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The Intersection Between NFTs, Cryptocurrencies, and Securities

Right now, non-fungible tokens (NFT) are all the buzz in the cryptocurrency and securities law space. People all over are trying to figure out what is an NFT. Specifically, people want to know how it is used and traded, whether it is something that will be affected by securities regulations, and whether there are any other legal considerations. There can not be a discussion about NFTs without mentioning Beeple’s recent sale. On March 11th, Beeple—a digital artist from North Carolina—sold an NFT for an astonishing $69.3 million dollars. His piece titled “Everydays: The First 5000 Days” is a collage of images that he made every day for 13 years depicting his life and current events at that time. As a result of this windfall, there are a lot of people now interested in selling NFTs.

So, what exactly is an NFT? An NFT is an unique item that is often rare or scarce, not divisible, and one that cannot be exchanged for the same amount. Commonly referred to as art or a collectible, but in a digital form. Beeple’s digital art is considered an NFT as it is not divisible, is unique, and cannot be exchanged with another item for the same value. Whereas a fungible token (FT) is divisible and can be exchanged with another token for the same amount. Cryptocurrencies like Bitcoin and Dogecoin are examples of fungible tokens. One Bitcoin can be traded with another Bitcoin for the same amount because they are always equal in value. This concept can also be applied to Dogecoin.

The most popular network to mint, buy, and resell NFT tokens is on the Ethereum (ETH) Network. Ethereum is an example of a type of decentralized cryptocurrency. If you have an interest in creating an NFT, then you should do your research and consult a securities attorney to ensure that you do not hit any legal roadblocks. Are NFTs considered securities? Here is where things get tricky. Like most answers from attorneys, it depends. There is no clear-cut answer to this question. At first glance, the answer is no. Handbags, cars, and books are not considered securities if they are bought or sold as NFTs. However, that can change.

For example, if Beeple sold his piece as an NFT and told the buyer that he would be creating a series of similar pieces using the money from the sale to market the series, which in turn would also increase the value of the original NFT that was sold, this would be considered an investment scheme. The buyer would be expecting a profit and therefore this would be a security in need of an exemption or registration with the U.S. Securities Exchange Commission (SEC) prior to sale.

Additionally, fractionalizing an NFT, selling parts it in parts or selling part of the profits, is likely to create a security under the SEC. The reason why is because this would monetize the NFT. Let’s use the Beeple example again. If Beeple allowed buyers to buy 1/1000 of the $69.3 million dollar deal this would be a security. Not only would the security need to be registered (or eligible for an exemption) with the SEC, but the platform being used to sell the NFT would also need to be a licensed broker-dealer. By applying the popular Howey test, issuers can determine whether or not their NFT falls into the realm of securities law.

In the infamous Howey case, the Supreme Court determined that investors who purchased interests in an orange grove, although passive, relied on the developer’s best efforts to service the groves, was an investment contract (i.e. “security”). In the context of blockchain tokens, a transaction is an investment contract and therefore a security, if all three of the following prongs are met: (1) there is an investment of money; (2) in a common enterprise; and (3) with an expectation of profits predominantly from the efforts of others.

What is most attractive to those who are interested in NFTs are the chain of title features. The origins of the NFT, i.e. who created it, lasts forever. Because of the nature of blockchain, users are able to see who the owner of the NFT is from its creation.

Think of the famous Mona Lisa which is owned by the French Republic. The French Republic loaned the painting to The Louvre for display and it can be found anywhere online with a quick Google search. However, we know who the true owners are. People issuing the NFT, can also ensure they receive royalties from future purchases of their sold NFT. It is important to note that these royalties are not investment contracts. A royalty for an NFT does not meet the Howey test and therefore is not a security. Instead, it would be considered a royalty contract.

In addition to the above, other legal considerations can come into play during the sale of an NFT or cryptocurrency trading, such as deceptive trade practices where individuals could face criminal penalties. First, one needs to be clear what exactly is being sold and whether any rights or expectations of profits are connected with the sale. Second, one needs to ensure that what they are representing in the sale is true and accurate in order to avoid misrepresenting or engaging in deceptive trade practices.

For example, some art could be sold as an NFT but the seller did not have the rights to sell it in the first place which could cause legal issues. As shown, an NFT or a cryptocurrency might be subjected to securities laws, and other laws. This is why it is so important that one consults a securities attorney if they are considering selling a NFT or other cryptocurrency. Although a grey area, we sense that the SEC might come out with some guidelines after the recent big ticket sales of NFTs. Schedule a consultation with us to learn about your compliance requirements.

*co-authored by Elizabeth L. Carter, Esq., Managing Attorney

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