Howey Should Think About NFTs and Securities Laws

In this, the latest installment in our series about non-fungible tokens (NFTs), we’re looking at securities and regulatory concerns.

To recap, an NFT is a unique blockchain token, not replaceable and not interchangeable, and designed to prove ownership of a unique digital or physical asset. Despite the downturn in digital assets generally over the last ten months, the interest in NFTs has only grown. In addition to the popularity of NFT marketplaces, including OpenSea and Rarible, and the soaring prices of high-profile collections such as the Bored Ape Yacht Club, businesses from Tiffany & Co. to AMC Theatres have created NFTs and distributed them to customers. As creators and potential purchasers show greater interest in NFTs, regulators will ask whether these assets should be treated as “securities” that would require registration with the Securities and Exchange Commission (SEC) and be subject to SEC regulation and oversight.

Howey Power

At the moment, it is unclear under what circumstances—if any—the SEC or a court would view NFTs as “securities.” The SEC has largely focused on fungible tokens—digital assets that are not distinguishable from one another—and courts have discussed the issue for fungible tokens in only a handful of cases. As for non-fungible tokens, courts have not yet addressed whether they are securities, and the SEC has not taken a clear position on the question.

The starting point is the Supreme Court’s Howey test (established in 1946), under which an asset or arrangement must satisfy four criteria to be deemed an “investment contract”—a type of “security”—by federal law. It must be:

1. an investment of money . . .
2. in a common enterprise . . . 
3. with a reasonable expectation of profits . . .
4. to be derived from the efforts of others.

Determining any of these prongs depends on the facts and circumstances of the specific NFT. 

A purchase of any NFT will likely satisfy the first prong, but not if it is given away for free. And it may be difficult for the SEC to prove the existence of a common enterprise—the second prong—if the NFT represents a unique piece of digital art. The third prong is particularly difficult to judge when it comes to NFTs. While many NFTs—digital collectibles similar to comic books, baseball cards, and beanie babies—increase in value over time, many diminish in value if there is little interest in the collectible. Plus, whether the value of any particular collectible rises is usually due to market factors outside the control of any one person, including the collectible’s creator—for example, the owner of a 1952 Mickey Mantle rookie card has likely profited based on factors primarily outside the control of Topps, the card manufacturer. As for the fourth Howey prong, it is often a community of purchasers rather than a unified project team or marketing department that generates interest in the NFTs, for example, through social media avatars. In that scenario, there is a colorable argument that this should not meet the “efforts of others” required by the Howey test because the purchasers themselves, not a separate project team, are actively engaged in efforts to promote the NFTs.

How the SEC or a court would answer these questions will depend on the facts and circumstances of the particular NFT, including who created it and who sold it. A single NFT may resemble a piece of art—look at Beeple’s Everydays: The First 5,000 Days, an NFT that sold for $69 million at auction in March 2021—but what if you could divide ownership of that single NFT into a large number of digital assets, and sell those tokens to a bunch of purchasers?

Fractional NFTs

Divided ownership of one or more unique assets is the concept behind fractional NFTs. When asked about NFTs in March 2021, SEC Commissioner Hester Peirce warned that fractionalized NFTs could be considered securities: “You also have to be careful if you’re going to take a bunch of these NFTs and put them in a basket and then break them up and sell fractional interests, or even if you take one NFT. If they’re selling for $69 million, you might want to break them up and sell fractional interests. And then you better be careful that you’re not creating something that’s an investment product, that’s a security. . . . As we’ve seen, the definition of security can be pretty broad.” In March 2022, Bloomberg reported that the SEC had issued subpoenas to entities that had fractionalized and sold NFTs.

As always, whether fractionalized NFTs are deemed securities will depend on the facts and circumstances. The SEC would presumably argue that purchasing tokens representing fractionalized ownership of an NFT likely constitutes an investment, and further that such fractionalized ownership in many cases qualifies as a common enterprise. But the SEC may have more difficulty proving that a purchaser of fractionalized NFTs has a reasonable expectation of profits based on the “efforts of others.” For example, if an NFT is merely fractionalized and sold without marketing statements suggesting that such fractionalized interests will increase in value, the SEC may not be able to prove that a purchaser’s expectation of profits is “reasonable” within the meaning of Howey. In that context, there would be no promises or suggestions of price appreciation of the fractionalized NFT, and no promoter committed to generating more interest from potential purchasers.

NFT Collections

Today, many NFTs are sold as part of collections, not as a single piece like Beeple’s collage. Are there circumstances in which one NFT that is part of a collection might constitute a security under Howey? That is the question in Friel v. Dapper Labs, Inc., where a proposed class of plaintiffs has sued Dapper Labs, Inc., for violating the federal securities laws through the sale of “NBA Top Shot Moments” NFTs. According to the complaint, these NFTs, which are built on Dapper Labs’ native Flow blockchain and feature video highlights from NBA games, could be purchased at their initial sale directly from Dapper Labs or via resale on the Dapper Labs–operated by the NBA Top Shot Marketplace. Dapper Labs charged a fee for Marketplace transactions and on transfers from users’ Dapper wallets to their bank accounts. While the NBA Top Shot website allegedly stated that wallet withdrawals would occur within 21 days of a request, plaintiffs allege that they were damaged because withdrawals took far longer.

Dapper Labs is relying on Howey in seeking to dismiss the complaint. A key battle is over the “common enterprise” prong, which typically requires (i) investors to put money toward the same enterprise (“horizontal” commonality) or (ii) a link between the success of an investment and the success of the party being invested in (“vertical” commonality). Dapper Labs argues that there can be no common enterprise because, among NBA Top Shot collectors, each NFT is unique (and not tied to the value of the other NFTs)—so there is no horizontal commonality. To evidence vertical commonality, the plaintiffs point to a percentage fee that Dapper Labs charges on all transactions in the secondary Top Shot Marketplace—allegedly the only place where NFT holders can sell—which Dapper Labs calls a sales-based commission. Dapper Labs argues that the simple fact that there is a fixed transaction fee on NFT purchases in Dapper Labs’ marketplace indicates that there is no link between the fortunes of Dapper Labs as a company and the value of an individual collector’s NFT—for example, if a purchaser buys an NFT in the Marketplace and later resells it at a loss caused by exterior market forces, the fee paid by the seller would in no way be tied to Dapper Labs’ fortunes. In other words, Dapper Labs argues, Top Shot collectors have control over their NFTs and, as with any other physical or digital collectible, they can choose to sell when the price is right for them.

Another Howey prong in Dapper Labs’ crosshairs is the “reasonable expectations of profits,” which requires an objective inquiry into the character of the instrument or transaction, focusing on what a reasonable purchaser would have expected under the circumstances. Here, Dapper Labs argues that the plaintiffs fail to allege that any NBA Top Shot marketing material mentions “profits.” Dapper Labs seizes on allegations in the complaint that holders of the NFTs must agree to use them “primarily as objects of play and not for investment or speculative purposes.” Dapper Labs also argues that scattered tweets and statements from its CEO referencing financial benefits are not promises of future profits.

According to the schedule set by the court, Dapper Labs’ motion to dismiss and both parties’ accompanying briefing—which will likely set forth the arguments above—will be complete by November 30, and then the court will either schedule oral argument or decide the motion based on the briefs.

Tokens Awoken

No matter how NFTs are eventually treated by the courts or the SEC, new uses for these digital assets keep popping up, including in the legal system itself. The plaintiff in LCX AG v. John Doe Nos. 1-25 sought in June to freeze allegedly stolen assets in the wallet of an anonymous defendant. Struggling with serving the asset-freeze order on an anonymous defendant associated only with a digital wallet, plaintiffs proposed serving it by airdropping an NFT with a hyperlink to the order into the defendant’s wallet. The court allowed this method of service, requiring the plaintiffs to serve via “airdrop” to the anonymous defendant’s wallet address “a special-purpose Ethereum-based token (the Service Token) . . . wherein Plaintiff’s attorneys shall publish this Order to Show Cause and all papers upon which it is based.” Several weeks later, a U.K. court, in D’Aloia v. Persons Unknown, allowed a plaintiff to serve process on an alleged crypto thief via an airdropped NFT.

If NFTs have percolated into the legal world, there is clearly no stopping them now. They will be a force to reckon with, not only in the art business, but in other businesses as well. We will do our best to keep you informed. Stay tuned for the next client alert in our NFT series (it’s about intellectual property rights). In the meantime, you will probably have questions. Contact professionals at O’Melveny for answers.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. William Pao, an O’Melveny partner licensed to practice law in California, Bill Martin, an O’Melveny counsel licensed to practice law in New York, and Patrick Plassio, an O’Melveny counsel licensed to practice law in Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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