The U.S. Securities and Exchange Commission (“SEC”) has reportedly set its sights on the company behind the Bored Ape Yacht Club non-fungible tokens (“NFTs”), probing Miami-based Yuga Labs to determine whether its offerings amount to unregulated securities. “The SEC is examining whether certain NFTs from [Yuga Labs] are more akin to stocks and should [be subject to] the same disclosure rules,” Bloomberg first reported on Tuesday, citing a person familiar with the matter. The SEC is also said to looking at Yuga’s release of ApeCoin governance tokens, which were distributed this spring to certain Bored Ape NFT holders.
Inevitably at the heart of the SEC’s reported probe is the question of whether the 10,000 Bored Ape Yacht Club NFTs, and potentially other Yuga-owned projects, such as the CryptoPunks and Meebits NFT collections, as well as the ApeCoin tokens, amount to securities subject to federal law. “By their nature, NFTs can be linked to a variety of different assets and represent numerous rights and obligations, making them challenging to classify,” Jones Day attorneys stated in a note last spring. It does not help that, to date, regulators have largely focused on fungible tokens (i.e., digital assets, such as cryptocurrencies, that are indistinguishable from one another), and thus, the SEC has not provided regulatory clarity on how it views their non-fungible – or unique – counterparts.
At the moment, O’Melveny & Myers LLP’s William Pao, Bill Martin, and Patrick Plassio state that it is “unclear under what circumstances – if any – the SEC or a court would view NFTs as ‘securities.’” However, what is clear is that if a court or the SEC were to take on this issue (which is what the SEC appears to be doing with Yuga and its NFTs), their analysis would bring the Supreme Court-crafted Howey test into play. In accordance with that test, which was established in 1946 in SEC v. W. J. Howey Co., an asset or transaction must satisfy four criteria in order to be deemed an “investment contract” under federal law. It must be: (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; and (4) to be derived from the efforts of others.
The purchase of any NFT “will likely satisfy the first prong,” according to Pao, Martin, and Plassio. However, the other factors are less straightforward. It “may be difficult,” for example, “for the SEC to prove the existence of a common enterprise if the NFT represents a unique piece of digital art.” At the same time, they note that the “reasonable expectation of profits” prong is similarly questionable, as “while many NFTs – which are digital collectibles [that are not dissimilar] 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.” Beyond that, the issue of “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 factor, “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,” per Pao, Martin, and Plassio. “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.”
On the surface, “NFTs that constitute art or collectibles should arguably not be deemed to be securities,” Latham & Watkins LLP’s Stephen Wink, Miles Jennings, Shaun Musuka, and Deric Behar argue. However, they also assert that NFTs that constitute art or collectibles “may only be the tip of the iceberg” in light of the rise of other projects, such as those that include the financialization of NFTs. But not limited to NFTs that have been divided into smaller fractions and sold to multiple holders, for instance, it is worth noting that certain NFTs that are tied to art may fall into a potentially gray area; as Jeremy Goldman previously told TFL, there are a growing number of projects in which as many as “tens of thousands of NFTs” are offered up by issuers. These could prove to be an example of where the SEC might find that NFTs do, in fact, amount to securities, he says.
If an asset or transaction does qualify as an “investment contract” under Howey, then it is considered to be a security under the Securities Act of 1933 and the Securities Exchange Act of 1934, and subject to certain disclosure and registration requirements as a result. For instance, such a classification would call for “registration or exemption of the offering under the Securities Act of 1933; registration of the sellers of those instruments as broker-dealers under the Securities Exchange Act of 1934; registration of the marketplaces on which the instruments are sold as securities exchanges under the Exchange Act; securities law liability for material omissions or misstatements and insider trading; restrictions on short sales and market stabilization around an initial offering; and so on,” per Jones Day.
In a statement to Bloomberg on Tuesday, Yuga Labs said, “It’s well-known that policymakers and regulators have sought to learn more about the novel world of web3. We hope to partner with the rest of the industry and regulators to define and shape the burgeoning ecosystem. As a leader in the space, Yuga is committed to fully cooperating with any inquiries along the way.”
THE BIG PICTURE: The Yuga probe by the SEC comes as the regulator has been examining the digital assets market more broadly, and taking action. It comes in the immediate wake of the agency settling charges waged against Kim Kardashian over her failure to disclose that she was paid $250,000 to publish a post on her Instagram account promoting EMAX tokens, the crypto asset security being offered by EthereumMax. The SEC found that Kardashian’s post violated the anti-touting provision of the federal securities laws ((17(b) of the of the Securities Act), which “makes it unlawful for any person to promote a security without fully disclosing the receipt and amount of such consideration from an issuer.” Before that, crypto exchange Coinbase revealed this summer that it was under investigation by he SEC over “the Company’s processes for listing assets, the classification of certain listed assets, its staking programs, and its stablecoin and yield-generating products.”
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