What Was: Security and Utility Tokens
Almost two years have disappeared in a heartbeat, but nothing much substantial appears to have changed on the US securities regulatory landscape for blockchain tokens and other digital assets.
When it comes to any substantive pronouncement, the date of The Securities and Exchange Commission’s (SEC) Strategic Hub for Financial Innovation and Technology’s (FINHUB) last deep dive into digital assets appears to be April 3, 2019, the date of its “Statement on “Framework for ‘Investment Contract’ Analysis of Digital Assets”” and accompanying “Framework for “Investment Contract” Analysis of Digital Assets” (Framework). We wrote about the Framework in an earlier post (“Is there any Utility left in Utility Tokens: the SEC Speaks”), and waxed on about the SEC ‘No-Action Letters’ In Re TurnKey Jet, Inc. and Pocket Full of Quarters, Inc (PoQ).
We thought hopefully about the potential for the Token Taxonomy Act (TTA) and the Blockchain Regulatory Certainty Act “…making their (slow way) through Congress…” in our article “Blockchain Utility Tokens : Throwing The Baby Out With The (Securities Regulation) Bathwater?”.
But what has become of this speculation? What has become of this hope, this beacon for blockchain tokens and digital assets?
Well, as far as we have seen, not much.
Not only are the aforementioned pieces of would-be federal legislation slow moving; they appear for all accounts to be still born.
Despite ongoing SEC enforcement actions against “unregistered initial coin offerings”, the token-driven blockchain startup ship seems largely stuck in the doldrums.
We argued that there should be room to allow more flexibility for utility tokens beyond the very limited constraints imposed by the the two SEC No-Action letters. We saw utility tokens as more than the “book-of-the-month” club tokens ala erstwhile SEC Chairman Jay Clayton and necessary drivers of the new frontier of blockchain startups.
What Is: Non-Fungible Tokens (NFT’s)
So here we are. Two years on and a little deflated.
While unregistered or non-exempt token offerings were started with great fanfare, reaching their crescendo in 2017 with the wild-west of unregistered ICO’s shot down O.K. Corral style by the SEC, followed by the utility being sucked out of utility tokens, we have now arrived at the third blockchain marvel attracting ever-increasing interest, and, dare we say it, speculation.
Enter Non-Fungible Tokens, now intimately called NFT’s or Nifty’s or other variations on the acronym, with room after room on Clubhouse packed with aspirant or actual minters of the, mainly digital art tokens, and platforms like Superare and Nifty Gateway minting, promoting, or creating markets in NFT’s.
Another goldrush it seems?
Even established art dealers and auction houses are getting in on NFT’s, with NFT’s becoming the new buzzword.
At the time of writing, Christies has Beeple’s (AKA Mike Winkelmann ) ‘Everydays: The First 5,000 Days’, a unique digital monolithic composition of thirteen years of Beeple’s daily artwork in a dedicated online sale that Christies hails as the “…the first time a purely digital work of art, also known as an Non-Fungible Token (NFT), has ever been offered by a major auction house…[and]…an important milestone in the development of the market for digital art.” The ‘current’ bid for the work is a staggering $2,400,000, with the Christies’ estimate saying it all “Estimate unknown”.
Artnet reports that this isn’t the highest price so far for a Beeple. According to its report and (Nifty Gateway’s twitter account), Nifty Gateway’s art buying service facilitated a $6,600,000 sale of ‘Crossroad #1/1’ on February 24th, an example of the platform’s direct market-making.
Now everyone seems to see blockchain (and art blockchain) in a different light: not just Bitcoin, but digital art tokens can hold value as authenticated originals, the original artifact, stores of value; all worthy of speculation.
From the early days of Colored Coins, to Cryptopunks and CryptoKitties to now digital artists on dedicated digital art platforms selling tokenized digital images for prices, currently, up to hundreds of thousands of dollars.
Non-fungible they are, in the sense of being unique blockchain stamped tokens that are not directly interchangeable with other digital tokens, but they remain digital tokens nonetheless, made operable, most notably through ownership-recognizing Ethereum ERC-721 and, now, ERC-1155 standard interfaces, instead of the standard fungible token interface, ERC-20.
It was fungible tokens that caught the eye, and wrath of the SEC in the initial token goldrush, as being ‘investment contracts’, AKA securities requiring registration or exemption from registration in their offering or sale.
What Could Be: NFT Securities Implications?
So what’s the story with NFT’s?
Are these, as their makers, minters or promoters may say, simply assets, bought and sold like one would a digital print?
As the rush escalates, and NFT platforms proliferate, the SEC, seems to be, at least outwardly, quiet. It has been quiet, it seems since April 2019, the time of its release of its Framework, in which FINHUB stated that “…[i]n evaluating digital assets, we have found that a “common enterprise” typically exists…” continuing at foot note 11, that “…[b]ased on our experiences to date, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts…”.
Those familiar with the SEC discourse on the matter will immediately recognize that a ‘common enterprise’ is one of the components of the Howey test used to determine whether an arrangement or instrument is an ‘investment contract’ and whether its offering or sale is a securities transaction, subject to the US securities regime.
The SEC expressed the Framework to be exactly that: a framework for determining whether a digital token is an investment contract, AKA a security.
Back to SEC v. W. J. Howey Co.
The Framework, applying the Howey test, that an ‘investment contract’ exists: “…when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others…” (our emphasis) The Framework then went on to evaluate digital assets under that test after saying that, “…[w]hether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances…”, spelling out the primary components, viz. ‘investment of money’, ‘common enterprise’ and a ‘reasonable expectation of profits derived from the efforts of others’.
Investment of Money
Looking at how this may apply to NFT’s, as we have seen, value, and lots of it, appears to be given for NFT’s.
Platforms minting NFT’s tend to emphasize the considerable sums being paid for unique digital originals or multiples.
Examples of the extent of this are the Beeple works. But that is one out of a list of many trading at many multiples of the initial Drop. One work, just as an example, by Slimesunday also listed recently on Nifty Gateway, titled ‘The Last Stand of the Nation State’, marketed as a multiple in an edition of 415 at an original listing price of $40, “last sold” at $17,000.
Common Enterprise
The second Howey head, and this takes us back to the FINHUB’s perhaps prescient comment that a ‘common enterprise’ usually exists with digital assets, because “…the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts…” (see above).
One may argue, perhaps, the SEC was not concerned when it wrote the Framework in 2019 with the current NFT-hype, and certainly art blockchain tokens were not then on its mind. Its Framework, after all, one may say, starts with “…[i]f you are considering an Initial Coin Offering, sometimes referred to as an “ICO,” or otherwise engaging in the offer, sale, or distribution of a digital asset,[2] you need to consider whether the U.S. federal securities laws apply…”, and ICO’s were the focus of the time.
But, to counter. one may add that, after all, it is a Framework for investment contract analysis of digital assets, as a whole, and Howey, as a matter of US federal law, applies to analyses of investment contracts generally regardless whether one is issuing, for value, fungible digital tokens or non-fungible tokens, with or without a digital image.
The SEC’s statement here seems to be a bold one, albeit qualified in that footnote 11 on its experience to date.
So, are the fortunes of NFT purchasers linked to each other or the success of the promoter’s efforts?
The promoters, after all, provide the market, mint the tokens, and promote the value in the digital assets, driving the demand. The promoters usually take a percentage of the sales, and have a vested interest in driving both primary sales (“Drops”) or a secondary market place for NFT resale. As we have seen from the Beeple sale, there appears to be active involvement in market-making.
Does it matter that its tokens, unlike the usual fungible tokens, have a digital image associated with it or that that image has been created by artists or other contributors, or that the platforms take a (relatively) small percentage of the proceeds? Is this an enterprise? Are the fortunes of the NFT buyers not tied to the buoyancy of the market, the enterprise carried on by the promoters? Is this not an example of “vertical commonality”, referenced in footnote 10 of the Framework, as an example of a common enterprise? Lots of questions in unchartered territory.
Reasonable Expectation of Profits Derived from the Efforts of Others
The last Howey prong takes up a sizeable part of the Framework, and whether there is “reliance on the efforts of others” devolves into two considerations (quoting from the Framework for each rung):
A. “ Does the purchaser reasonably expect to rely on the efforts of a…[promoter]?” B. “Are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise,”[14] as opposed to efforts that are more ministerial in nature?”.
These considerations, turn, themselves, on certain characteristics mentioned by FINHUB, which in essence relate to the promoter’s control of the platform, its direction, rules, governance, supply of digital tokens and whether it creates or supports a market for the platform.
From these factors it appears, that the more centralized and controlled the platform, and the issuance of tokens are, the more there is reliance on the efforts of others.
One factor here is which stands out is the promoter’s determination of where the digital asset will trade. Here the Framework mentions that “…[f]or example, purchasers may reasonably rely on a…[promoter]…for liquidity, such as where the …[promoter]…has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform.”
Here NFT promoters appear to be instrumental in minting the digital assets, and in creating the market for it.
However, that works are appearing prominently in other sales channels, Christies as an example, may point to the conclusion that this is a market not-dependent on each platform and something that is primarily driven by market factors, easily capable of surviving and thriving independently of the platforms’ efforts.
Reasonable Expectation of Profits
The creation and support of both primary and secondary markets are factors which FINHUB mentions in support of there being a reasonable expectation of profits.
While, according to the Framework, “…[p]rice 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…”, neither is actual participation in the profits of the enterprise a pre-requisite for falling within this rung of the test.
FINHUB mentions that realizing “…gain from capital appreciation of the digital asset…” is a factor leaning towards a reasonable expectation of profits, and again, “…particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains…”.
Harking back to the rationale for ICO’s, FINHUB further looks in the Framework at whether the digital asset is being offered to potential purchasers broadly, rather than users of the promoter’s goods or services, and other factors aimed, apparently, at correlating purchase of digital assets with use of platform goods and services, indicative of an ‘investment intent’ if the holding of tokens doesn’t reflect the purchasers need for the enterprise’s goods or services.
Much of this analysis appears to be focused on the ICO experience. Unlike an enterprise carrying on a business providing wholly distinct goods and services, NFT promoters appear to offer no primary products or services other than the minting of the tokens and the creation, or facilitation of the markets for these digital assets.
In other words, there appears to be no business separate to the digital tokens themselves, the success of which could fuel the value of the tokens. The capital appreciation in the tokens, it could be argued, is derived from the uniqueness of the digital assets and general NFT market fascination and speculation.
But, it seems that there may be some argument that the success of these platforms, and the liquidity of the digital assets on them “…comes, at least in part, from the operation, promotion, improvement, or other positive developments in the…[platform]…particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains”.
It is further arguable, that as these platforms mature, some may be more successful or popular than others, with access to one being more exclusive or lucrative than the other. Although using blockchain for its core functionality, the NFT platforms are not decentralized.
For the most part, they appear to be for profit platforms deriving revenue from token issuances and secondary resales. It could be said that there is a clear incentive to improve and develop the platforms, and as a result, an expectation of enhanced appreciation in the value of the digital art NFT’s it mints.
Overall, given the frenzy surrounding digital art NFT’s, the prices apparently being paid, and the availability of promoter directly provided secondary markets, it may be difficult to argue that there is no ‘expectation of profit’.
Breaking the Silence
In the heady day of the ICO craze, tokens were hailed as the new ‘thing’, the new way of raising capital without securities concerns.
Purchasers apparently poured billions into tokens with little disclosure, and little knowledge of the underlying businesses that issued the tokens.
Professionals opined as to the ‘utility’ of the tokens making them something other than registerable securities; assets not securities, they said.
Then the SEC caught up. Its determinations and enforcement actions were damning, and its crackdowns on ICO’s continue to this day. Even on utility tokens, its No-Action Letters (as in TurnKey Jet and Pocket Full of Quarters) were, it is submitted, very narrowly tailored.
And now digital art NFT’s are all the rage. A new twist on digital tokens, which one could view, arguably, as nothing more than token issuances for the sake of it, where the attraction is the nature and uniqueness of the tokens themselves, but whose value, and the fortunes of its purchasers are, for at least for the most part, dependent on the very market-making of the issuer of those tokens itself.
Conversely, the argument is that this is nothing more then the creation and sale of an asset, albeit a digital asset that has inherent value because of its uniqueness and extraneous market demand, and this is being borne out now by the acceptance of the digital assets in traditional secondary market sales channels.
But, if that argument sounds vaguely familiar, it may be that we have heard it before. It certainly appears that a lot of money is being invested into these digital stores of value with promoters earning their share, and perhaps with not much insight as to nature of NFT’s, how these markets operate and what longevity and sustainable value there is. One can argue that there is bound to be abuse, losses and casualties of these new markets.
Digital assets and digital currencies are vital economies that provide not only considerable opportunities for streamlining day-to-day functioning and making the way we interact with, the world, manage and own assets that much more certain and efficient, but are also potentially a catalyst for growth and expansion of the very start ups that initiate and move these economies forward.
Blockchain and art blockchain are not fads. Digital art NFT’s are one use of asset-based blockchain, and how we hold, manage and transact in assets, we believe, is bound to be one of the most promising blockchain use cases.
It needs to be said, though, that it is ever so slightly troubling that blockchain’s true potential may well be missed in the headlights of speculation, and we can only hope that this is the beginning of something which draws people’s attention to the immense potential of art blockchain and blockchain in general.
What is sorely needed now, though, is a break in regulatory silence. Almost two years in this fast moving market, COVID aside, is a very long time, and, as we have touched on briefly here, two-year old guidance doesn’t really fit digital art NFT’s that well.
Stalling initiatives on utility tokens, and apparently not updating guidance on emerging token uses creates uncertainty, opportunities for abuse and slows progression in other blockchain use cases.
Interest in Digital art NFT’s has exploded over night. Whether it proves to be another chapter in blockchain misadventure or a sustainable industry remains to be seen. However, without any apparent regulatory pronouncement on the industry, perhaps a measure of caution is the best medicine for now.
** This article is intended to be informational only, and does not constitute legal advice. Competent, specific legal advice from a suitable, licensed attorney, should always first be obtained before taking any action, and the information in this article should not be relied upon independently of that advice.