Are NFTs Securities? The Controversy And The Implications

When we talk about crypto assets, non-fungible tokens (NFTs) are sure to come up. The total market cap for well-known NFT collections is more than $11 billion as of May 25, 2022, according to CoinMarketCap.

But what are the investment implications of NFTs? Are they considered securities? Or are they something else altogether? Let’s take a look at NFTs and where they might fit when it comes to investment opportunities.

Why Are NFTs Considered Assets?

Many people consider NFTs assets because they represent something of value. They can potentially increase in value over time. Additionally, some NFTs tokenize ownership in digital content, including videos, images and music. 

As a result of this tokenization of ownership, some people view NFTs as collectibles. Much as you could collect a piece of fine art, antique, baseball card or even classic car, NFTs could be thought of as collectibles. Many people enjoy displaying their NFTs as profile pictures, and collection various NFTs from popular collections.

Even though the NFT market has crashed in recent weeks, there are still those who believe that there’s enough value there for many NFTs to recover.

But does that mean that NFTs are securities? Let’s take a look at when they might be considered securities  — and when they might not be.

What Is A Security?

So far, the Securities and Exchange Commission (SEC) hasn’t issued any formal guidance on NFTs and whether they’re securities. However, some experts are looking to what’s known as the Howey test to try to determine if NFTs could be considered securities.

The Howey test stems from a 1946 Supreme Court decision that tried to nail down what is considered a security. Looking at the Howey test and applying it to digital assets in general, the SEC has a basic framework to try to determine whether NFTs are securities. There are three main considerations when applying the Howey test to digital assets:

1. Exchange for ownership of the asset. First of all, someone must have provided some type of payment or consideration for the asset. This can technically include cryptocurrency. So, someone paying ether for an NFT would be considered to have made an exchange for the asset.
2. Common enterprise. The next part of the test is whether there’s a common enterprise involved. In many NFT projects, there’s a goal and those who buy NFTs get some sort of common benefit.
   
3. Reasonable expectation that profits will result from the efforts put forth by others. The final part of this test is the most problematic when it comes to applying the Howey test to NFTs. When you buy a security like a stock, you expect that the company owners will continue to develop the company and grow it. You invest with the expectation that there will be ongoing profits. Further functionality might not be guaranteed with an NFT.
   

Basically, even though you might buy an NFT with the hope that it will increase in value and you can get more money for it later, it doesn’t mean it’s a security. In most cases, you aren’t likely to see ongoing revenues or dividends from the investment. 

Additionally, in some cases, an NFT is little more than a receipt. Actual licensing and true ownership of the asset isn’t always cut and dry, especially when it comes to intellectual property.

A security is basically something that should provide ongoing profit and potential for multiple people to participate in an “enterprise.” By that definition not every NFT could be considered a security. Just like you don’t own a security when you buy a valuable Magic card, you might not have a security when you purchase an NFT.

NFTs As Securities

There are some instances in which some experts think that NFTs could be considered securities. 

One of the biggest ways that NFTs could migrate to security status includes the fact that some NFTs come with ownership in a larger project. If buying an NFT also includes ownership participation in a decentralized autonomous organization (DAO), it could potentially be considered a security. After all, that NFT represents a portion of ownership in a shared enterprise expected to develop and provide ongoing profits.

Another possibility is fractional ownership. For example, if it costs more than $1 million to buy a Bored Ape, you might not be able to purchase one on your own. However, someone could take a leading position for a group of investors to pool their resources and purchase a Bored Ape or a Top Shot or any other type of costly NFT.

Each person would have a “share” in the asset. By creating this type of arrangement, including potentially forming an organization that invests in buckets of NFTs or projects, it might be possible to securitize NFTs in a way that would bring them under the jurisdiction of the SEC.

There are also issues that relate to using NFTs as a way to raise money for a business (include DAOs) or that pay royalties to those who purchase them. If royalties are being paid out, that could be considered ongoing profits.

One of the biggest sticking points is the fact that NFTs are essentially governed by smart contract. So whether an NFT is actually a security depends on what the contract allows, and how the contract is structured. Some NFTs are little more than licenses that allow the buyer exclusive rights to display a piece of digital art, while other NFTs offer privileges and bestow intellectual property and commercial rights.

SEC Looking Into NFTs

Even though the SEC hasn’t issued official guidance beyond offering a framework to apply the Howey test, it’s doing a bit of digging. According to various reports, the SEC is issuing subpoenas to various organizations and trying to determine how to classify NFTs. 

One result of some of these investigations is the $100 million fine against BlockFi. The platform has been lending out digital tokens and paying high interest rates to participants. The SEC fined BlockFi for its failure to register these digital assets properly.

So far, one of the commissioners of the SEC has pointed out that, while not all NFTs could be considered securities, there are so many types of NFTs that some of them likely fit the definition of a security, according to Bloomberg.

There have also been lawsuits, including those against NBA Top Shots, the popular NFT marketplace that offers access to videos of top moments in sports, such as LeBron James dunking a basketball. 

Other regulators are also looking at whether certain NFTs could be fall under the purview of other agencies, such as the Commodity Futures Trading Commission or even the Federal Trade Commission. Additionally, what are the implications of intellectual property law when it comes to tokenized versions of artwork sold online. What if you turn a picture you took of a famous painting into an NFT? What happens when someone grabs a clip of music and then turns it into an NFT and then sells it without permission from the original artist?

Finally, there are concerns about contract law and transferred ownership when it comes to NFTs that are connected to “real world” assets. What about the title to a home? You could potentially use a smart contract to complete the sale of a home and then have the title issued in NFT format. What happens when someone then sells that NFT? Does the contract still apply to the real-world asset when the NFT is sold?

Bottom Line

There are many types of NFTs, and right now regulators are trying to figure out where they fall in the investment landscape. Some NFTs might be considered securities, while others wouldn’t qualify as securities. Navigating this space can be tricky since NFTs have implications in a variety of spheres, ranging from securities law to intellectual property concerns to contract law.

Until these issues are properly sorted out, it can be difficult to know how NFTs will be viewed. In fact, there’s a good chance that there’s no one way to regulate NFTs and that the type of NFT will matter. Your purchase of a collectible meme NFT might not qualify as a security, but going in on a Bored Ape with other investors that is designed for a commercial project could be.