Last week, OpenSea, a popular NFT [non-fungible token] marketplace, revealed that it had received a Wells Notice from the Securities and Exchange Commission (SEC). The missive indicates a good probability of a forthcoming enforcement action against the firm.
While NFTs are largely aligned with digital collectibles, the sector has nuance, and it appears the SEC may deem certain NFTs issued and traded on the platform as digital asset securities.
CI connected with two legal experts on the issue. First, Philip Moustakis, a former SEC enforcement attorney and now a partner at the law firm of Seward & Kissel, shared his opinion on the Commission’s actions. Moustakis explained that in the past, SEC Chairman Gary Gensler has emphasized that the SEC does not regulate technology—it regulates outcomes.
“Put another way, the Howey Test should be agnostic as to the technology underlying the offer and sale of an investment contract. Can an NFT or fractional interest be sold in a manner that involves an investment of money in a common enterprise with the expectation of profits based on the efforts of others? Yes, in theory, and the SEC may bring a few cases to make the point. But, the vast majority of NFTs on the market reference art or collectibles, which are not securities,” Moustakis explained.
Does the SEC’s actions open up broader interpretations of other collectible/ownership markets? For example, what about fractional home ownership? Moustakis said it depends on the facts and circumstances, namely, whether the fractional ownership of the home is for investment purposes or because the holder intends to live in the house.
We asked if the fact we are in an election year has any bearing on SEC activity. He said this has no impact on the SEC’s success in court. In registration cases like Ripple this has been difficult for the SEC because the issues are challenging.
“An election year impacts the work of the SEC to the extent there is turnover in senior management and a new administration may have different priorities,” he added.
Arthur Jakoby, Partner and co-chair of the Securities Litigation and Enforcement practice at Herrick, Feinstein, and former SEC Special Trial Consul at the Division of Enforcement, said the test for whether OpenSea is making a market in securities will be whether any of the NFTs they are trading are deemed to be securities. Currently, there is no indication as to which NFTs the SEC will claim are securities.
“Once that is known, it will be necessary to examine each NFT, apply the four prongs of the Howey Test, and determine whether a court is likely to find that it is or is not a security.”
Is there an argument to be made by the SEC regarding NFTs and fractional holdings?
“Selling fractional units to the public and maintaining a market for secondary purchases of the fractional units is a situation which would clearly be the sale of securities,” stated Jakoby.
Does this open up far broader interpretations of other collectible/ownership markets (for example, houses)?
“A ruling by a court with respect to the sale of fractional units would not expand existing law since the Howey Test involved the sale of fractional units in a citrus grove. In other words, the sale of fractional housing units is already a security. That is why when you buy a condominium from a developer, the offering memo you receive states that the sale of the condo or coop is the sale of a security, but exempt from registration.”
So, where should the line be drawn? Jakoby believes it will be based on the Supreme Court’s 1946 Howey Test ruling.
“The NFT and crypto industry is looking for a new set of rules related to the issuance and marketing of digital assets which takes into consideration these 21st-century assets. The security rules were drafted in 1933 and 1934 and the Howey test is based upon an interpretation of these 1930s laws. Congress in 1933 and 1934 could not have imagined – and clearly did not contemplate – that one day there would be an internet or digital assets. The question is whether these ancient laws should apply to digital assets. No one is saying that digital assets should not be regulated. Rather, the argument is that these assets are unique, and, thus, a new body of laws, enacted after congressional, consumer, and industry input, is what is needed to safeguard the public. While the industry is seeking clear laws regulating digital assets, the SEC prefers to maintain its jurisdiction and interpret existing laws, and thereby govern digital assets via enforcement actions.”
Jakoby anticipates that issuers and exchanges of digital assets will flee the US to operate overseas and then prohibit sales of digital assets to US citizens in order to avoid the uncertainty of U.S. regulations.
“That is not a result that benefits the U.S. economy.”
He added that the SEC staff is apolitical and that large digital asset cases that have been lost (IE Ripple) were commenced several years ago when no one anticipated that a court decision would be authored in 2024, several months before an election. Jakoby believes that politics does not play any role regarding SEC cases or when a Wells Notice is issued.
