Are NFT Projects Next In Line To Be Sued By The SEC?

Cryptocurrency enthusiasts are painfully aware of the SEC’s behavior regarding lawsuits brought against crypto projects without warning, but the agency has not gone after any NFT projects yet. There is nothing stopping an NFT project from creating blockchain tokens that replicate the functionality of financial securities. Most NFTs sold meet the SEC’s definition of a financial security, yet they have somehow evaded multi-million dollar lawsuits from the regulatory agency.

NFTs began as digital collectibles whose scarcity was guaranteed by the blockchain, and which (allegedly) function as titles of ownership over the content they contain. However, NFTs are incredibly simple at their code level, and can be easily modified and combined with other internet technologies to create far more sophisticated products than just expensive JPEGs. For example, NFTs have been created as redeemable tokens for professional services, and popular decentralized exchange Uniswap uses NFTs to represent the deposits of its liquidity providers, just to name two alternative uses. NFTs are openly tradable with other users by default thanks to their transfer function, but this functionality can be removed or restricted during development to create utility tokens, such as NFTs that track counterfeit products.

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To date, no NFT project has been sued by the SEC, despite the latter’s series of lawsuits against several cryptocurrency projects over the years. According to Coingape, SEC regulators are divided on the issue, and that’s why enforcement actions have not been taken yet. SEC Commissioner Hester Peirce claims the regulators have kept developers and investors in the dark regarding securities laws, exposing NFT and DAO projects to enforcement actions without warning or guidance. At a time when many blockchain companies, decentralized projects, and politicians are demanding regulatory clarity from the SEC and the CFTC, both agencies are choosing to remain silent.

Do NFTs Fit The Definition Of A Security?

According to Investopedia, the landmark 1946 court case “Howey vs. SEC” determines if an asset is a security by analyzing its distribution and investor expectations according to the ‘Howey Test.‘ Under the test, an asset classified as a security must involve an investment of money into a ‘common enterprise’ (like a business or development project) where the investors expect to make a return on their investment as a result of the actions of a third party or a promoter. This definition is so broad it can apply to almost everything in blockchain, such as NFTs that issue royalty payments and dividends to their holders.

However, where NFTs are different from cryptocurrencies is that they provide some kind of product to their buyers, and many do have utility or value-added benefits that can be seen as a product manufactured and sold by a company as part of a business strategy, rather than an investment contract. On the other hand, there also exist many metaverse and Web3 gaming projects that sell NFT assets to raise money to develop their worlds/games before the NFTs themselves have any actual use, and this kind of fundraising activity blurs the line between an investment in a common enterprise versus purchasing a product before it is released.

It is unknown at this time whether the SEC will begin suing NFT projects, but it is highly likely that it will eventually. Projects that offer fractional NFTs (F-NFTs) to the public may be the first to be hit, as they create a link between non-fungible and fungible tokens and often work as investments in a more valuable income-bearing asset (i.e. fractional real estate). However, the internal politics of the SEC indicates that regulators are divided about NFTs at this time, and that is why they have not (yet) filed any enforcement actions against NFT projects.

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Source: Coingape, Investopedia