Legal Issues Of Non-Fungible Tokens

Non-fungible tokens (“NFTs”) are unique digital items that have been a focus of the United States Securities and Exchange Commission (“SEC”) which is the federal government agency that enforces security regulations to protect investors. NFTs are made out of computer code and recorded on a blockchain ledger that can prove authenticity and ownership of the unique item. As such, they are not interchangeable and can be used to verify ownership of the unique item (e.g., real estate, antique car, painting).

There is argument to be made that they should be considered as commodities pursuant to the Commodity Exchange Act (“CEA”) which yields a catch-all provision for all other goods and articles. The SEC has recently focused on celebrity advertisings on the internet in an effort to encourage the purchase of stocks and other investments. It’s important to note that the advertiser must disclose the nature, source, and compensation received by the advertisement.

The most prominent case that’s applicable in the determination of whether an NFT is a security or an asset is SEC v. W.J. Howey Co., 328 U.S. 293 (1946) which set out the following test: (1) there is an investment of money or some other consideration; (2) in a common enterprise; (3) with a reasonable expectation of profits; and (4) to be derived from someone else’s efforts.

So, the NFT can be categorized as a security if the buyer had a reasonable expectation of profit based on the efforts of others. For example, if the investor shared a partial interest in the NFT with third parties, then it could be considered as a Fractional NFT (“F-NFT”). Also, if the asset that’s being sold is related to a “smart contract,” then it could be deemed as a security.

Now, if the NFT is considered a security, then it must be issued pursuant to the Initial Public Offering rules unless there is an exemption. Also, the issuer may be subject to parallel state securities laws in their jurisdiction. Therefore, it’s important to speak with local counsel to avoid government prosecution. It must be noted that any issuer who is seeking to benefit from a public offering should strictly adhere to the applicable state and federal securities laws. The SEC has been known to file complaints against companies or individuals who do not comply with the rules.

A question that has come up is whether NFTs are subject to anti-money laundering laws. The federal agency in charge of combating money laundering is the Financial Crimes Enforcement Network (“FinCEN”). However, as of now, this agency has not issued any rulings on this matter. Scholars have argued that since non-fungible tokens are considered digital representations of ownership in unique assets and not value which substitutes currencies, then they should not be subject to the agency’s oversight. Also, the Office of Foreign Assets Control (“OFAC”) which is in charge of administering sanction programs has not issued any rulings on this matter. OFAC has stated that sanctions could apply to digital transactions and currencies.

There could be other considerations such as intellectual property rights, anti-money laundering, and cybersecurity when it comes to non-fungible tokens. In particular, NFTs have become a target by hackers for personal financial gain. In fact, centralized NFT marketplaces which keep private keys could be targeted by the malicious actors in an effort to steal the private keys to access, transfer, or sell non-fungible tokens without consent.

Our law firm has managed legal actions in state and federal courts for several years. We are ready to assist our clients in matters related to business, internet, and technology laws. Please contact our law firm to speak with an internet attorney at your earliest convenience.