Overreach. Jurisdictional landgrab. Regulation by enforcement. These terms and expressions — and many more “colorful” turns of phrase — are used by some to describe the Securities and Exchange Commission’s approach to enforcement at the intersection of digital assets and the federal securities laws. The SEC has repeatedly rejected such claims and has yet to act upon industry calls for increased clarity and guidance. Instead, the agency has repeatedly asserted that its enforcement approach for digital assets is consistent with what it has done for decades: policing markets for potential violations of the federal securities laws by analyzing the “economic realities” of a transaction and applying long-held precedent — such as Supreme Court cases SEC v. W.J. Howey or Reeves v. Ernst & Young — to those facts. Conversely, two of the five SEC Commissioners take issue with this approach, continually adding oxygen to fiery criticisms of overreach and regulation by enforcement.
Reasonable minds can differ on how justified or off-base the agency has been in its now yearslong journey into digital asset enforcement, progressing from unregistered ICOs to alleged frauds to actions targeting exchanges and intermediaries. But it is the SEC’s most recent enforcement actions — its first two cases involving nonfungible tokens — that have yet again brought forth the SEC’s critics. What should we make of these first-of-their-kind enforcement actions? Doesn’t the lack of fungibility of NFTs move these tokens outside the SEC’s jurisdictional reach, making this the latest example of overreach? Or are these matters simply the latest actions in line with the SEC’s longstanding enforcement approach?
You are invited to join The Texas Lawbook on Monday, Oct. 2 for a CLE ethics program on the key developments and enforcement trends at the Securities and Exchange Commission with an expert panel including Regional Director Eric Werner; Holland & Knight partners Scott Mascianica and Jessica Magee; Vinson & Elkins partner Rebecca Fike; Vistra Energy associate general counsel Yuki Whitmire; and Charles Schwab chief counsel for risk and regulatory Shamoil Shipchandler. Please email firstname.lastname@example.org for more information.
Background on NFT Enforcement Actions
In the Matter of Impact Theory, LLC
On Aug. 28 the SEC initiated a settled administrative proceeding, in which it issued an order against Los Angeles-based media and entertainment company Impact Theory. According to the SEC’s order, from October to December 2021, Impact Theory offered and sold three tiers of NFTs, known as Founder’s Keys, to hundreds of investors. Impact Theory raised approximately $29.9 million in connection with the offering, funds they represented would be used for development of the of the NFT ecosystem.
According to the SEC’s order, Impact Theory collected proceeds from the sale of Founder’s Keys in a single wallet. The SEC also took care to dedicate a significant portion of the order to highlighting economic realities of the offering that, in the agency’s view, satisfied the Howey test for establishing the existence of investment contract securities, including: (a) various company statements about the profit potential of the investment; (b) the company’s emphasis on its own efforts to drive the value increase of the NFTs; and (c) how the fortunes of Founder Keys’ investors were tied together. Additionally, the order describes how Impact Theory programmed the NFT smart contract so that the company received a 10 percent royalty on every secondary market transaction.
Without admitting or denying the findings in the order, Impact Theory settled to violations of Securities Act Section 5 for engaging in an unregistered offering of securities (the NFTs). The SEC ordered Impact Theory to pay more than $5.5 million in disgorgement and prejudgment interest plus an additional civil monetary penalty of $500,000. In addition, Impact Theory agreed to certain undertakings, including destroying remaining NFTs and eliminating its royalty interest. Notably, the SEC took Impact Theory’s remedial efforts into consideration — its previous offer to repurchase Founder’s Keys from investors and its repurchase of nearly 3,000 NFTs via the return of $7.7 million worth of ETH to investors.
In the Matter of Stoner Cats 2, LLC
On Sept. 13, just weeks after announcing the Impact Theory action, the SEC announced a second, settled administrative proceeding involving NFTs as securities. This time against Stoner Cats 2, a Delaware corporation that managed and produced the “Stoner Cats” web series.
The SEC’s order found that Stoner Cats raised approximately $8.2 million by selling Stoner Cats NFTs. As set forth in the order, Stoner Cats marketed the success of the show as tied to the success of the NFTs and claimed that the proceeds would be used to fund production of the entity’s web series. Similar to Impact Theory, Stoner Cats configured their NFTs to secure a royalty for the company on each secondary NFT transaction. The SEC also detailed the entity’s extensive media campaign to promote the sale of NFTs — both at the initial offering and thereafter. Additionally, the SEC also made multiple references to Stoner Cats marketing of its management team’s special and unique experience as tied to the success of the NFTs (the “NFTs would be successful as a result of [Stoner Cats] entrepreneurial and managerial efforts”).
Without admitting or denying the findings in the order, Stoner Cats — like Impact Theory before it—settled to violations of Section 5 of the Securities Act for engaging in an unregistered securities offering. The SEC did not order disgorgement but did order Stoner Cats to pay a civil monetary penalty of $1,000,000 and ordered the company to agree to certain undertakings (including assisting the Commission in crafting a distribution plan to affected investors).
SEC Not of One Voice
Commissioners Hester Peirce and Mark Uyeda dissented from both of these actions. Calling for more agency guidance and clarity in the SEC’s approach to NFT and digital asset enforcement, they observed how NFTs can have a variety of use cases which may not implicate the securities laws. They also asserted the long-held refrain that NFTs can often be comparable to the sale of collectibles, artwork and other assets that may increase in value over time including through “fan crowdfunding.”
- Concerns about SEC Enforcement of NFT Activity Might be Valid … Just Not Yet.
Given our experience both supervising enforcement actions for the SEC and representing clients in SEC enforcement investigations and proceedings — including matters involving NFTs as possible securities — we have observed firsthand the pros and cons to both sides of the debate. While soundbite discourse may garner headlines, an assessment of the facts reveals a more nuanced landscape.
The SEC has long approached enforcement by looking at the economic realities of the transaction, not transaction labels or descriptions. Although the general view is that NFTs are nonfungible and therefore unique, this does not make every NFT arrangement the equivalent of a baseball card or piece of antique art. Even SEC Commissioner Hester Peirce — a longtime critic of the agency’s digital asset enforcement — has acknowledged that NFTs in certain structures could implicate the securities laws. She expressed similar sentiments in her dissents to Impact Theory and Stoner Cats along with Commissioner Uyeda. Furthermore, a private litigation has found — at the motion to dismiss stage — that in certain instances NFTs can be securities.
Based on the facts of the SEC’s orders in Impact Theory and Stoner Cats, the SEC seemingly satisfies the Howey factors for both sets of NFTs. The Impact Theory order includes compelling assertions of common enterprise and includes extensive allegations concerning the efforts of others. The Stoner Cats order similarly includes multiple allegations that the success of the venture was directly tied to the managerial and entrepreneurial efforts of the promoters. Both orders included details of the profit promotions. The reaction to these enforcement actions cannot simply be “overreach.”
However, broader programmatic concerns remain. Cases like Howey and Reeves present long-standing frameworks to identify different types of securities. Although the SEC has not issued any agency guidance since its 21(a) DAO Report in 2017, the SEC’s FinHub staff issued separate, nonbinding guidance in 2019 on the framework of an investment contract for digital assets. Although the framework is helpful, certain characteristics of NFTs can differ from more traditional digital assets. Furthermore, applying the guidance and the mosaic of case law precedent can be confounding — and significantly expensive — for even well-intentioned NFT developers. For example, if an NFT developer has fully developed its distributed ledger network for the NFTs in question prior to selling — a factor against a Howey finding — but markets the NFTs as being a potentially profitable purchase — a factor leaning towards Howey — what is the risk exposure? Of course, such an assessment will involve several other facts but the point remains: Many scenarios with NFT developers will often be shades of gray when it comes to the federal securities laws. We are eager to see how the SEC approaches NFT enforcement over the coming months to piece together how aggressive the agency will be on closer calls.
- Profit Motive is Key … to an Extent.
There is no shortage of soundbites and articles opining that the SEC pursued its first two NFT enforcement actions because of the royalty and profit mechanisms involved in the underlying transactions. There is certainly some truth to this. But this is only part of the story. By way of review, the elements of an “investment contract” security under Howey are: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profit; (4) based on the efforts of others (normally, the promoter). Both the Impact Theory and Stoner Cats actions detail the entities’ marketing campaigns and claims of potential significant profits associated with purchasing the NFTs.
Although undoubtedly an important factor in the analysis, standing alone, the mere possibility of profit does not justify SEC enforcement inasmuch as it satisfies just one component of Howey’s investment contract analysis. David Hirsch — an alum of the SEC’s Fort Worth office and current chief of the SEC Enforcement’s Division Crypto Assets and Cyber Unit — acknowledged that if NFT creators can demonstrate that the profit mechanism they’re employing is individualized, “then we don’t likely have Howey, and therefore it’s not the SEC’s jurisdiction and responsibility.” Developers and companies who can demonstrate the individualized profit mechanism of the NFTs are far more likely to find a receptive audience to claims that their product is more akin to baseball cards and artwork than a security.
- Common Enterprise Bears Watching.
When assessing NFTs in the context of Howey, the factor most directly correlated with fungibility — or lack thereof — is the common enterprise element. Critics of the SEC continue to analogize NFTs to unique pieces of artwork and other unique collectibles because of their lack of fungibility. If they are not fungible, the argument goes, then purchasers are not similarly situated and thus there isn’t a common enterprise.
The SEC has long taken the position it does not view “common enterprise” as a separate element of Howey. Federal courts, however, generally require elemental proof of a “common enterprise,” although different circuits have differing views on the type of “commonality” required. “Horizontal commonality” is typically viewed as the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets, whereas “vertical commonality” looks at the relationship between the promoter and the group of investors.
Although litigated actions and contested decisions will provide more context here, in the interim we expect that the SEC will continue to assert that the investors who purchase NFTs with an expectation of profits based on the managerial efforts of others satisfy Howey. And, as the promoter’s efforts become more integral to the success or failure of the offering, we expect the SEC to be more aggressive in asserting jurisdiction.
- Settled Actions are Not Binding Authority but May Have Deterrent Impact.
Both settlements are important for the several reasons detailed herein. However, it is worth noting that the settled orders are not binding authority for any action litigated in federal court. Although non-SEC decisions like those in Dapper Labs present more compelling (albeit still limited) authority for NFTs-as-securities, the landscape for contested decisions on this subject remains sparse. And the lack of visibility into NFTs-as-securities investigations the SEC has closed makes it difficult for developers and practitioners to fully understand the safe zones. However, as the SEC continues to achieve settlements — or “collecting enforcement actions” as Commissioner Peirce asserted — this could have a deterrent effect on the NFT industry writ large.