The Bored Ape Yacht Club (BAYC) is the undisputed heavyweight champ of the NFT world. It comprises 10,000 unique Bored Ape NFTs and the cheapest will ‘only’ set you back a casual US$100,000. The total collection is worth around US$930 million making it the most successful NFT project to date.
But rumours have been circulating for some time that regulatory strife may be on the horizon for the simian-inspired NFT titans. And it turns out those concerns may be valid. After weeks of speculation, US regulator the Securities and Exchange Commission (SEC) has turned the screws on what it deems as unregistered offerings.
Recently, Kim Kardashian was the subject of SEC chairman Gary Gensler’s wrath for failing to disclose her financial interests in promoting a largely unknown token ‘EthereumMax’. A fact that led to a US$1.26 million fine being imposed, far exceeding the US$250,000 she received to promote in the first place. And now Yuga Labs – the company behind the BAYC – is being probed for so-called unregistered offerings relating to its NFTs and its token ApeCoin.
At this stage Gensler seems committed to “regulating by enforcement”, rather than clearly articulating what is required to comply with existing securities laws. Speaking to The Chainsaw, a digital assets lawyer and director of Blockchain Australia Michael Bacina suggested the approach was “not an economically or legally efficient way to set behavioural norms” and that it “often creates more questions than it answers”.
There’s a fair bit going on and on the surface some may argue that it’s just business as usual – careerist regulators looking to make a splash. But for those paying attention to the SEC’s actions over the past couple years, there is possibly something bigger brewing. Perhaps this isn’t just about the BAYC or Kim K, but about NFTs and crypto more broadly.
What is the SEC?
The SEC is the regulatory body responsible for overseeing federal securities laws whose focus is on protecting retail investors that own US$38 trillion worth of equities, just under 60% of the market.
What then are securities? That question in fact goes to the heart of the thorny matter at hand. But for the moment, think of securities as financial instruments or investments available to the general public – most commonly things like shares or bonds.
The SEC’s purpose is fairly straightforward in principle – to ensure that investors are treated fairly and have access to all relevant facts about investments and those who sell them. To achieve that, it requires all market participants to “regularly disclose significant financial and other information so investors have the timely, accurate, and complete information they need to make confident and informed decisions about when or where to invest”.
What should people disclose?
But disclose what exactly? Companies wishing to raise capital from the public need to disclose the history of the business and its founders, the shareholding structure, financial statements, executive compensation, risk factors (both current and future), management’s explanation of operations, and any other material facts relevant to the offering.
Extending these principles to crypto, disclosure may include a range of factors such as whether there was a pre-mine or what the initial allocation of tokens was to developers, founders and venture capital firms. It could also conceivably require information as to the project’s tokenomics and the percentage of tokens sold to retail relative to that owned by the early investors.
What’s the dealio with the SEC?
The long and short of it is that the SEC is all about investor protection. Specifically, it wants to make sure investors have all the necessary facts about a potential investment to make an informed decision. Sounds easy enough in principle, but this is where things get complicated.
Good ol’ Howey Test
In order for the SEC to have jurisdiction over an investment, it needs to constitute a ‘security’ which is defined by the so-called Howey test established in a 1946 US Supreme Court decision.
It provides a four-prong test to determine whether an offering constitutes an investment contract rendering it a security, and thus requiring registration with the SEC. To pass the test it must meet each of the following:
- It involves an investment of money;
- It has a common enterprise (the pooling of investor funds where the fortune of each investor is tied to the success of the overall venture);
- It was made with a reasonable expectation of profits; and
- It is derived from the entrepreneurial or managerial efforts of others.
This test is not however without controversy and has been criticised as being unsuitable for digital assets such as cryptocurrencies and NFTs. Bitcoin permabull Michael Saylor and former Goldman Sachs hedge fund manager Raoul Pal infamously duked it out in a video that went truly viral.
Australian digital asset lawyer Michael Bacina said that there were “definite similarities between the definition of a ‘managed investment scheme’ in Australia and an ‘investment contract’ under the Howey decision in the US”. However, in Australia the “test as to whether a digital asset is a financial product (whether a managed investment scheme or something else) under Australian law has not been determined in any cases by a Court to date”.
And so we reach the pointy end of the stick. Do cryptocurrencies and NFTs constitute ‘securities’ as defined by the Howey Test, rendering them under the control of the SEC and its rules?
Given the amount of cryptocurrencies and NFTs, one should be hesitant to make sweeping pronouncements. Instead, let’s focus on both the SEC’s words and deeds in relation to specific projects to get a sense of what is happening.
Are NFTs securities?
Earlier this week, Bloomberg broke the story that the SEC had initiated a probe into Yuga Labs – the company behind the BAYC and its widely recognisable NFTs and ApeCoin token – as potentially constituting ‘unregistered securities’.
Digital asset legal specialist Michael Bacina told The Chainsaw that this wasn’t entirely surprising as “the SEC chairman has repeatedly said that he considers nearly all crypto-asset tokens to be securities under US law”. However he asserted that the situation was somewhat more complex:
“The suggestion that NFTs themselves are securities is a much harder assertion to justify but we don’t know much at this time other than the SEC has been looking into NFTs, and some of Yuga Labs NFTs in particular.”
Naturally Twitter was awash with opinions ranging from sincere concern to spiteful delight. As always, some managed to find humour in the situation.
Importantly, it is an investigation, not a lawsuit. Notwithstanding, the SEC’s recent actions aren’t completely surprising as in March this year, it was reported that the SEC had commenced an investigation into the entire NFT market.
The devil is in the detail
However when it comes to NFTs, the specifics matter – they can be used in profile pics, artwork, collectibles, music, gaming, ticketing, membership passes or even domain names. Some NFTs are driven primarily by utility and others more closely resemble investments in collectibles or art. Many offer a hybrid between utility and investment.
In other words, the context is likely to be critical in determining how the NFT will be classified. While a sweeping ruling on NFTs isn’t out of the question, it appears far more likely that it would be assessed on a case by case basis. Bacina confirmed this sentiment saying that “any analysis will be highly fact driven”.
If one assumes for the moment that a particular NFT such as BAYC is a security, what are the possible implications? Under those circumstances, Yuga Labs ought to have registered with the SEC and a penalty would most likely be levied against it. This would be on the basis that the NFTs constituted an ‘unregistered security’ and lacked the requisite disclosures.
Furthermore – and admittedly this ventures into speculative terrain – you’d imagine that the higher the level of disclosure made to prospective investors in raising funds, the less severe the penalties. Of course, enforcement isn’t always done on the basis of principle, it can sometimes be motivated by other factors. However commonsense would require a degree of proportionality between the sanction and the extent of non-disclosure.
According to Australian lawyer Michael Bacina, he said it would be “interesting to see if the SEC sets out an argument as to why some NFTs should be treated as securities and just what features of an NFT the SEC would consider problematic”.
“The sale of these ‘very expensive JPEGs’ appears far closer to the sale of a genuine collectible than the sale of a security. It may be that elements of the airdrop of ApeCoins to Ape holders or other promises of returns to NFT holders could be of concern to the SEC but any analysis will be highly fact driven.”, he added.
Are cryptocurrencies securities?
At least in the US, the situation is murky. While the SEC regulates securities and the Commodities Trading Futures Commission (CTFC) regulates commodities, there has been a little regulatory tug-o-war between the two in recent years. The CTFC has been particularly scathing of the SEC’s “blatant regulation by enforcement”.
Notwithstanding, the status of all cryptocurrencies remains somewhat grey, save for Bitcoin which has been recognised by the CTFC and SEC as a commodity.
SEC chairman Gensler has been notoriously evasive in terms of pronouncing on the status of other cryptocurrencies. Yet while the official SEC position remains grey, Gensler’s personal position is arguably less so.
Prior to taking office, he articulated his views during his stint doing public lectures teaching blockchain technology at MIT.
Gensler has been known to describe many cryptocurrencies as securities, with the most recent example being a quote from the Kim Kardashian case where he said: “Ms. Kardashian’s case also serves as a reminder to celebrities and others that the law requires them to disclose to the public when and how much they are paid to promote investing in securities [emphasis added]”.
Commenting on the case, Bacina said that he found the case interesting for two reasons:
“First the SEC continued, as usual, to assert and assume the crypto-asset Ms Kardashian promoted was a security without pursuing the issuer of the token and seeking a finding that in fact it is a security. The issuer has had no opportunity to respond to that assertion. Second, Ms Kardashian didn’t explicitly endorse the crypto-asset in question, but referred to it and provided a link.”
These actions in his view demonstrated a “willingness on the part of regulators to recognise the brand power of influencers, even by being associated with a product, is equivalent to an endorsement”.
Contrasting that to the approach of the the Australian Securities and Investments Commission (ASIC), Bacina noted that it had already issued guidance on ‘finfluencers’ and that the “question of whether a person is in breach of the law will ultimately turn on whether what is being promoted is or is not a financial product.”
While the question of whether crypto constitutes a security under US law remains uncertain for now, the Lummis-Gillibrand Responsible Financial Innovation bill under discussion is looking to change that in the early part of 2023.
Australia’s current situation is arguably equally uncertain. Although there are positive signs on the horizon given the recently released Digital Assets (Market Regulation) Bill and the federal government’s “token-mapping exercise”.
An asymmetry of information when raising capital is arguably not only unethical, but potentially illegal. Securities law exists to protect investors by requiring those raising funds to disclose all material information to enable investors to make informed decisions. And to that extent, most would agree that the regulator’s objectives are both reasonable and noble.
But that’s all well and good, however on a practical level, how does one deal with a situation where a crypto or NFT is deemed a ‘security’ but the money has already been raised and the project is years down the track? How do you put the toothpaste back in the proverbial bottle and regulate retrospectively?
Laws are generally not retroactive since it is unreasonable to expect people and companies to comply with laws that weren’t in existence at the time of their conduct. It’s easy enough to require future cryptocurrencies and NFTs to comply with securities laws, but the million dollar question is what to do with those that exist now?
For the time being, NFT and crypto investors will likely have to endure continued regulatory uncertainty in the short term. Regulators such as the SEC and ASIC haven’t clarified the situation. And if they did, the question of whether specific cryptocurrencies or NFTs are securities is unlikely to become perfectly clear even once federal digital asset laws are enacted.
In reality, the space is complex and regulators likely recognise that an entire sector cannot be painted with a single brush. Instead, it’s far more plausible that we’ll see a broad set of guidelines issued in accordance within a digital asset framework.
And then the facts of each case can determine if first, it is indeed a security and second, whether those raising funds have made sufficient disclosure in compliance with the guidelines. Now that could potentially deal with the future, but how to deal with the past and present – now that is an entirely different question that nobody can answer at present.
So what does this mean for the holders of NFTs and cryptocurrencies?
Unfortunately, their position is as clear as mud. The best an investor can do in the interim is keep an eye on the regulatory movements and establish some sort of course of action in the event of there being clarity regarding a specific token or NFT.
Some may choose to ditch their investments in the face of growing regulatory pressure while others will stand firm. There’s no right or wrong answer yet. The facts are yet to be determined, which makes things a little more complicated.
But the genie is out of the bottle and we can’t put it back in.