NFTs: Are They Securities?

By Susan J. Lutzker, Carolyn Wimbly Martin and Sara Etemad-Moghadam

This is the second in a two-part series on the current status of NFTs. The first Insight in the series discusses the evolving, less sensational but more functional approach to the use of NFTs. In part two of the series we explore whether an NFT is a security and, if so, the additional scrutiny and requirements this will bring to this nascent market.

The issue of whether an NFT is deemed a “security” within the meaning of federal securities laws is unsettled. How this question is answered will significantly impact the NFT market going forward.

Is an NFT a security?

There are conflicting legal opinions as to whether an NFT constitutes a “security” under U.S. law so as to require compliance with complicated disclosure requirements. For example, in the unconfirmed investigation (described below) by the U.S. Securities and Exchange Commission (“SEC”) of Yuga Labs for possible securities violations involving the Bored Ape NFT collection, those in the “no” camp point to the diversity within the collection. Those in the “yes” camp, however, see no meaningful difference between the purchase of an NFT and the purchase of a share of stock in a traditional company. Investors look for a profit in each case with profits rising and falling with the reputation of the brand.

A class action lawsuit directly addressing the issue of whether an NFT is a security survived a motion to dismiss in February 2023. In Friel v. Dapper Labs, Inc., No. 21 CIV. 5837 (VM), ECF No. 43 (S.D.N.Y. Feb. 22, 2023), the Defendant Dapper Labs argued that NFTs are like art, given the diversity within the collection, and are not subject to federal securities law. Dapper partnered with the NBA to sell digital basketball cards, featuring player stats and video clips of plays. They claimed that, like physical basketball cards, these digital cards could be bought in packs, traded among collectors, assembled into sets and shown off to friends. A judge on the U.S. District Court for the Southern District of New York rejected Dapper’s motion to dismiss and the case is moving forward. However, as the court acknowledged in its ruling, the ultimate analysis in the case will involve examination of the specific facts, so it is unclear whether the reach of this decision will be limited to the facts of this case.

The SEC has also filed suit against Ripple Labs, claiming that they raised more than $1.3 billion through an unregistered securities offering for the sale of their XRP cryptocurrency token. While this case does not involve NFTs, the decision as to whether XRP is a security could have implications for the NFT market. In July 2023, the U.S. District Court for the Southern District of New York held that the XRP tokens were not securities because buyers did not have a reasonable expectation of profits tied to Ripple’s efforts.

On August 28, 2023, the SEC fined Impact Theory, LLC, an entertainment company based in Los Angeles, $6.1 million, for offering and selling NFTs in an unregistered offering. The SEC cited the Howey Test, which includes the following criteria to determine whether something is an investment contract: “(1) [t]here is an investment of money; (2) in a common enterprise; (3) in which the investor expects a profit; and (4) the profit is derived solely from the efforts of others.” The SEC pointed to Impact Theory’s promises to deliver “tremendous value” to purchasers of their NFTs. In addition to the fine, the SEC has also mandated that the company destroy any remaining NFTs in its possession and return all funds to investors who purchased any NFTs.

A potentially high-profile matter is an unconfirmed investigation by the SEC of Yuga Labs for possible violation of federal securities laws involving the Bored Ape NFT collection, derivative products and ApeCoin, its proprietary digital currency. Many question why Bored Ape would be the first to be investigated and suggest that this is an attempt by the SEC to protect its turf by carving out a role in this burgeoning industry. This inquiry, however, is consistent with a trend at the SEC to regulate the crypto market, following a $50 million fine on crypto exchange firm BlockFi for failing to register the offers and sales of their products. Others question why the SEC would even want to be involved in regulating the uniquely complex art market.

Interestingly, a similar debate is taking place in the United Kingdom, where a mural by the famous and elusive artist Banksy was fractionalized and sold in shares. Although as yet there is no direct legal challenge, questions have been raised as to whether this constitutes a collective investment scheme subject to UK securities regulations.

Will additional regulatory oversight give investors more confidence in the NFT investment market or accelerate the shift from a get-rich-quick scheme to other business models focusing on authentication, provenance and a vehicle to track and compensate artists with resale royalties? While it may be too early to know, Lutzker & Lutzker will continue to follow these developments.