Like many other things, art and collectibles have gone digital. This year has seen explosive growth for NFTs, with NFT sales for 2021 already exceeding $2.5 billion. With the growing market for NFTs comes innovation, most notably the emergence of f-NFTs (“fractional non-fungible tokens”). Where financial innovation goes, the SEC is bound to follow. F-NFTs are no exception. Although perhaps not intending to rain on the creative parade, in March 2021 comments, SEC Commissioner Hester M. Peirce sounded a note of caution, warning creators of f-NFTs to be careful that they are not creating securities that would be subject to regulation.
NFTs and f-NFTs: A Primer
An NFT, or non-fungible token, is a digital asset that represents a real-world object, most commonly a piece of art, music, or video. Built using blockchain technology, NFTs share some similarities with cryptocurrency, but, unlike a Bitcoin or Ethereum, NFTs are non-fungible. Each NFT has a unique digital signature, which allows for its authenticity and provenance easily to be verified. The most famous (and expensive) example of an NFT is an image called “EVERDAYS: The First 5000 Days” created by the artist Beeple, which sold at auction in March 2021 for over $69 million. Other well-known examples of NFTs include NBA Top Shot, a digital trading card system that features video highlight reels, as well as the first tweet sent by Twitter founder and CEO Jack Dorsey. Stripping away the technological gloss, at the core, an NFT is akin to any other collectible object and the purchaser of an NFT is akin to an afficionado of traditional art and collectibles. Where J. Paul Getty chose to collect 16th century Persian carpets, however, the moguls of today may choose to collect the digital image of a startled-looking Shiba Inu dog – the star of the ubiquitous Doge meme – that recently sold as an NFT for $4 million.
Though not all NFTs sell for millions of dollars, for reasons that elude many of us, a large number of NFTs come with a hefty price tag. Fractional non-fungible tokens have emerged to meet the needs of people who might want to enter the NFT market without spending seven figures. Simply put, an f-NFT is a fraction – or “shard” – of an NFT that can be bought and sold. For example, a collection of 50 CryptoPunks, digital images that are among the earliest NFTs and that routinely sell individually for millions of dollars recently have been fractionalized into millions of tokens, with each f-NFT representing a fraction of the larger collection. Although an NFT easily can be analogized to traditional collectible art, and the owner of an NFT to a traditional collector, that analogy fails to capture f-NFTs, which represent merely a small portion of the underlying work, and their owners, who possess only a fraction of the underlying work. Moreover, signs exist that f-NFT innovators are looking to expand beyond the relatively small art and collectibles markets, with some in the crypto space imagining the possibility of wrapping real-world assets into NFTs, fractionalizing them, and then making the resulting f-NFTs tradeable. Indeed, several platforms have emerged to facilitate the trading of f-NFTs, including Fractional, Niftex, and DAOfi. Thus, although f-NFTs may seem like a niche product for digital art enthusiasts now, they may not remain so for long. As such, thinking through the possible approach regulators may take to f-NFTs is a helpful exercise, and it boils down to one question: what is the likelihood that the SEC will regulate f-NFTs as securities?
The SEC and f-NFTs
Though, despite the note of caution, the SEC’s regulatory approach to cryptocurrency is not yet settled, the Commission has undertaken an increasing number of enforcement actions in the crypto space, including crackdowns on ICOs (initial coin offerings) and a pending federal court action against Ripple Labs. Thus, though the SEC has not yet spoken in great depth about NFTs or f-NFTs, f-NFTs are on the Commission’s radar. How might the guidance the SEC has offered regarding the regulatory status of crypto generally apply to f-NFTs in particular? The best place to start is the 2019 guidance on evaluating digital assets issued by the SEC’s Strategic Hub for Innovation and Financial Technology.
A security is subject to a host of regulations: not only must issuers register non-exempt securities with the SEC under Section 5 of the Securities Act of 1933, but any platform or exchange that lists the security would also have to consider whether it was required to register with the SEC. When determining whether a transaction qualifies as an investment contract (and so is subject to regulation as a security), courts look to the 1946 Supreme Court case SEC v. W.J. Howey Co., 328 U.S. 293 (1946). There, the Supreme Court promulgated a four-prong test (the Howey test): an instrument is an investment contract if it is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others. How might f-NFTs fare under the Howey test?
The first prong of Howey is also the most straightforward: courts have held that an “investment of money” need not be in the form of cash and thus, even though f-NFTs are bought using cryptocurrency, they likely satisfy the first prong. The status of f-NFTs under the second prong – the existence of a common enterprise – is more difficult to assess. In its 2019 guidance, the SEC noted that it typically has found a common enterprise when evaluating digital assets. This analysis may not apply to traditional NFTs because, by its very nature an NFT bestows unique rights on a single purchaser. The analysis, however, likely does apply to an f-NFT. The owner of an f-NFT has only a partial ownership interest in the underlying NFT, the value of which is inextricably bound up with the value of the NFT as a whole. In this way, the fortunes of each holder of a shard of a given NFT are tied to the fortunes of every other shard holder: if the value of the underlying NFT appreciates, so does the value of each shard, and vice versa. With the caveat that Howey is a fact-sensitive test, as a general proposition, f-NFTs may meet the horizontal and vertical commonality analysis that courts have applied when determining whether a common enterprise exists for purposes of the Howey test: namely, that the fortunes of each investor in a pool of investors are tied to the success of the overall venture and there is an interdependence between the fortunes of the investor and the promoter (in the case of an f-NFT, likely the person or entity having control or custody of the underlying NFT).
The third prong of Howey looks at whether a reasonable expectation of profits exists in the purchase. Here, the SEC’s guidance looks at several factors, including whether the asset can be traded on or through a secondary market or platform, the identity of the target buyer, and the marketing efforts surrounding the asset. This prong is particularly fact-sensitive and dependent on the circumstances surrounding a given fractionalized NFT. For example, while some f-NFTs may be accompanied by marketing materials touting the opportunity to join the ranks of connoisseurs by owning a shard of a masterpiece (making it less likely to meet this prong), others may be accompanied by materials focusing on the likelihood that the shard will appreciate, or emphasizing efforts being undertaken to support demand for the underlying NFT (making it more likely to meet this prong). Further, the existence of a secondary market for a given f-NFT – such as the ability to trade it on an f-NFT exchange – would likely also support a finding of a reasonable expectation of profits under Howey.
Finally, the Howey test asks whether that reasonable expectation of profits is derived from the entrepreneurial and managerial efforts of others. Whereas a traditional NFT is unlikely to meet this prong (once the NFT is sold the prior owner surrenders all control over it to the new owner), f-NFTs may be another story. Again, circumstances surrounding a particular f-NFT will bear heavily on the analysis, but it is certainly conceivable that the issuer of an f-NFT might maintain managerial control over the underlying asset (particularly if f-NFTs expand beyond the niche art and collectibles market as some in the crypto space are predicting), thereby meeting the fourth prong of Howey.
Two conclusions follow from the Howey analysis. First, given the general lack of clarity from the SEC regarding cryptocurrency, no degree of certainty exists as to whether and to what extent f-NFTs will become the subject of regulatory scrutiny in the future. Second, that caveat aside, if the SEC does turn its attention to the world of NFTs, f-NFTs are significantly more likely to be regulated as securities than are traditional NFTs. As the f-NFT market continues to innovate, promoters, exchanges, and customers would be wise to heed the SEC Commissioner’s note of caution. Promoters in particular ought to proceed carefully, especially with regards to what marketing strategies they adopt and what degree of control they retain over the underlying NFT.
To read more from Robert J. Anello please visit maglaw.com
Bronwyn Roantree, an attorney with Morvillo Abramowitz, assisted in the preparation of this article.