The SEC announced last week that it had reached a settlement with Impact Theory following the SEC’s first enforcement action against the sale of Non-Fungible Tokens (“NFTs”) which the SEC charged were unlicensed securities. The first step in attempting to understand the SEC’s position on this matter is to go back to the beginning where Impact Theory sold the NFTs that are the subject of this enforcement action. Between October and December of 2021, Impact Theory, a Los Angeles based media and entertainment startup, raised approximately $30 million worth of Ethereum through the sale of NFTs that Impact Theory named “Founder’s Keys”. Impact theory made certain statements related to the Founder’s Keys offering and the use of funds. These statements included that Impact Theory would deliver “tremendous value” to NFT purchasers and that they would use the proceeds for “development,” “bringing on more team,” and “creating more projects.” The SEC determined that Impact Theory was offering and sold these NFTs as investment contracts, and therefore they should be deemed as securities, based on the Howey test (see explanation below).  Since the purchasers of these NFTs had a reasonable expectation of obtaining a future profit based on Impact Theory’s managerial and entrepreneurial efforts, they qualify as ‘securities’ under the Howey test.

Examples of statements that were made by Impact Theory in the run up to the sale of the NFTs include some of the following, which were selected by the SEC for inclusion in their public filing regarding the settlement of this matter:

• Statement indicating that investors would profit from their purchases if Impact Theory was successful in their efforts
• “If you’re paying 1.5 ETH, you’re going to get some massive amount more than that. So, no one is going to walk away saying, ‘Oh man, I don’t think I got value here.’ I’m freakishly bullish on that. I will do whatever it takes to make sure that this is true.”
• “But yea, I will make sure that we do something that by any reasonable standard, people got a crushing, hilarious amount of value.”
• “NFTs are the mechanism by which communities will be able to capture economic value from the growth of the company that they support.”

According to the SEC, the above statements, and others, led purchasers to believe that their purchases of the NFTs would enable the company to develop the various projects with the end result being the appreciation of value, over time, of their purchased NFTs. Ultimately, 13,921 NFTs were sold by Impact Theory to hundreds of investors, including investors in multiple US states. Additionally, these NFTs could be sold on the secondary market and Impact Theory would receive a 10% “royalty” on each secondary market sale. These secondary market sales generated nearly $1 million in royalty payments to Impact Theory.

Impact Theory entered into a settlement with the SEC that included approximately $6.1 million in disgorgement of profits and penalties, as well as the destruction of any NFTs in their possession and an update to the smart contract associated with the NFTs that would eliminate the 10% royalty on secondary market sales. While the facts of this case and the outcome are noteworthy due to it being the first time that the SEC has brought an enforcement action involving the sale of NFTs as unregistered securities, it is the potential impact of this action on the NFT market and the SEC’s broad interpretation of the Howey test that has the crypto community’s attention.

Under the Howey test, an ‘investment contract’ is any contract, transaction or scheme whereby a person (1) invests his/her money (2) in a common enterprise and (3) is led to expect profits (4) solely from the efforts of the promoter or a third party. Based on this definition, and its application to the Impact Theory NFTs, the logical conclusion is that many of NFTs being offered today would fall within the definition used to initiate an enforcement action against Impact Theory. A large percentage of NFTs purchased are not purchased for their collectible value but are instead purchased to provide some benefit to holders based on the efforts made by the company selling the NFTs. Those holder benefits are typically provided in the form of expectation of profits which can be derived from a multitude of options that are constantly changing.

Years ago, when profit driven NFTs began to be introduced into the market, those expectations of profits were through the marketing efforts of the NFT issuing company to continually drive up the value of the NFTs as well as collaborations that would provide NFT holders with access to partner NFTs for free or at a reduced price that would yield additional profits through the sale of those partner NFTs. The NFT and Crypto landscapes adapt extremely fast as one value driver trend peaks followed closely by the next value driver trend. Today, expectations of profit take the form of dividends from investment projects where the NFT sales are used to fund investment vehicles operated by entity selling the NFTs and each NFT represents a certain percentage of trading profits. Expectations of profit also take the form of higher yields from staking the NFT (as well as the connected cryptocurrency) where an NFT holder may receive 10% Annual Percentage Yield (“APY”) while the non-NFT holder is able to stake either underlying cryptocurrency for 5% APY. There are endless mechanisms through which current NFT issuers entice individuals to buy their NFTs based on the reputation or historical performance of the team selling the NFTs and these mechanisms change far faster than what is possible for the SEC to keep up with. A quick review of projects on Telegram or Discord will show the variety of mechanisms through which projects with no funding launch the sale of NFTs to fund the development of the project, which could range from creating a trading robot to launching a full video game, where there investor is taking the risk of early investment for the sole purpose of realizing profits in the future.

These issues are why two of the SEC Commissioners dissented to the application of the Howey test to the Impact Theory NFT sales. These Commissioners outlined 9 pending questions that they believe the SEC should have addressed and offered guidance long ago when NFTs started proliferating. A discussion of those 9 questions will be discussed in a later blog, but at a high level they address questions that go to the core of the SEC’s view of NFTs with the goal being for the SEC to issue guidance rather than enforce without guidance. While it is unlikely that a decentralized ecosystem with participants around the globe will adhere to the guidance provided by the SEC, projects that seek to raise millions through a US registered entity will greatly benefit from such a guidance. These projects that seek to adhere to rules and regulations will drive the next wave of blockchain innovation and it is imperative that the SEC provide a framework for this innovation to occur.