SEC Brings Its First NFT Enforcement Action

The Securities and Exchange Commission (SEC) recently brought its first enforcement action involving non-fungible tokens or NFTs. The charges signal that the SEC is likely ramping up its efforts to police the marketplace.

Explosion of NFT Marketplace

The popularity of NFTs has skyrocketed in recent years. NFTs are generally defined as unique digital identifiers that cannot be copied, substituted, or subdivided and are recorded in a blockchain. They can be used to certify the authenticity and ownership of various digital assets, each with specific rights associated with it. Once created, NFTs are listed on an NFT marketplace where they can be sold or traded under “smart contracts” that govern the transfers. NFTs are non-distributable and can’t be shared by multiple owners. NFTs have diverse applications due to their distinctive attributes. One of these applications is granting owners access to specific digital content linked to the NFT. They are particularly popular among collectors of art and memorabilia, with rare NFTs being auctioned for millions of dollars.

SEC Alleges NFTs Are Unregistered Securities

In its enforcement action against Impact Theory, LLC (Impact), the SEC alleged that NFTs issued by the media and entertainment company were “securities” under federal securities law. According to the SEC’s order, from October to December 2021, Impact Theory offered and sold three tiers of NFTs, known as Founder’s Keys, which Impact Theory called “Legendary,” “Heroic,” and “Relentless.” The SEC maintains that Impact Theory encouraged potential investors to view the purchase of a Founder’s Key as an investment into the business, stating that investors would profit from their purchases if Impact Theory was successful in its efforts.

According to the SEC, Impact Theory claimed that it was “trying to build the next Disney,” and, if successful, it would deliver “tremendous value” to Founder’s Key purchasers. Statements made to purchasers also included the following: “We’re going to be investing that money into development, into bringing on more team, creating more projects, making sure that we’re delivering just an obscene amount of value”; and “Our goal is to make sure that as Impact Theory is enriched, as [its founders] are enriched, as our team here at Impact Theory is enriched, that you guys are also enriched.”

SEC Rules NFTs as Securities: Impact Theory Faces $6.1 Million Penalty

Based on the foregoing, the SEC concluded that Impact “invited potential investors to view the purchase of a KeyNFT as an investment into the business,” thereby constituting the offer and sale of investment contracts under the Supreme Court’s test outlined in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). In Howey, the Court defined “investment contract” as a contract, transaction, or scheme in which (i) a person invests money in a common enterprise; (ii) with a reasonable expectation of profits; (iii) to be derived from the entrepreneurial or managerial efforts of others. The SEC has routinely applied this broad test to a wide range of investment schemes, including the sale of digital assets.

Under the SEC’s latest order against Impact, the agency found that the NFTs offered and sold to investors were investment contracts and therefore securities. Accordingly, Impact Theory violated federal securities laws by offering and selling these crypto asset securities to the public. Their offering was unregistered and did not qualify for an exemption from registration.

Impact Theory’s SEC Consent Order and Penalties

Impact Theory, without admitting guilt, consented to a cease-and-desist order issued by the SEC. The order established that Impact Theory had violated registration provisions outlined in the Securities Act of 1933. This violation led to a substantial financial penalty exceeding $6.1 million, encompassing disgorgement, prejudgment interest, and a civil penalty. The SEC order also establishes a Fair Fund to return monies that investors paid to purchase the NFTs. Impact Theory has also committed to three significant actions: First, they will destroy all Founder’s Keys they possess or control. Second, they will publish an order notice on their websites and social media channels. Lastly, they will forgo any royalties they might have received from future secondary market transactions involving the Founder’s Keys.

Notably, not all of the SEC’s commissioners supported the decision to bring an enforcement action against Impact. As Commissioners Hester Peirce and Mark Uyeda wrote in their dissent, the SEC doesn’t “routinely bring enforcement actions against people that sell watches, paintings, or collectibles along with vague promises to build the brand and thus increase the resale value of those tangible items.”

What’s Next?

The SEC’s broad interpretation of securities is guiding its efforts to set boundaries within the NFT market. This approach aligns with the agency’s regulatory stance. It comes as no surprise given the agency’s expansive perspective on securities. Expect more NFT enforcement actions soon. Understanding when federal securities laws require registration is crucial. As highlighted by its first enforcement action, entities should be particularly cautious when promoting NFTs as “investments” rather than products.

At this point, it is unclear whether the SEC will ultimately consider a rulemaking regarding NFTs. Entities and NFT investors should remain vigilant in monitoring this dynamic legal landscape. For any inquiries, it’s advisable to seek guidance from experienced legal counsel.

Stay ahead of NFT regulations! Stay informed and consult with our experienced counsel to navigate the evolving NFT landscape effectively.