The debate over whether non-fungible tokens (NFTs) should be classified as securities has been getting attention in recent court cases. In two recent enforcement actions, the Securities and Exchange Commission (SEC) classified NFTs as securities and charged two companies with conducting unregistered securities offerings.

In the matter involving Impact Theory LLC in August 2023, the SEC concluded that Impact Theory’s offering and sale of three tiers of NFTs was an unregistered securities offering in violation of U.S. federal securities laws. Three of the five SEC commissioners voted in favor of the enforcement action. Impact Theory’s NFTs, known as Founder’s Keys, were deemed to be “investment contracts” to the public, and therefore subject to U.S. securities laws. The company represented to potential purchasers online that investors would profit tremendously from purchasing their NFTs. The company reached a $6 million settlement with the SEC.

The two dissenting commissioners, Hester Pierce and Mark Uyeda, questioned whether securities laws should be regulating the sale of NFTs in the Impact Theory case. In their dissenting opinion, they stated that “the NFTs were not shares of a company and did not generate any type of dividend for the purchasers.”

In the matter involving Stoner Cats 2, LLC in September 2023, the SEC concluded that Stoner Cat’s offering and sale of its NFT was an unregistered securities offering in violation of U.S. federal securities laws. The NFT, called Stoner Cat, was being offered to raise money for the production of an animated TV series. The SEC claimed that the proceeds of the NFT sales were being used to compensate coders, animators, and others contributing to the animated TV series project.

NFTs are unique digital assets that link ownership and authenticity to an associated physical or digital item. A purchaser of an NFT gets the right to an irrevocable digital certificate of ownership that is separate from the NFT. As the name suggests, NFTs are non-fungible and each NFT comes with a unique digital identifier. This is distinct from cryptocurrencies, which are considered fungible tokens. NFT ownership is recorded on the blockchain.

The Howey test provides the legal basis for determining whether a transaction should be deemed an “investment contract” and therefore subject to U.S. federal securities laws. The term “security” covers investment contracts as well as instruments such as stocks and bonds. The Howey legal framework was developed from the Supreme Court case SEC v. Howey in 1946. There are four prongs to the Howey test:

• Investment of money: This prong is typically satisfied in an offering of digital assets since the digital asset is usually being purchased for monetary value.
• Common enterprise: This prong is typically satisfied in an offering of digital assets.
• Reasonable expectation of profits derived from efforts of others: A key issue is determining whether the purchaser of a digital asset had a reasonable expectation of profits derived from the efforts of others. The inquiry focuses on the “economic reality” of the transaction and the manner in which the digital asset is sold. The efforts must be “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”
• Reliance on others: The purchaser must reasonably expect to rely on the efforts of an active promoter, sponsor, or other third party. This prong is more likely to be satisfied if the active third party is performing essential tasks and responsibilities that creates or supports a market for the digital asset.