NFTs and fNFTs – Priceless Collectables, Digital Trinkets, or Regulatable Securities?

Sabrina Ortega – Non-fungible tokens, or NFTs, have been a major topic of conversation in the business sphere since their inception in the late 2000s. While debate rages over the financial and aesthetic value of NFTs, proponents, and skeptics can both agree that NFTs have gone from niche to mainstream over the last two years. As record-breaking NFT sales continue to grab headlines, creators and collectors may rightly start to wonder when, and not if, government regulation is going to enter the picture.  In particular, NFT enthusiasts will be closely watching how regulators parse distinctions between different types of NFT ownership models and the differences, if any, between NFTs and securities more generally.

NFTs are cryptographic tokens representing digital assets that can be bought and sold to purchasers. Most NFTs are hosted on the Ethereum blockchain. Ethereum is a cryptocurrency similar to Bitcoin or Dogecoin. The blockchain “supports these NFTs, which store extra information that makes them work differently from, say, an ETH coin.” NFTs are bought and sold on online marketplaces and are available at all price points. Often, these sales are conducted as auctions with prices of the most sought after NFTs climbing well past the six-figure range. Recently, NFTs have also been sold at reputable auction houses like Sotheby’s and Christie’s. Auction houses and their customers have recognized NFTs to be part of a new wave of digital artistic masterpieces. Many argue the substantial price tags do not appropriately reflect what a purchaser can potentially do with their new asset. To appeal to those who want to participate in this new market without breaking the bank, fractional non-fungible tokens, or fNFTs, have been created. Owning an fNFT is exactly what it sounds like. The owner of an fNFT owns a portion of the NFT being purchased. 

Without a doubt, the most pressing question regarding NFTs and fNFTs is: which government agency or agencies will be responsible for regulating the NFT and fNFT market?  The answer is not yet clear. NFTs are taxed at the  collectibles tax rate designated by the IRS. Additionally, “if cryptocurrency was used to buy an NFT … capital gains taxes on the profits made, would be applied. What about the possible securities transactions involving NFTs? The SEC has not yet settled its approach to cryptocurrency. However, the Commission has not stayed silent on its thoughts regarding the cryptocurrency sector. The SEC has recently directed its attention to initial coin offerings or ICOs. Many critics argue NFTs should not be considered the “new” ICO for SEC regulation purposes. Specifically, skeptics generally do not classify NFTs as securities, but “the manner of sale, facts, and circumstances may cross the line so that the whole arrangement could be treated as an investment contract.” .

Securities are subjected to regulations imposed on the issuers of a given security and any platform or exchange that lists the security. The SEC has yet to determine or confirm whether NFTs or fNFTs would qualify as investment contracts for purposes of regulation by the agency. The only guidance the SEC has provided regarding digital assets can be found in the 2019 guidance issued by the SEC’s Strategic Hub for Innovation and Financial Technology. The guidance provides examples and key useful definitions to better understand the Supreme Court’s holdings regarding securities regulation, specifically in reference to digital assets. SCOTUS’s test for investment contract qualification in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) provides the best guidance for determining whether an instrument is an investment contract. The Howey test establishes: “an instrument is an investment contract if it is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others.

Arguably, prong two would be the most difficult to analyze in its application to fNFTs and NFTs, respectively. The SEC’s guidance on the investment contract analysis of digital assets confirms that courts generally analyze a “common enterprise” as a distinct element of an investment contract. This definition may more easily fit fNFTs as opposed to NFTs because all fNFTS investors are engaged in a common enterprise via their investment in a single token. The income derived from a “shard of a given fNFT” is tied to every shard holder. If the value of a given NFT appreciates, each fNFT owner benefits as well. However, the Howey test stresses a fact and circumstance-dependent inquiry.

Though the SEC has not yet disclosed how it plans to regulate fNFTs and NFTs, it is very clear that regulations will be making their way onto the books very soon. However, only time will tell whether the SEC regulations will distinguish between fNFTs and NFTs and the need for regulation.

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