Non-fungible tokens, commonly called NFTs for short, have become an increasingly popular digital asset, especially in light of some eye-popping sale transactions involving Jack Dorsey’s first tweet, Bored Ape NFTs, NBA Top Shots Moments, and a number of other digital works of art. However, like other blockchain-based digital assets, NFTs raise some interesting and novel legal questions.
How are NFTs Different?
As the name suggests, NFTs are different from other types of crypto-tokens because they are non-fungible, meaning that each one is unique and cannot be exchanged for another identical token. This is unlike, for example, Bitcoin; if you hold a Bitcoin, you can exchange it for another Bitcoin, and there is no difference. Each NFT is one of a kind. In some cases, this is literally true; in other cases, an NFT may be one of a limited number of a similar tokens, with each one uniquely numbered. In the latter instance, earlier numbered NFTs may be more valuable than later numbers.
Are NFTs Securities?
Before discussing this question, please note that the standard disclaimer for blockchain-related legal issues applies. In other words, the law in this area is uncertain and rapidly evolving, both in terms of the courts and in terms of federal policy and legislation. Several pending court cases and proposed laws could alter this landscape very quickly.
With that preface, the answer to whether or not an NFT is a security depends entirely on what the NFT represents. Many NFTs are clearly not securities. For example, NFTs that represent entire discrete assets, such as a work of art, a tweet, or the rights to a song, are clearly not securities, because the NFT merely serves the purpose of providing an immutable representation of the purchaser’s ownership of that item. Similarly, an NFT might represent membership in an organization, a digital ticket to attend a concert or other event, or an access token enabling participation in an online community (e.g. a Discord server). This same concept also extends to circumstances where the NFT represents ownership of a physical good, such as a bottle of wine, or a baseball card; for collectible items, the NFT can serve as a digital certificate of authenticity.
On the other hand, when an NFT represents a partial interest in an asset or enterprise, or a right to receive profits from a project or business, the NFT is likely to be classified as a security. The key difference is that, in the latter examples, the value of the NFT is directly dependent on the efforts of others, which is a key element of the principal test that is used to analyze whether something is a security. The test, called the Howey test after the 1946 U.S. Supreme Court case that first set out the criteria, uses four criteria to analyze whether a particular arrangement qualifies as an investment contract, which is a type of security. The elements of the test are; (1) an investment of money into (2) a common enterprise, pursuant to which (3) there is an expectation of profits (4) solely based on the efforts of others.
Of course, the challenge with the Howey test is its age; in 1946, computers were mostly the stuff of science fiction, and technologies like the internet and blockchain were unimaginable. Thus, while the analysis is straightforward for some NFTs, for others, the application of Howey is less clear. For example, does the fact that the issuer of NFTs representing sports video highlights also offers a secondary market for owners to resell and trade those NFTs constitute an “expectation of profits solely based on the efforts” of others? That is the central question before a U.S. District Court in the ongoing case of Friel v. Dapper Labs, Inc.
In 2019, the SEC published its Framework for “Investment Contract” Analysis of Digital Assets in an attempt to provide a modern framework for analyzing whether a particular arrangement involving digital assets is a security. Though it is not binding on the SEC in the same manner that a statute or regulation would be, it does provide good insights into the agency’s current thinking. However, some level of uncertainty will likely persist until Congress passes new laws. Several bills are currently pending, some of which would provide a significantly clearer and more practical framework; The Lummis-Gillibrand Responsible Financial Innovation Act is particularly noteworthy in this regard.
NFTs are vulnerable to certain types of scams. For example, NFTs representing art or other creative works can be plagiarized, just as traditional art can be. In fact, popular NFT marketplace operator OpenSea tweeted in January 2022 that a significant number of NFTs minted using its lazy minting process are plagiarized. Similarly, NFTs representing art can be used for money laundering purposes just as traditional art has often been used for such purposes historically.
However, we've recently seen misuse of this feature increase exponentially.
Over 80% of the items created with this tool were plagiarized works, fake collections, and spam.
— OpenSea (@opensea) January 27, 2022
NFTs also can be used for other types of fraud. One example is “wash trading”, which involves members of a group trading NFTs back and forth among themselves for higher and higher values, until eventually someone who is outside the group buys the NFT at the artificially inflated price.
Other examples include variants on phishing scams intended to access someone’s private digital wallet keys or similarly sensitive information.
NFTs are likely no less risky than any other purchase or trading activity online, but, because they are new, it may be easier for people to miss the warning signs. Anyone purchasing or trading NFTs would be wise to spend some time doing their own research on a particular opportunity. As with other online activities, a bit of due diligence and a dose of common sense will likely help most users avoid common scams.
NFTs are an interesting and unique type of digital asset presenting novel opportunities and also novel questions. Both the business of NFTs and the laws and regulations are evolving rapidly, and the courts and regulators are finally starting to address various concerns. No one knows what will change, but it is certain to be interesting.
Chris Sloan is an attorney at the law firm Baker Donelson and chair of the firm’s Emerging Companies Team. He focuses his practice on startups and other emerging businesses. Sloan can be reached at firstname.lastname@example.org.