFT is typically hosted on external URLs or IPFS, some caution that NFT networks must be maintained to ensure that NFTs sold on the platform do not disappear, buyers do not lose their purchases, and NFTs do not lose their value. This dynamic can create a system in which “the value of the art is tethered to the value of the platform hosting it.”161 The managerial efforts of the NFT platforms would be directly tied to the value of the NFTs because if the NFT platforms are not run properly or are shut down, the value of the NFTs decreases or disappears altogether. An issuer can also take a lead role in continuously developing f-NFTs if the issuer is an artist, athlete, celebrity, or company, and the value of their f-NFT is tied to that specific issuer’s popularity or the efforts they undertake to grow their popularity. When buying an f-NFT, you are not buying the underlying artwork but instead are purchasing the right to gain profits from the increased popularity of the creator, whether it be an artist like Beeple or an athlete like Patrick Mahomes.162 People may invest in NFTs with the hope that the creator increases in fame, which can then increase the profits from the particular NFT. For example, many college athletes are creating their own NFTs, and as an athlete’s career progresses to professional sports, the value of that NFT could exponentially increase.163 NFTs issued by corporations or influential public figures may also satisfy the “efforts of others” prong. For example, Nike recently announced its plan to sell “digital shoes,” which resemble an NFT for its iconic shoes; Martha Stewart also created an NFT collection consisting of digital art of her home décor.164 Nike and Martha Stewart may have a central role in the ongoing development of their respective NFTs because as they put in effort to continuously grow the popularity and profitability of their brand, their NFTs may also grow in value. If an NFT is tied to a specific company or person, the NFT’s value relies on the efforts of that issuer to increase their popularity, which will in turn help develop the underlying NFT.
The fifth characteristic is that the issuer has “a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents.”165 Some examples of what constitutes a “managerial role” include: “determining whether and where the digital asset will trade,” having “responsibility for the ongoing security of the network,” and “making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally.”166 The DAO Curators had a large managerial role over the DAO Token—and its potential value—because investors relied on the Curators’ expertise to monitor the operation of The DAO, safeguard their funds, and determine when proposed contracts should be put to a vote to fund projects.167 F-NFT platforms may serve this “managerial role” through providing ongoing security for the network. For example, f-NFT platforms must manage their networks to prevent any hacking attempts or fraud that could steal funds during an NFT transaction or destroy the linkage to the underlying NFT.168 This is similar to how The DAO and its Curators were relied on for “failsafe protection” and for protecting the system from “malicous [sic] actors.”169 Current f-NFT platforms have yet to show how their managerial decisions can significantly impact the success of f-NFTs, given that they do not have Curator-type workers who actively control f-NFTs. However, if f-NFT platforms sold
f-NFT bundles, investors would have to rely on the platform’s judgment for what types of NFTs were being pooled together in a bundle and sold as
f-NFTs. The platform’s expertise may then affect the value of the f-NFT bundle, and it would be more likely that f-NFTs had continuous management from others.
The sixth characteristic is that “[p]urchasers would reasonably expect the [issuer] to undertake efforts to promote its own interests and enhance the value of the network or digital asset” where the issuer has a stake in the digital asset and can realize its own gain from the digital asset or monetize the value of the digital asset.170 Issuers or creators of f-NFTs may satisfy this characteristic because they can program a smart contract to automatically charge a type of royalty or curator fee any time an f-NFT is resold or used in a specific way.171 This enables the issuer to monetize the value of the digital asset and promote its own interests in the digital asset. Some platforms such as Niftex have also automatically programmed their f-NFT smart contracts to set aside five percent of an NFT’s fractions for the artist.172 In this system, instead of the creator taking a cut every time a fraction is traded on the open market, they now get to share in the profits of just owning some of the shards. It seems that f-NFT issuers may promote their own interests and enhance the value of the digital asset, because the higher the value of the asset, the more money they can make off their own shards.
Whether or not f-NFTs satisfy the fourth Howey prong will once again come down to the specific facts of how the f-NFT is marketed to purchasers and the specific platform or issuer. However, given the various SEC characteristics taken together and their application to f-NFTs, there may be a good argument that f-NFTs can gain their value from the “efforts of others.” After analyzing f-NFTs under the four Howey prongs and comparing them to other established digital asset securities, f-NFTs can be considered securities.
IV. HOW CAN NFTS BE REGULATED?
Even if f-NFTs can satisfy all the Howey prongs and be classified as a security, the question still remains whether the SEC should regulate these digital assets and what regulatory framework should be adopted. The SEC cautioned that as financial technologies continue to innovate, there is a possibility that market participants (such as f-NFT buyers, sellers, and platforms) may be conducting activities that fall within the SEC’s jurisdiction in which their transactions, persons, or entities may be subject to registration, regulation, or oversight.173 The SEC can regulate three different types of actors: (1) buyers of a security, (2) sellers or issuers of a security, and (3) platforms facilitating exchanges.174 If designated as a security, buyers, sellers, or platforms of f-NFTs sold without registration may be subject to penalties, registration requirements, or filing periodic reports with the SEC.175
The SEC needs to discover what types of regulations it can impose on buyers, sellers, and platforms of f-NFTs. This Part analyzes the risks and opportunities of regulating f-NFTs under the existing regulatory framework and how regulations can be applied to the three different actors within the NFT space to recommend a new, modified framework better suited for this digital asset.
A. REGULATION OF BUYERS
The SEC regulates buyers of securities by only allowing certain “accredited investors” to purchase unregistered securities, which typically are subject to fewer requirements and regulations.176 SEC Regulation D (“Reg. D”) governs unregistered securities and explains the exemptions from being required to register with the SEC.177 Under Rule 501(a) of Reg. D, accredited investors can be institutional investors and entities such as banks, mutual funds, insurance companies, or pension plans;178 insiders within an issuer such as officers or directors of the issuer of the securities;179 or wealthy natural persons such as those with a net worth of greater than $1 million, excluding primary residence and mortgage,180 or those with an annual income of greater than $200,000 for the last two years ($300,000 if filing jointly with one’s spouse).181
The policy behind limiting buyers from purchasing certain securities through this regulation is to protect less-knowledgeable individual investors, who may not have the financial stability to absorb the high risks of investing in unregistered securities, while also promoting investments into risky entrepreneurial ventures. Accredited investors are treated differently from the general public because they are sophisticated enough to bear the risks, are more knowledgeable, or have the money to hire someone like a financial advisor to help them make informed decisions. Given that f-NFTs may be unregistered securities, the SEC could regulate f-NFT buyers by only allowing accredited investors to purchase them. However, it may be difficult to prevent people from buying a certain digital asset on a decentralized and easily accessible platform. This would mean that every time an f-NFT was created or sold, an issuer or platform would have to go through the
time-consuming and costly process of ensuring that every purchaser complies with the definition of an accredited investor. The whole purpose of fractionalizing NFTs was to make these digital assets more accessible to average investors. Thus, it seems counterintuitive to place a new barrier in front of average investors and their ability to participate in this emerging market. The accredited investor regulation is meant to protect average investors from more risky activities, but there may be other ways to prevent harm to less-knowledgeable investors than completely cutting them off from these new assets, such as requiring NFT platforms to provide easily accessible and relevant information regarding trading NFTs and maintaining certain security protocols to protect f-NFT investors and their funds. Thus, it is unlikely that the SEC could or should place any regulations on buyers of f-NFTs.
B. REGULATION OF SELLERS OR ISSUERS
The SEC may be able to place registration requirements on the initial creators or issuers of f-NFTs. Under section 5 of the Securities Act, any issuer offering or selling an unregistered security in interstate commerce must register non-exempt securities with the SEC.182 These registration requirements serve two main goals: (1) to provide investors with financial and other material information regarding the securities being offered or sold and (2) to prohibit and minimize fraud, deceit, misrepresentations, and other dangers in the sale of securities.183 Requiring issuers to provide information regarding their assets to investors through the SEC increases the likelihood that investors will make well-informed decisions and provides a certain standard to minimize fraudulent sales. If f-NFTs are deemed to be securities, the individual or entity that initially fractionalizes the NFT and sells these
f-NFTs may be considered an issuer under section 5 and thus be subject to SEC requirements such as filing a registration statement and periodically disclosing material information.184
The SEC has cracked down on digital assets and ICOs by bringing and winning enforcement actions against a variety of issuers who have offered and sold digital assets that are deemed securities and were not registered pursuant to the Securities Act.185 In 2019, the SEC brought two high-profile enforcement actions against Kik Interactive Inc. (“Kik”) and Telegram Group Inc. (“Telegram”) arguing that the Kik and Telegram tokens were sold to investors as unregistered securities and thus violated federal securities law. The courts applied the Howey test and found that both tokens were securities because the funds from the token sale were used for operating the companies’ respective ecosystem and messaging apps, the tokens were marketed to prospective investors as a way “you could make a lot of money,” and the value of the investments depended on the companies’ respective efforts to develop their messaging apps.186 While some issuers of digital assets like cryptocurrency were subject to registration requirements, other issuers of digital assets such as tokens for a membership rewards program (TurnKey Jet, Inc.) or tokens for video game currency (Pocketful of Quarters, Inc.) were given “no-action” letters from the SEC promising that the it would not take any enforcement action against these issuers for selling the digital assets without registration.187 The SEC held that these rewards and video game tokens were not securities because none of the funds from the token sales were used to develop the issuer’s platform, the tokens were immediately usable for their intended functionality (purchasing air charter services or gaming) at the time they were sold, token transfers were restricted to only the company’s internal “wallets,” and the tokens were both marketed in a way that emphasized the functionality of the token for consumption.188
Given the unchartered territory of f-NFTs, it is difficult to apply the regulation of issuers to the creators of f-NFTs. Although selling f-NFTs may look like a type of ICO, there may be policy reasons not to require registration every time creators wish to fractionalize their NFT. Registering the sale of an asset is a time-consuming and costly process, and it seems unnecessary to require extensive disclosures given that the costs of registration may outweigh the benefits of having an accessible f-NFT marketplace. The main goals of these registration requirements are to provide investors with sufficient information regarding the f-NFT and to prevent fraud.189 However, f-NFTs’ blockchain and smart contract technology may satisfy these goals without the need for costly registration. Many platforms always display relevant information regarding an NFT right next to the image of the NFT. This information typically includes a description of the NFT, the total supply of fractionalized shards, the valuation, and some type of table showing all the transactions of that specific NFT, the date on which each sale occurred, the buyers and sellers for each sale, and the price at which it was sold.190 Thus, potential purchasers can already easily see the relevant financial information regarding the assets to help them make an informed decision. Also, since each f-NFT has a digital ledger that automatically records every transaction and every buyer and seller of that f-NFT, it can be easier to fend off certain types of fraud and easily authenticate true ownership. F-NFTs’ blockchain technology, decentralized network, and easy authentication process can help satisfy the goals that registration requirements aim to reach.
One may argue that if an f-NFT is being sold by a specific entity, artist, or athlete, and the value of that f-NFT is tied to that entity or individual’s external success, then the issuer may need to provide disclosure regarding the entity or individual. For example, would a professional athlete’s f-NFT issuance require a registration statement about their professional sports career? Brands such as Nike and Martha Stewart have recently announced their digital asset plans such as Nike’s “digital shoes” and Martha Stewart’s NFT collection of digital images depicting her home decor and designs.191 Thus, if a company or brand is issuing an NFT or f-NFT, it seems more likely that the SEC may impose registration requirements and disclosures regarding that specific company or brand. Even if the SEC decides to impose registration requirements for the initial fractionalization of an NFT, there should be exemptions for small NFTs of little value or where there is a low number of shards in the initial fractionalization. For example, Reg. D under Rule 504 provides an exemption from registration requirements for companies that issue a small amount of securities, in which they are not allowed to sell more than $10 million worth of securities in any twelve-month period.192 This rule could easily be applied or adapted to fit small sales of f-NFTs such that issuers would not be required to register the sale of their f-NFTs if the total value of the sale was below a certain threshold. The SEC will need to balance the costs of the registration requirements for initial
f-NFT issuers with the need to promote or encourage new markets and assets and not stifle innovation and creativity.
C. REGULATION OF PLATFORMS OR EXCHANGES
Although it may be more difficult to regulate buyers or the initial creators of f-NFTs, it may be more reasonable to focus securities regulation on f-NFT platforms or networks that provide for the fractionalization of NFTs and manage the secondary market trading of these digital assets. If an f-NFT platform such as Niftex, Fractional.art, or DAOfi satisfies the definition of an “exchange” under Exchange Act Rule 3b-16(a)’s test, then these types of platforms will need to register with the SEC under section 6 of the Exchange Act as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS”) in compliance with Regulation ATS.193 The registration requirements for exchanges apply regardless if the issuing entity is a decentralized autonomous organization as opposed to a traditional company, if purchased using virtual currencies as opposed to traditional paper currency, or if distributed through ledger technology as opposed to certificated form.194
Under the Exchange Act Rule 3b-16(a), an entity is an “exchange” if it (1) “brings together orders for securities of multiple buyers and sellers,” and (2) uses “established, non-discretionary methods.”195 The SEC clarifies this two-pronged functional test by stating that a system “brings together orders” “if it displays, or otherwise represents, trading interests entered on the system to system users” or “if it receives subscribers’ orders centrally for future processing and execution.”196 The SEC also explains that a system uses “established, non-discretionary methods either by providing a trading facility or by setting rules governing trading . . . among the multiple buyers and sellers entering orders into the system.”197 These methods include a computer system in which orders interact, a “trading mechanism that provides a means or location for the bringing together and execut[ing] of orders,” or rules that impose execution procedures or priorities on orders.198
Recently, this test was applied to the EtherDelta, which is an online trading platform that allows buyers and sellers to trade digital assets such as Ether and ERC20 tokens in secondary market trading. The SEC entered an enforcement order arguing that EtherDelta violated section 5 of the Exchange Act because its digital token was a security and the EtherDelta platform was an unregistered “exchange” that was transacting in a security.199 This enforcement action found that EtherDelta satisfied the criteria of an “exchange” under Exchange Act Rule 3b-16(a) because it (1) operated as a marketplace for bringing together the orders of multiple buyers and sellers of a digital asset that was considered a securities under the Howey test “by receiving and storing orders in token in the EtherDelta order book and displaying the top 500 orders (including token symbol, size, and price) as bids and offers,” and (2) “provided means for orders to interact and execute through the combined use of the EtherDelta’s website, order book, and pre-programmed trading protocols on the EtherDelta smart contract.”200 The EtherDelta website also had numerous features that were similar to online securities trading platforms, such as providing access to the EtherDelta order book, sorting the tokens by price and color, and providing account information, market depth charts, lists of user’s confirmed trades, daily transaction volumes per token, and fields for users to input deposits, withdrawals, and trading interests.201 Many of these features are similar to the online trading platforms of f-NFTs. When applying this functional test to f-NFT platforms and comparing them to the EtherDelta, it seems like f-NFT platforms can satisfy Rule 3b-16(a)’s two requirements.
First, f-NFT platforms bring together multiple buyers and sellers onto a single network to transact orders of f-NFTs. f-NFT platforms satisfy the “multiple buyers and sellers” aspect since there is a wide variety of f-NFTs issuers and multiple buyers who can purchase these f-NFTs.202 These platforms satisfy the aspect of “bringing together” people to “transact orders” because they not only provide a place to fractionalize NFTs but also create and maintain marketplaces for users to trade their f-NFTs. Platforms typically receive and store f-NFT orders in a ledger on the Ethereum blockchain that keeps track of all the transactions of a specific f-NFT, much like the EtherDelta order book.203 All of these orders and f-NFTs are easily displayed on f-NFT platforms where users can see any past f-NFT transactions and execute orders to buy or sell these digital assets. Similar to EtherDelta, f-NFT platforms like Fracitonal.art also display the top orders and include information such as the token name, number of fractions, and price.204
Second, f-NFT platforms use a decentralized network that acts as a trading facility and sets rules for any f-NFT transaction through the underlying smart contracts that these platforms embed in the f-NFTs.205 Like EtherDelta, current f-NFT platforms provide a network or trading facility for orders to interact and execute through their individual websites such as Niftex, Fractional.art, or DAOfi, their digital ledgers, and their pre-programmed smart contracts with embedded trading protocols.206 These websites provide the “means or location” for bringing together users and executing orders for f-NFTs.207 Also, smart contracts use execution procedures and priorities to impose rules and determine the terms for any
f-NFT transaction on the network.208 Smart contracts can confirm the validity of the transactions and set the conditions of the order by checking certain information, such as whether the f-NFT contains a valid cryptographic signature, if the f-NFT comes with some type of royalty, if there is a buyout option, or if there is some type of curator fee.209 These characteristics provide the “established, non-discretionary methods” that govern how f-NFT orders interact with each other.
If an f-NFT platform is considered an “exchange,” it could still escape registration requirements if it satisfies one of the exemptions in Exchange Act Rule 3a1-1(a). It is unlikely that an NFT trading platform would fall under the 3a1-1(a)(1) (exemption for an ATS operated by a national securities association) or 3a1-1(a)(3) (exemption for an ATS not required to comply with Regulation ATS pursuant to Rule 301(a) of Regulation ATS) exemptions.210 However one could analyze whether an f-NFT trading platform could be considered an ATS that complies with Regulation ATS and thus fits into the 3a1-1(a)(2) exemption for ATSs. This exemption would allow f-NFT exchanges to register as a broker-dealer, which has lower regulatory costs and fewer notice and reporting requirements, instead of as a national securities exchange.211 Although operating under this exemption would still come with some notice, reporting, and recordkeeping requirements, it could prevent f-NFT platforms from spending even more time and money on registering as a national securities exchange and dealing with periodic disclosures.
Although digital asset trading platforms resemble traditional exchanges or alternative trading systems, regulators may need to adjust the regulatory framework, much like they did for ATSs, to account for differing characteristics of blockchain-based exchange platforms. Differences between digital asset exchanges and national securities exchanges can include transparency, fairness, and efficiency.212 The decentralized aspects of f-NFT platforms may provide their own form of protection that may be more or equally as transparent, fair, and efficient as the regulations the SEC would impose. Thus, the SEC could adopt another new regulatory framework for exchange platforms of digital assets such as f-NFTs that requires less registration or fewer requirements than a national securities exchange and recognizes the fraud and misrepresentation protection that a blockchain platform already affords.
A decentralized platform may be better than SEC-imposed regulation at detecting fraud and protecting users on these types of f-NFT platforms. First, these platforms’ “decentralized” and public nature provides fairness because no one entity controls the network, and therefore anyone can easily access and interact on the platform and all transactions are verified by others on the network. Second, “decentralized” exchanges provide efficiency because the blockchain technology allows them to easily show users “verified business logic [in a publicly verified smart contact],” which a centralized exchange could not do.213 Third, f-NFT platforms provide transparency because while traditional exchanges hold your funds with an “exchange owner,” decentralized ones hold your funds through easily verifiable and public digital ledgers that also contain a list of all transactions for a specific f-NFT, including the buyer, seller, and price.214 The cryptographics embedded in f-NFTs make everything in a sense “registered” through its digital ledger, and all transactions are verified through the whole blockchain network. Thus, the sale of these digital assets may not need SEC regulation.
Even in decentralized networks, there is still a chance of hacking, fraud, and loss that may be mitigated through government regulation. Just as the SEC modernized the regulatory framework to “better integrate alternative trading systems into the national market system,” the SEC may need to modernize the regulatory framework again to integrate NFT trading systems and digital asset sales.215 For example, the SEC may adopt a new regulatory framework that requires an f-NFT exchange platform to provide or display either convenient one-time reports or costly regular reports on its security protocols and how it deals with bad actors such as hackers that manipulate code to steal the proceeds of an NFT sale.216 The SEC may also implement a limiting framework, similar to how Regulation ATS requirements are limited to a subset of ATSs that occupy a certain large percentage of the total trading volume of any security.217 For example, the SEC could only require registration for f-NFT exchanges that account for a large volume of the overall traded f-NFTs. This may ensure investor protection from large actors while still allowing for innovation through smaller actors. The SEC can also require platforms to comply with certain capacity, integrity, and security standards to ensure f-NFT investors’ funds and assets are protected, given that an f-NFT’s value may be tied to the platform’s ability to maintain and retrieve the NFT.
SEC Commissioner Hester Peirce’s proposal for a “safe harbor” for digital assets and exchanges shows a glimpse into the beginning of a new framework that can provide guidance for digital asset issuers and exchanges. Peirce proposed a regulation in which digital asset exchanges would be allowed to begin distributing their tokens broadly if they provide disclosures such as plans for the network and who is behind the network.218 These exchanges would then have three years from a token’s initial distribution to develop the network before they would be subject to any securities laws.219 This three-year safe harbor allows issuers of digital assets to be exempt from SEC regulation for a certain time period and prevents their digital asset from being immediately classified as a security. It also gives digital asset creators time to set up their networks without government regulation and establish whether their digital asset can be classified as a security. This framework may allow creators to innovate digital and financial assets while continuing to protect investors. At the end of the day, the SEC needs to balance “encourag[ing] market innovation while ensuring basic investor protections.”220
V. PRELIMINARY EXPLORATION OF EXISTING REGULATORY MODELS
The SEC has existing regulation for non-digital securitized products, such as traditional stocks in companies or REITs, which may be applicable to f-NFT products and provide regulators with a starting point from which to develop regulations specific to f-NFTs.
When an individual or entity initially fractionalizes and issues their
f-NFTs, it could be called an “Initial Fractionalization Offering,” or “IFO.” An IFO, in which the issuer sells multiple shards of the same NFT to multiple buyers, is similar to a type of IPO or ICO, in which the issuer sells multiple stocks or tokens of the same company to multiple buyers. F-NFTs can be treated as a stock in the original whole NFT, and the sale of these f-NFTs can be the same as selling a share in an individual company. Thus, instead of developing a whole new set of regulations for f-NFTs, regulators can just look at existing securities laws for traditional stock sales and apply them to f-NFTs sales. The rules governing traditional, non-digital securities such as stocks could be slightly modified to better apply to f-NFT sales. For example, f-NFT creators could be required to register their f-NFT sale or IFOs with the SEC by filing a modified Form S-1 that contains information regarding the past performance of the NFT such as its trading history, information regarding the performance of other similar NFTs if the NFT is part of a collection, or information regarding the company or individual creating the NFT.221 Providing the financial disclosures required by traditional IPOs may be more difficult for traditional NFTs because there is not any managerial or financial information behind a regular NFT besides its intrinsic or artistic value. However, NFTs from a particular brand, celebrity, or company would have an easier time producing accurate managerial and financial disclosures or material information regarding an NFT because these brands and celebrities typically have established financials or data regarding their performance, such as how popular a brand is or the performance statistics of an athlete. For example, Martha Stewart could be required to disclose managerial and financial information regarding her retail company if she tries to issue another NFT collection of her home décor, or Patrick Mahomes could be required to disclose information regarding his football statistics or other brand deals if he issued more NFTs. Thus, traditional registration requirements for issuing stock could be particularly appropriate for a celebrity or company that issues f-NFTs or NFTs and uses the proceeds from the sales to develop their brand or business.
REITs are another securitized product with an established regulatory structure that can be applied to f-NFT regulation. REITs are entities that own and typically operate various “income-producing real estate or real estate-related assets,” such as office buildings, apartments, shopping malls, hotels, or warehouses.222 In addition to other requirements, a REIT must have seventy-five percent of the entity’s total assets coming from real estate investment, be managed by a board of directors, and distribute at least ninety percent of its taxable income to shareholders annually in the form of dividends.223 REITs register and file reports with the SEC, can list and trade their shares on a public stock exchange, and allow investors to invest in and own shares of multiple large-scale, income-producing real estate properties without actually having to buy the real estate.224 In other words, REITs take a bunch of commercial real estate assets, bundle them together in one company, and then sell shares of that company to investors so they can reap the benefits of owning commercial real estate. Issuing shares of a REIT is like issuing fractional shares of a basket of NFTs. For example, one way to issue f-NFTs is to take multiple whole NFTs, bundle them together in one large NFT basket, and then sell f-NFTs or fractional shares of that basket
(“f-NFT bundles”) to investors so they can own shares in multiple NFTs. Just as REITs sell investors shares of a basket of real estate investment properties, f-NFT bundles sell investors shares of a basket of NFTs.
Given these similarities, securities regulations that apply to REITs may also translate and apply to f-NFTs. Most REITs are registered with the SEC and publicly traded on a stock exchange. Under the Securities Act, REITs are required to register their securities using Form S-11 to make disclosures regarding the REIT’s management team and other significant information and make regular SEC disclosures such as quarterly and yearly financial reports.225 Regulators could follow this existing regulatory model from REITs and impose similar requirements for fractional shares of NFT bundles. Form S-11 requires REIT issuers to disclose information detailing the price of the deal, how the REIT plans to use the proceeds, certain financial data like trends in revenue and profits, descriptions of the real estate, operating data, information on its directors and executive officers, and other data.226 These types of requirements could easily be adopted to regulate f-NFT bundles by creating a new, similar form to Form S-11 for issuers of f-NFTs to file with the SEC. For example, issuers of f-NFT bundles could be required to file a form like Form S-11 that discloses information like the price of each f-NFT; how the individual or entity issuing these f-NFT bundles plans to use the proceeds, such as to purchase more NFTs to add to the bundle; a description of the NFTs currently in the bundle as if they are part of a trending collection; certain financial data of each NFT, such as its past transactions or price; information on the individuals managing the bundle, such as their credentials or how they have managed digital assets in the past; and so forth.
However, REITs are different from f-NFTs in that REIT investors earn a share of the income produced through the rent or mortgage interests from the commercial real estate, while f-NFT investors can only earn a share of the increased value of the underlying NFT.227 It may be possible that an NFT’s smart contract could charge money to anyone who views the particular NFT and then automatically distribute these proceeds out to the
f-NFT investors as a type of dividend, but this has yet to be seen. Thus, REIT regulations may not translate perfectly to regulating f-NFT bundles since it is difficult to see how f-NFT bundles would file quarterly and yearly financial statements regarding just NFTs. REITs can provide financial disclosures regarding the profits and losses of their various real estate properties, but f-NFTs do not have similar financials beside the increase and decrease in value of the various NFTs within the bundle. However, as described above, there may be more financial information when f-NFTs are issued by specific celebrities or companies. Regulators will need to determine how f-NFTs can disclose financial information to best inform investors. Additionally, there has been a surge of investors buying Metaverse Real Estate, which is real estate in virtual worlds bought and sold using NFTs and cryptocurrency.228 People can now go onto virtual real estate platforms such as SuperWorld where they can buy a plot of land in the form of an NFT and then share in any of the commerce that happens on that piece of property.229 These types of real estate NFTs would be able to charge rent or gain interest on these virtual properties and thus could then distribute income out to the NFT owners, much like REITs, and be subject to similar regulation. This analysis is outside the scope of this Note, but it is a relevant issue that regulators will need to face in the future. Nevertheless, REITs can provide a baseline to help regulators analyze and develop ways to regulate different types of f-NFTs and NFTs.
Given the foregoing analysis, f-NFTs can be deemed an “investment contract” security under the Howey test, and the SEC may be able to regulate the issuers or exchanges that facilitate these fractionalization and trading.
F-NFTs satisfy the four Howey prongs because (1) f-NFT buyers make an investment using money in the form of cryptocurrency; (2) this investment is in a “common enterprise” where the fortunes of the buyer are tied to the successes of either other fractional investors of one NFT or the brand or celebrity that issued the NFT; (3) buyers have a “reasonable expectation of profit” because f-NFTs are traded on secondary markets and promoted as a unique liquidity opportunity; and (4) these financial returns are derived from the efforts of issuers to support the popularity and price of an f-NFT and platforms to maintain and develop f-NFT exchanges and marketplaces.
If f-NFTs or NFTs are deemed securities, the SEC can use the existing regulatory models of digital currencies, traditional stock, and REITs to create initial regulations of a continuously developing digital asset. Due to the wide variety of f-NFTs and the ways in which they are owned and operated, regulators will have difficulty developing one standard that applies broadly. However, by comparing issuers and exchanges of f-NFTs or NFTs to existing securitized products, one can apply slight modifications to established regulations and require disclosures such as an NFT’s transaction history or how an issuer and exchange will use the proceeds from the sale.
Hopefully, this analysis will appeal not only to the legal field and regulators but also to the average investor who is interested in buying, selling, or understanding new digital assets like NFTs. The legal field and the government must face the current issues with NFTs and their classification and regulation as a financial instrument in order to protect investors while also allowing for the innovation of new financial technologies.
* J.D., University of Southern California Gould School of Law, 2023. B.A., University of California, Los Angeles, 2019.