Are Fractionalized NFTs “Securities”?
- Issues Presented
There are two questions to consider in evaluating this issue: (i) Whether NFTs, standing by themselves, constitute “securities” under the jurisprudence of SEC v. Howey; and (ii) Even if whole NFTs are not considered to be securities, whether the sale of such NFTs in part, where the operation and usefulness of the files are managed by a centralized party (you or any other third party) renders such NFTs “securities” under the same legal standard.
- The Howey Standard
The elements and application of Howey is considered in some detail elsewhere. In summary, an instrument, scheme or economic arrangement constitutes an “investment contract”, and therefore a “security” if all of the following elements are present: (i) An investment of money; (ii) in a common enterprise; (iii) with the expectation of profits; (iv) solely from the efforts of others. I wish to reiterate that courts have largely interpreted out the word “solely” out of the original decision, instead applying an analysis that considers whether the efforts of a central authority or promoter are the predominant and indispensable efforts by which the project succeeds or fails.
- Legal Analysis – Are NFTs “securities” per se?
At present there is no definitive statutory or case law guidance on whether NFTs are considered to be “securities”. In some ways NFTs are very unlike existing cryptocurrencies or other digital tokens in that they are unique by design. Their uniqueness renders many NFTs more akin to “collectibles” such as art and antiques than to other digital assets built on the Ethereum blockchain or otherwise. That said, the myriad ways in which such unique digital files could be used opens the possibility that, under some factual circumstances, such files could be viewed to be securities.
The types of circumstances that could yield the conclusion that an NFT is a security centers primarily on the existence of a centralized entity, process or party that is designed to support the profitability of the NFT, either in the form of appreciated value or a stream of income. Where such an entity is present, it is more likely that an NFT could be viewed as a security, consistent with the “efforts of others” prong of Howey. Conversely, an NFT that functions like a collectible, that is, once minted there is no centralized entity controlling the rights associated with that file, is less likely to be considered a security.
Although there is no settled authority of which we are aware on the subject, the ongoing case of Jeeun Friel vs. Dapper Labs et. al.[1], pending in the United States District Court for the District of New York, provides some insight as to how courts might interpret Howey as applied to NFTs. In the Dapper case the Court considered, on a motion to dismiss[2], whether the plaintiffs – purchasers of Dapper Labs’ “Top Shot” series of NFTs – alleged facts sufficient to pursue their claim that the defendant sold unregistered securities. The Top Shot NFTs were deployed on the “private” Flow blockchain[3]. They could only be transferred using a marketplace that Dapper Labs controlled, and Flow tokens were required for all purchases and sales of the NFTs. Dapper Labs maintained a proprietary wallet for sales proceeds, from which it charged a fee when the user wished to convert sales proceeds to fiat. The project’s terms of use provided that the NFTs had “no intrinsic value”, conveyed no intellectual property rights, and that the users’ NFTs would be recorded exclusively on the Flow blockchain.
In ruling for the plaintiffs, the Dapper Labs Court relied heavily on the integrated nature of the Flow “ecosystem” and the Top Shot NFTs in concluding that Howey could apply. As in most “investment contract” cases, the Court focused on the “common enterprise” and “efforts of others” prongs of the Howey analysis. First, the Court found that the Plaintiffs sufficiently pled allegations that investors’ funds were “pooled” (showing “horizontal” commonality, and therefore, a “common enterprise”) in that Top Shot sales proceeds went towards the maintenance and development of the underlying blockchain. The Court noted that the successful operation of the blockchain was indispensable to the marketability and success of the Top Shot NFTs, as evidenced in part by a sharp drop in NFT prices where the Flow blockchain experienced technical difficulties. The Court further noted that Dapper Labs exercised control over when and how the NFTs could be transferred between users.
Second, the Court noted that, based on Tweets, marketing materials, and subjective statements of Top Shot purchasers, such purchasers did in fact have an “investment” rather than a “consumptive” intent for their Top Shot purchases. The Court held that the profits from these transactions were, for the reasons stated above, dependent on the “efforts of others”, that is, Dapper Labs. The Court noted that the purchasers probably lacked the requisite skills and expertise to maintain a blockchain on their own, if even the Top Shot NFTs could have been maintained on a blockchain other than Flow. The Court distinguished “collectibles” (such as rare art and baseball cards) from the Top Shot NFTs, noting that the trade in collectibles is not dependent on the creator of the collectible or the platform over which they are transferred from seller to buyer. This was not the case as to the Top Shot NFTs, which, as mentioned, were recorded on, transferred through and, in the Court’s view, dependent on the existence of the Flow blockchain. Interestingly, the Court noted that its decision might be different in the case of “public” blockchains, such as the Bitcoin blockchain, which is not controlled by any central entity analogous to Dapper Labs. The Court was also clear to point out that its holding was a narrow one, and limited to the facts before it.
Applying the Dapper Labs analysis to the present facts, whether your proposed NFTs would be deemed to be “securities” per se depends heavily on the relationship between those NFTs and the blockchain on which they are to be minted. I assume here that you are not developing a proprietary blockchain on which to deploy these NFTs, which would make your facts much like those in Dapper Labs. Using Ethereum or another well-established public blockchain for deployment of your NFTs would go far towards severing the link between the “ecosystem” and the NFTs, a link which was so critical to the Court’s reasoning in the Dapper Labs case, especially so if the NFTs could be transferred between different blockchains, or if they could be recorded on both Layer 1 and Layer 2 solutions. Next, in your development you might stress the uniqueness and independence of your NFTs from the minting organization. In other words, if your NFTs convey all intellectual property rights to the images or content of the NFT it would render them unlike the very restricted and carefully controlled Top Shot NFTs. Put simply, the more rights you give away, the more like your NFTs would be like unique “collectibles”, and less like securities. The more rights you retain, the more you highlight the importance of a centralized party on which “investors” would be relying for profit.
- Legal Analysis – Even if “whole” NFTs are not securities, are “fractionalized” NFTs likely to constitute “securities”?
Again, in the absence of binding precedent or clear legislation, we need to reason by analogy as to whether “fractionalized” NFTs would be considered to be “securities”. While not perfect comparisons, commentators[4] have considered, for example, whether fractionally owned real estate and fractional aircraft interests constituted “securities”. As before, the Howey standard is the basis for analysis. One thing that is clear from these scholarly works and from the Howey cases is that how a property right is used is essential to answering the question. In other words, an NFT, like a piece of real property or an airplane, can be “consumed” in the sense that someone may buy an image they like for display on their wall or personal satisfaction, just as a property can be lived in or an aircraft used for transportation. The central inquiry is, considering all of the facts and circumstances, is a “fractionalized” NFT designed for such consumptive intent, or rather, as a vehicle for investment?
The facts control the outcome of this analysis. In the case of real estate, for example, an arrangement is more likely to constitute a “security” if: (i) the consumptive use of the property is limited, such as where a property management company requires that it be used for rentals to unrelated third parties for some or all of the period for which it is owned; (ii) there is a “rental pool” or similar fund that is intended to distribute profits to owners, again from rentals to third parties; (iii) the units are marketed to the public as presenting a profit opportunity, rather than as a place to stay; (iv) the property interests are marketable to third party buyers, who may wish to purchase it at a profit to the original owner. Fractionally owned aircraft programs present similar issues. In such programs the aircraft manager often plays a very central role in the smooth operation of the program, as few if any of the participants have the requisite skill to replace the manager or fulfill its responsibilities. As such, it is more likely with respect to fractionally owned aircraft that program interests are part of a “common enterprise” in which users are reliant on the “efforts of others” for the success of the program. In order to avoid securities classification, most aircraft fractional ownership programs remove the “profit” element by restricting resale of the interest to the program company, and by limiting the seller’s recovery to his purchase price.
[1] Jeeun Friel vs. Dapper Labs and Roham Gharegozlou, Case 1:21-cv-05837-VM (S.D.N.Y, filed 02/22/2023);
[2] What’s important to know about a Motion To Dismiss is that it strictly considers whether the facts alleged by the plaintiff state a cause of action, not whether there is sufficient evidence to ultimatly support a decision in the plaintiff’s favor. As such, the Defendant, Dapper Labs, can still “win” the case in a later stage of the proceedings.
[3] The Court seems to misunderstand that a “private” blockchain is really a “permissioned” blockchain, in which all validators are private parties and invited by a central authority to validate transactions thereon. Flow is really a “public”, non-permissioned blockchain in that it is based on proof-of-stake validation and Flow tokens, while not originally issued in the United States, can be purchased and staked by anyone. What likely confused the Court into thinking that Flow is “private” is the central role that Dapper Labs plays in its development and administration, much like other blockchains with prominent foundations, and unlike highly distributed projects like Ethereum and certainly Bitcoin.
[4] See, e.g. Kenneth P. Krohm, Fractional Ownership and Timeshare Programs: Are they subject to the Securities Act of 1933 and the Securities Exchange Act of 1934?, Business Lawyer, 54 Bus. Law. 1181 (1999).
