In its first enforcement action involving NFTs, the SEC focused on issuer marketing that promised outsized returns on investment and platform building.
On August 28, 2023, the Securities and Exchange Commission (SEC) issued a cease-and-desist order (the Order) against a Los Angeles media and entertainment company (the Company) for an unregistered securities offering relating to its sale of $29.9 million worth of non-fungible tokens (NFTs). The company agreed to a settlement that includes disgorging $5 million, paying another $1 million in fees and penalties, and ceasing and desisting from violating the Securities Act of 1933. Notably, the settlement does not include fraud charges.
Key Facts and Findings
The SEC alleged that from October 13, 2021, to December 6, 2021, the Company offered its NFTs (called Founder’s Keys) to the public. It sold 13,921 NFTs and raised $29,896,237.16 worth of ether (ETH) from hundreds of “investors,” including individuals across the US.
Public information about the Company and Founder’s Keys reveals a long list of promised benefits to NFT holders. These benefits include the right to be “airdropped a digital collectible that will have additional utility within the [Company’s] ecosystem,” access to future content, the right to buy other NFTs at discounted prices, access to weekly meetings, and “university” type courses held by Company representatives. Whether the SEC found any of these promised benefits to be significant in its analysis is unclear. Rather, the Order focused primarily on the following statements by the Company or its founder:
- Touted the NFTs’ investment opportunity across several media channels (including the Company’s Discord, YouTube, and other social media channels), with the possibility of large “upside, for a small risk” (“[T]here is at this point in time no investment that has such an amazing Risk to Reward Ratio”)
- Compared the NFTs to “getting in on” a major media company before that company created its globally recognizable intellectual property, or making an early investment in a leading social network (“This is like being offered to invest in a booming company when they’re Series A.”)
- Stated that purchasing the NFTs was essentially “investing in [the Company] team”
- Stated that it would use the proceeds from the NFT offering for platform expansion, project development, and hiring of additional personnel (“we will just keep stocking [the NFTs] with value.”)
- Stated that these “NFTs are the mechanism by which communities will be able to capture economic value from the growth of the company that they support”
- Guaranteed the Company founder’s own efforts in maximizing economic value and return on investment for purchasers (“I will make sure that we do something that by any reasonable standard, people got a crushing, hilarious amount of value.”)
Separately, the SEC noted that in December 2021 and August 2022, the Company undertook “remedial acts” — specifically to repurchase 2,936 KeyNFTs, which the SEC characterized as “returning approximately $7.7 million worth of ETH to investors.”
Investment Contract Analysis
According to the SEC, “[b]ased on the facts and circumstances . . . KeyNFTs were offered and sold as investment contracts, and therefore securities, pursuant to the test laid out in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) and its progeny.” The SEC appears to have viewed this as a fairly straightforward case under Gary Plastic in which the marketing and promises made surrounding the instrument caused the overall arrangement to be an investment contract. The various statements cited above caused, in the SEC’s view, an expectation of profit on the part of purchasers due to the Company’s efforts.
The Company agreed to settle without admitting or denying violation of (or exemption from) the registration provisions of the Securities Act of 1933. It agreed to pay a $500,000 fine, disgorge $5,120,718.27 in illicit gains (via a “Fair Fund” to return monies that purchasers paid to obtain the NFTs), and pay prejudgment interest of $483,195.90. It also agreed to cease and desist from further Security Act violations and to destroy all implicated NFTs in its possession or control.
Dissent at the SEC
Commissioners Hester Peirce and Mark Uyeda issued a statement following the Order, noting that they dissented in part because they “disagreed with the application of the Howey analysis.” The dissent did not say precisely where it diverged from the majority, but asserted that “the handful of company and purchaser statements cited by the order are not the kinds of promises that form an investment contract.” The dissenting commissioners, however, focused more on the issue of enforcement priorities and the policy question of how NFTs should be treated generally: “[E]ven if the NFT sales here fit squarely within [the Howey Test], is this set of facts one that warrants an enforcement action?”
They also asked a series of “difficult questions” to spur policy discussion and development within the SEC. For example, given the fact-specific nature of every NFT offering, the dissent questioned the value of this Order as precedent in other NFT cases, particularly regarding the application of the securities laws and the stipulated remedies. It also asked whether the SEC views all previous NFT offerings as security offerings, and if so, if the SEC would “provide specific guidance to those issuers describing what they need to do to come into compliance.”
This Order highlights that marketing and communications will be a focus for the SEC in regard to NFT issuers, as they have been for other digital assets. As we have previously discussed, marketing NFTs as an investment because of the NFT’s expected appreciation based on the creator’s efforts can bear on the nature of the overall transaction and make it more likely that such sales would be considered securities transactions (for more information, see this Latham post).
This matter was especially notable in that the value of the NFTs at issue was marketed as being directly tied to the value of the company, which fits more readily within the traditional conception of an investment contract in which purchasers typically have a right in a legal entity.
 NFTs are essentially unique digital assets with blockchain-based authenticity, ownership, and transferability features. They differ from other blockchain-based assets such as Bitcoin, Ether, and stablecoins that are identical and interchangeable (i.e., fungible). NFTs can be purchased and sold peer-to-peer or on dedicated marketplaces online.
 Gary Plastic Packaging v. Merrill Lynch, Pierce, Fenner & Smith Inc., 756 F.2d 230, 240–41 (2d Cir. 1985) (the marketing of a non-security investment (i.e.,bank certificates of deposit) that included the promise of a secondary market transmuted the certificates of deposit into investment contracts).