On July 29, 2024, two artists filed a pre-emptory lawsuit against the United States Securities and Exchange Commission seeking judicial clarity on the applicability of US securities laws to the sale of digital artwork created by them in the form of Non-Fungible Tokens (“NFTs“).
As is known, NFTs are crypto-assets that serve as unique digital identifiers, cannot be copied, subdivided or substituted, are recorded on a blockchain and used to certify authenticity and ownership over the unique underlying asset, whether physical or digital.
This lawsuit did not occur in a vacuum – the rapid growth of the NFT market in 2020 added fuel to the intensifying debate over the appropriate regulatory enactment and interpretation of crypto-asset-related legislation, as well as the scope of authority conferred on the SEC when it comes to NFTs, as many claim that the SEC’s current stance has in fact contributed substantively to the growing apprehension among crypto-asset issuers and sellers, not only in the sense of creating legal uncertainty, but also in stifling innovation.
In Europe, the regulation of financial instruments and crypto-assets falls within the scope of several governing legal frameworks. In recent years, the European Commission has spearheaded investing enormous efforts aimed at bringing legal certainty to the crypto industry, and harmonizing the legislation of crypto-assets, including NFTs at the Union level, through the issuance of directives, public consultations and published guidelines.
More specifically, the newly enacted EU Directive of Markets in Crypto-Assets Regulation (“MiCA“), which entered into force in June 2023, and is set to be fully implemented by December 30, 2024, marks a significant milestone with respect to the governance of digital assets across the EU Member States, aimed at fostering innovation while upholding market integrity and financial stability. Essentially, MiCA lays down uniform market rules for crypto-assets that previously fell outside the scope of the then existing EU financial services legislation.
MiCA explicitly states (Article 2(3)) that it does not apply to crypto-assets that are unique and not fungible with other crypto-assets (namely, NFTs), whose value is attributed to the uniqueness and utility they bestow on their holder. However, this exemption is not absolute. Certain NFTs may fall within the scope of MiCA if, cumulatively, they do not meet the criteria of uniqueness and non-fungibility. In this context, it should be noted that the preamble of MiCA stipulates that when assessing and classifying crypto-assets (including NFTs), competent authorities should adopt a ‘substance over form’ approach, whereby the classification of a crypto-asset should be determined by its features, rather than its designation as portrayed by the issuer. Therefore, in order for an NFT to be considered a token exempt from MiCA, the underlying assets or rights must be inherently unique and non-fungible, regardless of the token’s technological attributes. For illustration purposes, reference is made in MiCA to certain features of NFTs that would preclude them from being construed as “nonfungible”, such as fractional NFTs, the issuance of a large series or collection of NFTs and the uniqueness of the underlying asset or service.
Nonetheless, the exclusion of NFTs from MiCA does not derogate from their potential qualification as “financial instruments”, as such term is defined in the EU Directive of Markets in Financial Instruments (“MiFID II“). A review of the list of financial instruments in Section C of Annex I to MiFID II suggests that NFTs might qualify as ‘transferable securities’, provided they satisfy three key criteria (Article 4(1)(44)): (1) they are negotiable, (2) they are transferable, and (3) they encapsulate rights attached to securities. NFTs that qualify as financial instruments under MiFID II are governed by existing EU financial services legislation so that the entire EU regulatory framework in place will accordingly apply with respect to issuers of such deemed financial instruments as well as to firms engaging in the creation, marketing and selling of such deemed financial instruments, thereby eliminating the applicability of MiCA in this regard.
Further, in order to better understand the circumstances under which crypto-assets (including, to the extent applicable, NFTs) may qualify as transferable securities, the European Securities and Markets Authority (“ESMA“) undertook a survey of the Member States in the summer of 2018 that highlighted the different classifications bestowed on identical crypto-asset by the various National Competent Authorities (NCAs), the findings of which demonstrated that: “The existence of attached profit rights, without having necessarily ownership or governance rights attached, was considered sufficient for a majority of NCAs to qualify crypto-assets as transferable securities whether as shares or another type of transferable security”.
It therefore seems that the existence of an expectation of profit, without necessarily having any ownership or governance rights attached, would suffice to qualify crypto-assets as transferable securities. However, such inference of an “expectation of profit” is not a concept that is expressly mentioned or even used to qualify a financial instrument under MiFID II. Although it could be construed as defining the transformation of an economic function into a qualification criterion, it has no clear legal basis under Union law.
In response to the survey findings, and due to concern of the potential misclassification of crypto-assets, on January 29, 2024 ESMA published draft guidelines on the Conditions and Criteria for the Qualification of Crypto-Assets as Financial Instruments (“Draft Guidelines”). The Draft Guidelines reiterate MiCA’s viewpoint that the legal qualification of a financial instrument should not be determined by its technological envelope, but rather a ‘substance over form’ approach should be followed on a case-by-case basis in order to assess whether the crypto-asset in question indeed qualifies as a financial instrument under MiFID II (i.e., a deemed transferable security), or as a crypto-asset falling within the scope of MiCA, or as an unregulated token. The Draft Guidelines also provide specific guidance for ascertaining whether an NFT would be deemed as falling within the scope of MiCA, and stipulates that crypto-assets that lack true uniqueness and are interchangeable, may fall within the regulatory purview of MiCA. For instance, the specific technological attributes of NFTs that offer similar utility or access rights, such as granting access to exclusive events, are less relevant when compared to the utility they provide, thus rendering those NFTs functionally interchangeable for practical purposes.
Contrary to the EU’s strategy, of enacting dedicated directives for regulating crypto-asset activities, in the US, the SEC and the US courts instead adopted the course of applying the prevailing four-prone Howey test that was established back in 1946 with respect to traditional financial instruments, in order to ascertain whether crypto-assets, including NFTs, fall within the scope of US securities laws and thus should be scrutinized as such. Under this test, an asset is deemed a security (or investment contract) if it involves: (1) an investment of money or something of value, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the essential entrepreneurial efforts of others.
For example, the SEC has already deemed that certain NFTs can be considered securities under the US Securities Act of 1933, as in the case of SEC v. Impact Theory LLC, where Impact Theory was charged with offering unregistered securities when it sold NFTs to raise funds. What contributed to the SEC’s decision in this case was Impact Theory’s marketing strategy of linking the value of its NFTs directly with its performance, thereby encouraging investors to view their purchase of NFTs as a business investment.
Additionally, on September 16, 2024, following the initiation of cease and desist proceedings, the SEC charged Flyfish Club LLC for having conducted an unregistered offering of crypto-asset securities in the form of NFTs. Specifically, the SEC issued an order against Flyfish Club for selling $14.8 million worth of NFTs, asserting that they were issued to the public in order to finance the construction and operation of a members-only restaurant and club in New York. According to the SEC, the NFTs were issued and sold as an investment contract, and therefore constitute securities, pursuant to the four-prone criteria established in the Howey test. Similarly to its ruling in the Impact Theory case, the SEC heavily emphasized the significant marketing efforts of the issuer and the potential profits to be gained from reselling the NFTs, their potential appreciation in value if the restaurant is successful and the like. The SEC also noted that the collection of NFTs purportedly linked to certain artwork in question was found not to be unique to each NFT.
As a precaution for creating and/or selling NFTs, all or some of the following measures can be taken in order to increase the probability of them falling outside the scope of the existing EU or US legal frameworks:
Lastly, it is important to recognize that laws focusing specifically on crypto-assets, and the application of existing financial services legislation to encompass the creation, marketing and selling of crypto-assets are still relatively new and consistently evolving, particularly given the rapid developments in technology generally, and technological developments in crypto-assets and the crypto-assets market in particular.
