A recent article by The New York Times - Manic Markets, Imploding Funds: Wall Street’s New Top Cop Has a Full Plate - discussed the potential areas of focus for Gary Gensler, the new Chairman of the U.S. Securities and Exchange Commission (SEC). One area of focus for Chairman Gensler may be the regulation of non-fungible tokens (NFTS).
The article discussed a petition for rulemaking filed by Sustainable Holdings and its broker-dealer subsidiary with the assistance of Richard B. Levin, the Chair of Nelson Mullin’s FinTech and Regulation Practice. The petition “asked the S.E.C. to weigh in on whether nonfungible tokens, which are being used to create digital art, are securities that require registration. The company, in its letter, asked the S.E.C. ‘to engage in a meaningful discussion of how to regulate fintech companies and individuals that are creating NFTs that may be deemed digital asset securities.’”
What are NFTs?
NFTs use blockchain technology to establish authenticity, ownership, and transferability of a unique asset. NFTs differ from other digital assets such as Bitcoins which are fungible. NFTs can be purchased and sold peer-to-peer or on dedicated platforms. NFTs are commonly associated with art, gaming and digital collectibles. The artist Mike Winkelmann, also known as Beeple, recently used an NFT to sell his digital art “Everydays - The First 5000 Days” for $69 million. The sale was the third-highest price paid for a piece of art by a living artist. Collectors and speculators have spent more than $200 million on NFT based artwork.
Are NFTs a Security?
The petition notes that as NFTs proliferate, new regulatory questions will arise. If an NFT relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be deemed a security. If an NFT promises a return on investment from the efforts of others, the NFT could be deemed a security. While NFTs are meant to be non-fungible, fractional NFTs that allow numerous purchasers to acquire a partial ownership interest in the NFT, increases the likelihood the NFT could be deemed a security.
Are NFT Platforms an Exchange?
The petition notes that if an NFT is a security, the platform facilitating the sale and secondary trading of the NFT may have to register with the SEC as an exchange. Section 3(a)(1) of the Exchange Act defines an “exchange” as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood .... “
Exchange Act Rule 3b-16(a) provides a functional test to assess whether a trading system meets the definition of exchange. Under Rule 3b-16(a), an organization, association, or group of persons will be deemed to provide “a marketplace or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,” if such organization, association, or group of persons: (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.
A system that meets the definition of an exchange and is not excluded under Rule 3b-16(b), must register as a national securities exchange or operate pursuant to an appropriate exemption. One frequently used exemption is for alternative trading systems (“ATS”). Rule 3a1-1(a)(2) exempts from the definition of “exchange” under Section 3(a)(1) an ATS that complies with Regulation ATS. An ATS that operates pursuant to the Rule 3a1-1(a)(2) exemption and complies with Regulation ATS would not be subject to the registration requirement of Section 5 of the Exchange Act.
The petition concludes that if an NFT is a security, any platform that brings together multiple buyers and sellers of the NFT using non-discretionary methods, will likely be deemed an exchange.
Any firm looking to offer an NFT or to host a platform that facilitates the offering and secondary trading of NFTs should be proceed with caution because such actions may constitute a sale of a security or operation of a securities exchange.