Original Title: "SEC Issues First Penalty to NFT Industry, What Kind of NFTs are Securities?"

Original Source: Web3 Xiao Lu

On August 28, 2023, the US Securities and Exchange Commission (SEC) took regulatory enforcement action against the NFT industry for the first time, accusing Impact Theory, LLC, a Los Angeles-based entertainment company, of selling unregistered securities. The company ultimately reached a settlement with the SEC.

This is the first regulatory enforcement by SEC on the NFT industry. Impact Theory promises to increase the value of NFTs, the company, and shared wealth to investors, which is crucial in determining NFTs as "securities". This article will examine SEC's regulatory enforcement on Impact Theory and the opposing views of SEC commissioners to see what kind of NFTs will be recognized as "securities".

One, Background of Impact Theory NFT Case

According to SEC, Impact Theory provided and sold three different types of NFTs from the Founder's Keys series to investors between October and November 2021. Prior to the NFT release, Impact Theory held online events on Discord and shared information on their website and social media channels for promotion.

SEC claims:

(1) Impact Theory tells investors that purchasing NFTs is considered an investment in the business of Impact Theory. If Impact Theory succeeds, it will bring profits to investors.

（2）Impact Theory tells potential investors that it is "trying to build the next Disney", and the value of NFTs will increase as a result.

(3) Impact Theory also stated that the fate of NFT investors is closely related to the fate of Impact Theory and its founder.

Impact Theory sold 13,921 NFTs to investors and raised over $29 million worth of ETH from the sale. In addition, Impact Theory also owns a 10% royalty on each resale of the NFTs, which generates an additional value of approximately $978,000 worth of ETH for Impact Theory.

Based on the above facts, the SEC concludes that "both potential and actual investors of Impact Theory NFT believe that NFT is an investment and will appreciate." The SEC accuses Impact Theory of violating Sections 5(a) and (c) of the Securities Act, which prohibit the issuance of unregistered securities.

Before accepting the settlement with SEC, Impact Theory took some remedial measures, such as repurchasing NFTs worth about $7.7 million from investors. As part of the settlement with SEC, Impact Theory agreed to (1) destroy all NFTs it owns or controls within 10 days of the order's release; (2) post notices of regulatory enforcement on its website and social media; (3) modify the NFT contract to eliminate its royalties; and (4) pay restitution and fines totaling approximately $6.1 million.

二、什么是「证券」？——Howey Test

Translation:

2. What is a "security"? - Howey Test

After the SEC v. Ripple case, the US regulators' standard for determining "securities" is the Howey Test. Although the SEC did not explicitly explain how this NFT meets the Howey Test in this regulatory enforcement document, we can still infer from the fact that Impact Theory issued and sold NFTs that the SEC considers NFTs to be "securities".

Regarding the testing of Howey, this article will not go into detail, and you can refer to the previous article: Interpreting the SEC v. Ripple case, further clearing up regulatory confusion, Not all NFTs can be recognized as securities, starting with SEC v.s. Yuga Labs.

In this case, we do see that the NFTs of Impact Theory appear to meet the standards of the Howey Test: (1) investors have put in money (ETH); (2) the purchased NFTs are for a "common enterprise" where the investors' wealth is linked to Impact Theory's wealth; (3) investors expect to profit from Impact Theory's efforts to build the "next Disney".

其中，Impact Theory promises investors that NFTs and the company will increase their shared wealth, which is recognized as a key "security".

Three, SEC Commissioner's Dissenting Statement

After the regulatory enforcement order was issued, SEC commissioners Hester Peirce and Mark Uyeda immediately issued a dissenting statement, stating that there are still many issues with the first regulatory enforcement of the NFT industry, and clarity needs to be achieved before the next regulatory enforcement case comes out.

First of all, they believe that the vague promises of Impact Theory to NFT investors cannot meet the standards of the Howey Test. The full disclosure principle of the U.S. Securities Law requires issuers to have a relatively clear and clear plan for the use of funds raised through the sale of securities and fundraising, as well as profit expectations, just like the prospectus for IPO and the white paper for ICO. Peirce and Uyeda further pointed out: "The SEC will not take enforcement action against people who sell watches, paintings, or collectibles, even if they make some vague promises of value appreciation, such as gradually building brand awareness to increase the resale value of these tangible items."

In addition, due to the dazzling promotion and unclear statements of Impact Theory, there has been a misleading impression created for investors. As Peirce and Uyeda pointed out: "In reality, does this illusion/misleading also constitute fraud charges, as this NFT has nothing to do with company equity, as well as the company's value?"

Secondly, Peirce and Uyeda also stated that even if the requirements of the Howey Test are met, it is still debatable whether SEC needs to take such regulatory enforcement actions. This is because the violation of issuing unregistered securities can usually be resolved through a Rescission Offer, which Impact Theory has already proposed through its buyback plan.

Finally, Peirce and Uyeda proposed several issues that they believe SEC should consider before regulating and enforcing the NFT industry in the future, including:

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Is the "Securities Law" suitable as a regulatory law for NFT? Is there a feasible regulatory path for NFT under the "Securities Law"?

除了 NFT 资产本身会有证券属性外，NFT 的发售方式、以及二级市场的版税交易是否也会构成「证券」？

Apart from the securities attributes of NFT assets themselves, will the issuance method and royalty transactions in the secondary market of NFT also constitute "securities"?

Regarding the compliance measures that need to be taken for the aforementioned regulatory enforcement and resolution, such as destroying NFTs and modifying them to have 0 royalties, whether they have become the standard for subsequent regulatory enforcement cases and whether they are appropriate remains to be seen.

4. What kind of NFT will be recognized as a security?

First, let's try to answer the question of how to regulate NFTs raised by Peirce and Uyeda. This is the foundation.

4.1 NFT How to Regulate?

The essence of NFT is a type of token, whose captured value depends on the value of the underlying asset it is anchored to. The source of value can be diverse, and the specific asset value attributes of NFT are linked to the value attributes of its underlying asset.

Reference to the reminder issued by the Securities and Futures Commission (SFC) of Hong Kong on June 6, 2022, investors should be aware of the risks associated with NFTs. The reminder indicates that if an NFT is a true digital representation of a collectible item (such as art, music, or film), activities related to it are not within the regulatory scope of the SFC. However, some NFTs cross the boundary between collectibles and financial assets and may be considered as "securities" under the Securities and Futures Ordinance, and therefore subject to regulation.

Therefore, based on the properties of the underlying assets of NFT, they can be classified into three categories for processing:

(1) NFTs with underlying assets as securities will be regulated under securities-related laws and regulations.

(2) NFTs with underlying assets as commodities will be regulated in accordance with laws and regulations related to commodities/virtual assets.

(3) If the underlying assets are various equities, then it should be assessed on a case-by-case basis based on the nature of the equity.

Similarly, NFTs need to disclose information and determine it based on the underlying assets' properties.

4.2 Besides the securities attributes of NFT assets themselves, does the issuance and sale of NFTs (secondary market trading) also constitute securities offerings?

According to the economic essence of the transaction, NFT can be classified into two categories that will be subject to "securities" regulation.

(1) The underlying assets issued are securities themselves, such as turning company equity into NFTs.

(2) Regardless of whether the underlying assets are securities or not, the method of NFT issuance constitutes the issuance of "securities".

As for (2), in the SEC v. Ripple case, the court held that: the underlying assets of most "investment contracts" are only commodities (Standalone Commodity), which may not necessarily meet the definition of "securities", just like the orchard in the SEC v. W.J. Howey Co. case, and some other "investment contracts" have underlying assets such as gold, crude oil, etc. How to determine whether a transaction constitutes an "investment contract" also requires examining the economic substance of the underlying transaction to determine whether the issuance in different ways constitutes the issuance of "securities".

In the SEC v. Ripple case, the Ripple token XRP may not meet the definition of "security", but the fact that it was promoted and sold to early investors as an investment contract constitutes a "security" under the definition.

In this case, the NFT itself does not have the "security" attribute, but Impact Theory's marketing and promotion to potential investors, telling them that it is trying to build the next Disney, will increase the value of NFT. This makes the sale of NFT potentially a "investment contract" and thus falls under the definition of "security".

Generally speaking, "securities" refers to investors passively participating in the business of third parties only through monetary investment, and expecting to gain benefits through the efforts of third parties. If the efforts of third parties fail or do not exist, investors will face the risk of losing their investment.

Five, in conclusion

Although the SEC's regulatory enforcement in this case does not have the effect of judicial judgment, the result is still significant because it is the first time that the sale of NFTs has been found to violate the provisions of the Securities Law regarding the sale of unregistered securities.

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