The US Securities and Exchange Commission (SEC) has commenced investigation into the question of whether non-fungible tokens (NFTs) constitute securities. Those with their finger on the regulatory pulse are not in the least bit surprised:
What is the likely outcome? Let’s start by defining “securities”.
Securities Defined
Securities are financial instruments that can be traded between parties in open markets, such as stock exchanges. Of the four main types, equities, or shares, are the most widely understood.
From a US legal perspective, there is a four-prong test to determine whether an offering constitutes an investment contract rendering it a security, and thus requiring registration with the SEC. The transaction must satisfy all four elements, known as the “Howey test”:
- It involves an investment of money;
- It has a common enterprise;
- It was made with a reasonable expectation of profits; and
- It is derived from the entrepreneurial or managerial efforts of others.
Are NFTs Securities?
Reports suggest that SEC attorneys have sent subpoenas to NFT creators and various exchanges requesting more information. In particular, they are apparently focused on fractional NFTs – those where the NFT is broken down into many parts and sold separately.
SEC Commissioner Hester Peirce forewarned that this was coming in December:
Given the breadth of the NFT landscape, certain pieces of it might fall within our jurisdiction … people need to be thinking about potential places where NFTs might run into the securities regulatory regime.
Hester Peirce, SEC Commissioner
SEC chief Gary Gensler has also previously said he believes many tokens are probably securities within the purview of the SEC since they pass the Howey Test.
While it is unclear whether the investigation is limited to fractional NFTs or the broader sector, some evidently understand that a strict interpretation of the Howey test may render them securities:
The SEC has had its hands full of late, from perpetually denying crypto exchange-traded funds (ETFs) to tackling initial coin offering (ICO) frauds.
At this point, it’s not clear what the end result of this NFT investigation will be. However, on a plain language understanding of the Howey test:
- Do NFTs involve an investment of money? Tick – fiat currency or ETH.
- Are NFTs a common enterprise? Tick – the project or club.
- Are NFT offerings made with a reasonable expectation of profits? Tick – of course.
- Are NFTs derived from the entrepreneurial or managerial efforts of others? Tick – the creators, developers, marketeers and entire team.
As with all things, the devil is in the detail. In addition, when it comes to enforcement action, politics are as relevant a factor as the law itself – just ask Wall Street.
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