Understanding the Nuances of NFTs and Securities Laws

Non-fungible tokens (NFTs) have undoubtedly become one of the most exciting parts of the crypto industry in the past year. Their application in the art and entertainment scenes has been prominent, with the tokens allowing people - especially artists - to achieve new income streams.

Understanding the Nuances of NFTs and Securities Laws

But, like most other things in the crypto space, there appears to be a growing amount of NFT misuse. One issue seems to be growing concern about NFTs and possible legal violations.

For those who still don’t know, NFTs are decentralized tokens, like Bitcoin and other cryptocurrencies. The difference is NFTs are created to be entirely unique, in stark contrast to traditional cryptocurrencies, where one unit of an asset can easily be exchanged for another unit of the same asset.

In the early days of NFTs, platforms like CryptoKitties and others simply ignored legal issues. Of course, it helped that NFTs barely had legal underpinnings in the first place. Now, new platforms deal with the possibility that NFT transactions could fall under some laws.

Valhil Capital Makes History

This month was quite an interesting one. Valhil Capital, a venture capital firm, announced it had underwritten the world’s first NFT securities offering. According to a company press release, Valhil completed a token sale at the Texas Blockchain Week, one of the year’s most highly anticipated crypto events.

As part of its sale, Valhil issued 9 of 10 minted NFTs in a series titled "Buen Viaje." All tokens were marketed and sold to accredited investors in accordance with the Securities Act. Jimmy Vallee, Managing Director of Valhil Capital, said of the sale:

"We took an artist's idea, organized a team of amazing partners, created and launched the first NFT securities offering in history during a live event in front of hundreds of people in about eight days. Most people don't even realize the significance of what has happened. But in time, this combination of artistic, intellectual property with the powerful economic attributes of financial securities will be prolific and profound, and Buen Viaje will forever be the first."

With the sale already making waves, many are asking whether NFTs can be considered securities.

Regulatory agencies are swarming the crypto space already. With NFTs the most vibrant part of the industry, Valhil has been ahead of the curve with regulatory compliance. Should the rest of the industry make the same move?

NFTs Aren’t Necessarily Securities

The current NFT frenzy draws similarities to the Initial Coin Offering (ICO) boom back in 2017. At the time, blockchain companies were pre-selling to raise money for their projects and initiatives. Although companies referred to their tokens as commodities or utilities, the Securities and Exchange Commission (SEC) took issue with these ICOs and soon cracked down.

Even some of the biggest tech platforms, including messaging app Telegram and social media platform Kik, had to take down their crypto projects due to action by the SEC. At the same time, the agency was in a legal tussle with Ripple Labs for almost a year, arguing the company’s XRP token - already one of the most valuable cryptocurrencies in the world by market cap - was a security.

Actions like these will cause anyone to rethink raising money using cryptocurrencies or transacting with them in any way.

On the other hand, NFTs are collectibles. By legal definition, they aren’t quite the same “investment contracts” you enter when you purchase traditional cryptocurrencies. Therefore, securities law might not necessarily apply to them.

The primary reason tech companies were caught in the SEC’s crosshairs is their token sales allegedly satisfied three requirements: (i) money was invested, (ii) in an enterprise, (iii) with investors expecting returns due to the work of a third party. On the other hand, while profit might be expected from an NFT sale, it’s not necessarily due to anyone’s effort.

This Doesn’t Mean They Can’t Be Securities

Consider a royalty contract for a book. The author can decide to convert the text to an e-book and sign it using NFT technology. He approaches an NFT platform operator to make one, and the operator does for half of the profits of the initial sale. Then, the operator gets 5 percent of all secondary book sales.

Both parties sign the contract, and the book is sold to someone, who then sells it to another person. On its own, this system doesn’t appear to constitute an investment contract. The initial book sale looks just like any regular transaction, and the secondary sale is essentially a private consumer good sale.

However, had the author decided to fractionalize the NFT and sell parts of it for more profits, this could be a securities law violation. At the same time, an NFT that benefits from cash flow from other tokens qualifies as a security.

An NFT that works like a regulated product will be treated as such. A simple name change won’t convince regulators otherwise. As a result, it’s crucial that people know what they’re buying. Initiatives from companies like Valhil Capital are also important.

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