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"Jim Hamilton’s World of Securities Regulation" - 1 new article
By John Filar Atwood
Like initial coin offerings (ICOs) before them, non-fungible tokens (NFTs) have grown in popularity very quickly, and Arkonis Capital believes it is now time for the SEC to step in and provide guidance on whether NFTs are securities. In a rulemaking petition, Arkonis said that a concept release on how to regulate NFTs is a meaningful first step in providing guidance, but that it would only prove beneficial if it is followed by an SEC rulemaking on the regulation of NFTs.
NFTs are digital assets that use blockchain technology to establish authenticity, ownership, and transferability. NFTs can be purchased and sold peer-to-peer or on dedicated platforms but differ from other digital assets such as bitcoin because they are not fungible. Arkonis noted that NFTs are commonly associated with art, gaming, and digital collectibles.
Is it a security? The issue of when an NFT is a security is unclear, according to Arkonis. The SEC evaluates digital assets in the same manner as traditional assets to determine whether they are securities, the company noted, but unlike ICOs, NFTs have not been the subject of SEC interpretative guidance. In addition, the SEC has not initiated an enforcement action against the creator of an NFT or the operator of a platform that facilitates the offer and sale of NFTs.
According to Arkonis, the current guidance on the regulation of digital assets as securities requires a facts and circumstances-based analysis by qualified counsel to determine if an NFT is a security and if a firm’s activities require it to register as a broker-dealer, an exchange, or an ATS. This analysis is cost prohibitive to early stage companies that drive much of the innovation in the fintech space, Arkonis argued.
While the SEC has not provided guidance on when an NFT is a security, Arkonis noted that in its framework of investment contract analysis of digital assets, the SEC staff said: "The main issue in analyzing a digital asset under the Howey test is whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others. A purchaser may expect to realize a return through participating in distributions or through other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market."
Under this analysis, Arkonis argued that 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. However, if an NFT promises a return on investment from the efforts of others, the NFT could be deemed a security. If NFTs are deemed securities, Arkonis continued, then a platform facilitating the sale and secondary trading of NFTs may have to register with the SEC as an exchange.
Recommendations. All of this has created a situation that calls for the SEC to step in and provide clarity and guidance, in the company’s view. Specifically, the company recommended that the Commission publish a concept release on the regulation of NFTs. Arkonis believes that SEC rulemaking paired with an opportunity for public comment will provide guidance to parties looking to create NFTs and to facilitate the sales of NFTs.
Arkonis likened the proliferation of NFTs to the rapid rise of ICOs. However, unlike ICOs, the SEC has not published guidance on the regulation of NFTs as digital asset securities. The regulation of NFTs presents the SEC with an opportunity, Arkonis said, to satisfy its statutory duties of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation by engaging in a constructive dialogue with the fintech industry on how to regulate NFTs.
Arkonis went one step further in its petition. It also requested that the Commission propose new rules to address when NFTs are securities. While SEC enforcement actions have provided some guidance on when digital assets are securities, the actions have not addressed the needs of fintech firms dealing with NFTs, the company argued. Rulemaking in this area will provide much needed clarity to the industry and would promote market integrity, capital formation, and protection of investors, Arkonis concluded.
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