NFT Firsts: SEC Settles First Two NFT Securities Cases
For the past two years, the SEC has become increasingly more hostile towards blockchain service providers and issuers, which has manifested in a deluge of enforcement actions against exchanges, decentralized finance (DeFi) protocols and token issuers. During that time, however, they had not issued any specific guidance or taken any public action against non-fungible token (NFT) issuers. That is, until now.
On August 28, the SEC charged Impact Theory, LLC, a Los Angeles based media and entertainment company, with offering unregistered securities.[i] According to its order, the SEC had alleged that Impact Theory, through the sale of its Founder’s Keys NFTs, had generated approximately $30 million in sales proceeds from hundreds of investors across the United States.[ii] As with most of its enforcement actions against cryptocurrency companies, the SEC sought to apply the Howey Test which sets forth the test for whether an asset was sold as part of a securities transaction. Howey tests whether the underlying transaction constitutes an “investment contract.” To qualify a security under this test, an offering (here, the sale of the NFTs) must involve (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of profit, (iv) which profit is derived from the efforts of others.”
In support of its action, the SEC’s settlement set forth the facts applicable to the finding that Impact Theory sold NFTs as part of a securities offering, including that Impact Theory made numerous communications to its investors starting that proceeds from NFT sales would be used for “development,” “bringing on more team,” and “creating more projects.”[iii] The company also communicated a vision of “trying to build the next Disney,” and made similar statements at live events, on social media, and on its website.[iv] Specifically, the SEC grouped Impact Theory’s communications into four categories:
- Impact Theory invited potential investors to view the purchase of a Founder’s Key as an investment into the business and, if it were successful, it would deliver “tremendous value” to purchasers.”[v]
- Impact Theory claimed this “purported value would be derived from the company’s efforts” and proceeds from NFT sales would be used for “development,” “bringing on more team,” and “creating more projects.”[vi]
- Impact Theory claimed the fortunes of NFT purchasers, Impact Theory, and Impact Theory’s founders “were all linked together.”[vii]
- In response to these statements, various prospective and actual purchasers made statements reflecting they have been moved by or adopted Impact Theory’s views on the investing opportunity NFTs represent.[viii]
Impact Theory: SEC Order and Accompanying Statement
As part of the settlement with the SEC, Impact Theory agreed to certain remedies. Impact Theory was ordered to (1) destroy all remaining KeyNFTs in its control, (2) publish notice of the SEC’s order and settlement to its website and social media, (3) revise the smart contract(s) or any other code of any remaining KeyNFTs to eliminate the 10 precent resale royalty collected by Impact Theory, (4) pay approximately $6.1 million in disgorgement of its profits, and (5) assist with the development and administration of a distribution plan.[ix]
Impact Theory also offered a repurchase program—where they offered to buy back KeyNFTs purchased in the Offering or on the secondary market.[x] These repurchases resulted in Impact Theory repurchasing 2,936 KeyNFTs, resulting in roughly $7.7 million worth of ETH at the time of purchase being returned to NFT owners.[xi]
Impact Theory: Commissioners Peirce and Uyeda Dissent
SEC Commissioners Peirce and Uyeda published a dissenting opinion to the SEC’s action against Impact Theory where they took issue with the Commission’s application of the Howey Test, questioned whether enforcement was warranted (even if KeyNFTs were offered as securities), and raised several additional questions applicable to NFTs.[xii]
In the opinion of Commissioners Pierce and Uyeda, Howey was misapplied because “the NFTs were not shares of a company and did not generate any type of dividend for the purchasers.”[xiii] While they conceded a “legitimate concern” over “the type of hype that entices people to spend almost $30 million for NFTs seemingly without having a clear idea about how they will use, enjoy, or profit from them,” that alone was not a “sufficient basis” for the Commission to step in with enforcement.[xiv] They go on to liken KeyNFTs to “watches, paintings, or collectables” that are coupled with “vague promises to build the brand and thus increase the resale value of those tangible items.”[xv]
The dissent also argues that even if KeyNFTs did meet the Howey Test requirements, an enforcement action was still unnecessary. They argue “the typical cure for a registration violation is a recission offer, which the company already made in the form of repurchase programs.”[xvi] During these repurchase programs, purchasers could have sold their NFT back to Impact Theory and gotten their money back—similar to how a distribution plan would remediate the same issue.[xvii]
Lastly, the Commissioners highlighted several open-ended questions to “help the Commission to approach [NFTs] sensibly.”[xviii] These questions include: (1) concerns over classification of various types of NFTs, (2) if the Commission were to create guidance for NFT creators, what questions would be best to address, (3) how should recent legislative efforts regarding cryptocurrency inform their decision on any guidance rendered, (4) whether a securities law regime is the best way to regulate NFTs, (5) if a securities law regime is best, what registration requirements and would best fit a unique asset like NFTs, (6) whether this action reflects the general view of the Commission, (7) whether any restrictions should apply to the secondary market, (8) whether precedent developed with NFTs in mind should apply to other unique pieces of digital art or music, and (9) what a precedent of revising smart contract or other code may be set for the future.[xix]
Stoner Cats’ Business and Activity
On September 13, 2023, the SEC brought its second enforcement action and announced a settlement, against the Stoner Cats NFT project.[xx] The background is as follows: on July 27, 2021, Stoner Cats 2, LLC (“SC2”) allegedly offered and sold 10,320 NFTs known as Stoner Cats (“Stoner Cat NFTs”), selling out in 35 minutes and generating approximately $8.2 million in sales.[xxi] Stoner Cat NFTs were sold for about $800 per NFT (or 0.35 ETH).[xxii] These NFTs were allegedly offered and sold to finance the production of an animated television show (“Stoner Cats is a story of a woman who uses medical marijuana to alleviate her early Alzheimer’s symptoms and her beautiful family of cats who will do literally anything to save her”), which featured a cast of Ashton Kutcher, Chris Rock, Seth MacFarlane and Vitalik Buterin.[xxiii] Similar to the KeyNFTs, SC2 had enabled a 2.5 percent resale royalty to be collected by SC2 on future secondary sales—allowing SC2 to capitalize on an additional $20 million spent by consumers (in approximately 10,475 secondary market transactions).[xxiv]
Before and after offering these NFTs for sale, SC2 engaged in a media campaign to promote Stoner Cat NFTs over their website and on social media, including podcasts, YouTube, X/Twitter, Instagram and Discord in addition to interviews aired on network and cable television.[xxv] Similar to Impact Theory, the Commission largely pointed to this media campaign in its evaluation its Howey Test analysis and its determination that the Stoner Cat NFTs were offered as part of an unregistered securities offering.
SC2: SEC Order and Accompanying Statement
The Commission focused on SC2’s advertising of “benefits of owning the Stoner Cats NFT,” including “(a) exclusive access to Stoner Cats content, along with additional access to any other content that the Stoner Cats producers created ‘in perpetuity’; (b) exclusive access to the Stoner Cats community on Discord, which included events, contests, and opportunities to engage with the creators of the animated show; and (c) the option for holders to resell their NFTs on the secondary market.”[xxvi]
Additionally, the Commission focused on SC2’s emphasis that it had the right team to execute their vision.[xxvii] The media campaign highlighted the special skills and experiences of the SC2 team in an attempt to convince investors that the show and NFTs would be successful.[xxviii] In particular, the media campaign emphasized the Hollywood expertise of the team as well as their reputations as “animators, writers, and editors, whose credits included highly-regarded animated films.”[xxix] On top of this, the campaign publicized significant experience and understanding of crypto projects, especially NFTs.[xxx]
Lastly, the Commission cited numerous tweets from the SC2 X/Twitter account including the following:
- @StonerCatsTV tweeted on September 7, 2021 a meme suggesting that the smartest thing to do during a dip in the crypto markets would be to “Buy more ETH & sweep the Stoner Cats floor.”[xxxi]
Market dips aren’t always bad 😉😸 pic.twitter.com/fLzk2hGbwA— Stoner Cats (@stonercatstv) September 7, 2021
- @StonerCatsTV tweeted on August 9, 2021 to highlight four recent sales of NFTs, priced in ETH a the equivalent of $137,493, $124,994, $31,134, and $17,123.[xxxii]
- @StonerCatsTV tweeted on August 9, 2021 the statement: “3376 unique holders” along with the then-current floor price (0.5 ETH) and the volume traded (“3.7k”).[xxxiii]
Similar to Impact Theory, this media campaign led to the SEC taking the position that SC2 violated the Securities Act.[xxxiv] As a result, and as part of the settlement, SC2 was ordered to (1) destroy all remaining Stoner Cat NFTs in its control, (2) publish notice of this order to its website and social media, (3) assist with the development and administration of a distribution plan, and (4) pay a civil money penalty of $1,000,000 to the SEC.[xxxv]
Commissioners Peirce and Uyeda once again objected to the Commission’s application of the Howey Test, as it “lacks any meaningful limiting principle.”[xxxvi] They suggest that “[r]ather than arbitrarily bringing enforcement actions against NFT projects, [they] ought to lay out some clear guidelines for artists and other creators who want to experiment with NFTs as a way to support their creative efforts and build their fan communities.”[xxxvii] They go on to say, “[t]he fact that money is involved does not transform NFTs into securities.”[xxxviii]
The Commissioners note that the allegedly offending action constitutes “fan crowdfunding—a common phenomenon in the world of artists, creators, and entertainers.”[xxxix] They then liken Stoner Cat NFTs to Star Wars collectibles sold in the 1970s.[xl] They argue:
“On the heels of the very successful release of Star Wars in 1977, fan excitement was high. To the delight of millions of children that holiday season, the toy company Kenner sold “Early Bird Certificate Packages,” redeemable for future Luke Skywalker, Princess Leia, and R2-D2 action figures and membership in the Star Wars fan club. The sales of these certificates helped to build a die-hard community of Star Wars fans. Would those I.O.U. certificates, which could be re-sold, constitute investment contracts? Using the analysis of today’s enforcement action, the SEC should have parachuted in to save those kids from Star Wars mania.”[xli]
While the Commissioners do not agree that Stoner Cat NFTs are securities, they acknowledge that “NFT creators, along with other artists, do not get a free pass from the securities laws.”[xlii] Commissioners Peirce and Uyeda recommend that “the Commission must take care to preserve the ability of artists to sell their work, build a fan base, and involve that fan base in future creative endeavors.”[xliii] In their view, the Commission’s action “discourages content creators from exploring ways to harness social networks to create and distribute content” and “contributes to the legal ambiguity facing artists, writers, musicians, filmmakers, and others seeking to build a loyal, engaged following.”[xliv]
The Future of Impact Theory and Stoner Cats
For Impact Theory, their founder Tom Bilyeu has stated in a X/Twitter post that they will “operate [their] go-forward business consistent with [their] good faith best understanding of all applicable laws, rules, and regulations, will make clear that all applicable laws, rules, and regulations, will make clear that all of Impact Theory’s digital assets are collectibles with utility within the exciting new landscape of Borderless Entertainment, and will fiercely discourage people from treating [their] digital assets as anything other than what they are—collectables with utility”.[xlv] Thus, the settlement seemingly allows the company to continue conducting their business.
In the SC2 case, the Commission did not have a repurchase program to evaluate as a possible mitigating factor to disgorgement or further penalty. Here, the Commission required only that SC2 pay a $1,000,000 civil penalty with no disgorgement. Again, the Company is seemingly allowed to continue doing business (although hasn’t posted on X/Twitter since the announcement of the settlement).
These two cases are likely illustrative of the SEC’s position when it comes to NFTs. Although both Impact Theory and Stoner Cats sold NFTs in 2021, the SEC issued no guidance specific to NFTs. Artists and creatives would love the opportunity to use NFTs and blockchain technology to find creative ways to crowdfund from their fans, and find creative ways to deliver art in return. However, the SEC’s lack of guidance and regulation by enforcement fails to provide concrete guidance for these creators desperate for such guidance. These points are all reiterated by Commissioner Pierce and Uyeda’s dissenting opinions, which ask valid questions to which the SEC as a whole has provided no answers.
Why these two projects? A lot of other NFT projects likely made similar statements at the same time, including larger and better funded companies. One view is that these companies were easy targets; they were notable, but not big enough to fight back, generating a quick and easy public relations win for the SEC, and precedent to point to in future enforcement actions. Another is that other enforcement actions remain planned or in motion, but for various reasons have not yet been brought or announced.
Ultimately, we agree with dissenting commissioners. Even if the SEC is fundamentally correct, that the offerings by these two NFT companies violated the securities law, the SEC’s approach has only left more uncertainty in its wake and giving entrepreneurs pause when they decide to do business in the U.S. Ultimately, these settlements are not binding on courts, and do not generate material or specific guidance that other companies in the nascent NFT industry can use as practical guidance.
In response to this, individuals or companies offering NFTs may be more cautious in the marketing and promotion of their projects. More NFT companies will consider forming outside of the U.S. or geo-screening out U.S. participants. This result only harms creators and fans in the U.S. that will miss out on these offerings and innovations, and ultimately harms creators in the U.S. that are looking for viable ways to fundraise to share and spread their art, and make a few dollars from their biggest fans. The SEC ought to rethink its approach, provide more practical guidance, or at minimum, begin answering some of the questions raised by the dissenting commissioners, otherwise the U.S. will only continue to fall further behind other countries that are approaching this burgeoning industry with a more forward-thinking approach.
We'd like to thank Joseph Bizub (FRB Fall Intern, JD Candidate at Brooklyn Law School) for their contribution to this article.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.
[i] Impact Theory, LLC, Release No. 33-11226 (Aug. 28, 2023) at 1.
[ii] Id. at 2.
[iv] Id. at 2-5.
[v] Id.at 3.
[vii] Id. at 4.
[ix] Id. at 7.
[x] Id. at 6.
[xii] NFTs & the SEC: Statement on Impact Theory, LLC, Hester M. Peirce and Mark T. Uyeda, (Aug. 28, 2023).
[xx] Stoner Cats 2, LLC, Release No. 11233 (Sep. 13, 2023) at 1.
[xxi] Id. at 2.
[xxiii] Id. at 3.
[xxiv] Id. at 6.
[xxv] Id. at 4-6.
[xxvii] Id. at 5.
[xxxi] Id. at 5-6.
[xxxii] Id. at 6.
[xxxiv] Id. at 6-7.
[xxxvi] Collecting Enforcement Actions: Statement on Stoner Cats 2, LLC, Hester M. Peirce and Mark T. Uyeda (Sep. 13, 2023).
[xlv] Tom Bilyeu (@TomBilyeu), X (Aug. 28, 2023, 12:40 PM), Tom Bilyeu on X: "Will be live in Discord later to answer questions. @impact_theory is pleased to announce that we have reached a settlement with the U.S. Securities and Exchange Commission in which we resolved the SEC’s investigation. We are happy to have concluded the SEC’s investigation, so…" / X (twitter.com).