When Does a Non-fungible Token (nft) Become a Security?

• Jurisdiction: United States,Federal
• Citation: Vol. 39 No. 2
• Publication year: 2023
• topic: Securities Law

When Does a Non-Fungible Token (NFT) Become a Security?

Brian Elzweig
University of West Florida, belzweig@uwf.edu

Lawrence J. Trautman
Prairie View A&M University, lawrence.j.trautman@gmail.com

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WHEN DOES A NON-FUNGIBLE TOKEN (NFT) BECOME A SECURITY?

Brian Elzweig* & Lawrence J. Trautman^**

Abstract

Non-fungible tokens (NFTs) gained prominence in the news cycle during March 2021 when $69 million was paid in a cryptocurrency known as Ether for a unique digital art piece titled Everydays: The First 5000 Days. Regulating NFTs is complicated because the technology encompasses varied applications. Therefore, it is the particular use of a given NFT that will determine its appropriate regulatory regime. For example, NFTs may take the form of collectibles, data associated with a physical item, financial instruments, or permanent records associated with a person, such as marriage licenses or property deeds. Just like digital art in the form of NFTs, our laws and regulations are in a constant struggle to keep pace with rapid introduction and diffusion of technological changes. Unlike digital or cryptocurrencies which are fungible, NFTs are not. The effective regulation of United States securities markets has a significant impact on capital formation, job creation, economic security, and growth of both the American and global economies. In

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recent years, the advent of the internet has created novel regulatory challenges for the U.S. Securities and Exchange Commission (SEC).

The focus of our Article is how and when an NFT becomes a security for purposes of U.S. securities law. We proceed in six parts. First, we briefly explain the evolution of the digital world and emergence of virtual economies within. Second, we describe blockchain technology and the growth in virtual currencies. Third, we provide an explanation of NFTs along with some examples of their various uses. Fourth, we discuss when an NFT is a security. Fifth, we explore SEC interpretations of when a crypto-asset is a regulatable security. And last, we conclude. Given the importance of U.S. securities markets in fostering job creation and global economic growth, we believe this work contributes to the understanding of this new technology and is of considerable interest to securities issuers, investors, and the regulatory community.

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CONTENTS

Introduction.................................................................................298

I. Evolution of the Digital World..........................................300

A. Second Life, Online Gaming, and Virtual Economies.......300
B. The Legal Challenge..........................................................301

II. Blockchain Technology and Virtual Currencies...........303

A. Law and Rapid Technological Change.............................303
B. Blockchain Defined............................................................304
C. Early Applications of Blockchain Technology..................305
D. Anticipated Uses................................................................306

III. Emergence of Non-Fungible Tokens (NFTs).....................306

A. Art Market for NFTs Explodes..........................................306
B. Sports and NFTs................................................................308

IV. When Is a Crypto-Asset a Security?.................................310

A. Crypto-Assets as Securities...............................................310
B. The Howey Test.................................................................311

V. SEC Interpretations of When Crypto-Assets Are a Regulatable Security.........................................................313

A. The DAO Report ................................................................314
B. CryptoPunks: The Security?..............................................330

Conclusion....................................................................................335

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Introduction

Non-fungible tokens (NFTs) gained prominence in the news in March 2021 when $69 million was paid in a cryptocurrency, known as Ether, for a unique, digital art piece titled Everydays: The First 5000 Days¹ This highly publicized sale, "fueled in part by the wealth recently created from digital currencies," influenced a rush of prominent art dealers like Sotheby's and Christie's to take advantage of the interest in this rapidly evolving market for digital art.² In less than two decades, the distributed digital ledger, blockchain technology, has spawned over 19,000 digital currencies like Bitcoin, Ethereum, Tether, and NFTs.³ Regulating NFTs is complicated by the fact that the technology encompasses varied applications.⁴ Therefore, the particular use of an NFT will determine its appropriate regulatory regime because the NFT may "alternatively represent a collectible, a financial instrument, or a permanent record associated with a person, digital or physical item, or data."⁵ Like digital art in NFT form, our laws and regulations are in a constant struggle to keep pace with "[r]apid introduction and diffusion of technological changes."⁶ Unlike digital or cryptocurrencies that are fungible, NFTs are not.⁷

The effective regulation of United States securities markets has a significant impact on capital formation, job creation, economic

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security, and growth of both the American and global economies.⁸ In recent years, the advent of the internet created novel regulatory challenges for the U.S. Securities and Exchange Commission (SEC).⁹ The financial industry has become an early adopter of blockchain "technology, and stock exchanges have proposed using blockchains as a new method for trading corporate equities and tracking their ownership."¹⁰

The focus of our Article is how and when an NFT becomes a security for purposes of U.S. securities law. We proceed in six parts. First, we briefly explain the evolution of the digital world and the emergence of virtual economies within. Second, we describe blockchain technology and the growth in virtual currencies. Third, we explain NFTs and provide examples of their various uses. Fourth, we discuss when an NFT is a security. Fifth, we explore SEC interpretations of when a crypto-asset is a regulatable security. And last, we conclude. Given the importance of U.S. securities markets in fostering job creation and global economic growth, we believe this work contributes to the understanding of this new technology and is of considerable interest to securities issuers, investors, and the regulatory community.

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I. Evolution of the Digital World

A. Second Life, Online Gaming, and Virtual Economies

Many observers attribute the genesis of virtual currencies to David Chaum's 1982 crypto journal article.¹¹ More than two decades ago, economist Edward Castronova wrote, "On March 16, 1999, Verant Interactive, a holding of Sony, launched an on-line computer game called Everquest on five servers in San Diego, California, USA. . . . Some 60,000 people visit Norrath in any given hour, paying for the privilege, around the clock, every day, year-round."¹² In terms of time commitment, "[n]early a third of the adults among them - perhaps some 93,000 people out of Norrath's 400,000 person user base - spend more time in Norrath in a typical week than they do working for pay."¹³ And, even in the early days of virtual economies, "[t]he exchange rate between Norrath's currency and the US dollar is determined in a highly liquid . . . currency market, and its value exceeds that of the Japanese Yen and the Italian Lira."¹⁴

Virtual assets and marketplaces developed in software games such as World of Warcraft, in other Massively Multiplayer online Role-Playing Games (MMoRPGs), and in other virtual reality environments, such as Second Life, where virtual assets were exchanged for actual sovereign currencies.¹⁵ Professors F. Gregory Lastowka and Dan Hunter write, "Representational proxies in these virtual spaces are known as 'avatars,' . . . [and] unlike prior videogame alter-egos, can be richly customized and are designed primarily

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for social interaction."¹⁶ Avatars may be personalized and "express themselves through appearance . . . . You can choose the face, clothes, and body shape of your avatar and communicate with others through body language. . . . Virtual-world participants design costumes, furniture, and houses for their avatars, and sell their creations to others."¹⁷ Early on, "[p]erhaps because [these] virtual worlds support this kind of rich social interaction, many of those who have chosen to visit virtual worlds remain residents of them. The average Everquest player and Norrath avatar, for instance, spends about twenty hours a week within the virtual world."¹⁸ Prominent uses for virtual worlds include "entertainment, academics, military training, medical treatment, and electronic commerce."¹⁹

B. The Legal Challenge

Professor Jack Balkin observed as early as 2004 that "legal regulation of virtual worlds is inevitable. If this regulation is not developed by courts through resolving contract and property disputes, it will surely occur through legislation and administrative regulation."²⁰ Professors Lastowka and Hunter state that although virtual worlds are "artificial, fictitious, imaginary, intangible, and invented," they are also real.²¹ "All things artificial or invented do not fall entirely outside the ambit of reality. If they did, we would need to banish from reality all manner of human actions and creations, including buildings, languages, and—most importantly for our purposes—laws."²²

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Like we will see with NFTs, early virtual worlds resulted in "[h]undreds of millions of dollars in revenue . . . flowing into the coffers of Sony, Electronic Arts, and the other companies that own virtual worlds. . . . One might predict that where large amounts of real money flow, legal consequences follow."²³ Professor Joshua A.T. Fairfield writes, "People being people, they defame, harass...