Monday, August 28th marked another milestone in the SEC’s quest to exercise control over the rapidly expanding crypto space. The Commission charged L.A.-based media company Impact Theory, LLC for selling unregistered securities in the form of non-fungible tokens (NFTs). The SEC argues that Impact Theory’s “Founder’s Keys”—which it used to raise $30 million in capital—qualify as investment contracts.

‍

If this is indeed an accurate assessment, that would have placed the onus on the issuer of this NFT to register as a security with the SEC.

‍

For those who have been paying attention, this should all sound very familiar. The action follows closely behind the flurry of lawsuits around the alleged issuance and/or exchange of unregistered cryptocurrency tokens. 

‍

See Ripple; See Coinbase; See Binance; See Terraform, etc.

‍

Duck, Duck, Goose

In a Press Release announcing the charges, the SEC explained it this way:

‍

“The order finds that Impact Theory encouraged potential investors to view the purchase of a Founder’s Key as an investment into the business, stating that investors would profit from their purchases if Impact Theory was successful in its efforts. Among other things, Impact Theory emphasized that it was “trying to build the next Disney,” and, if successful, it would deliver “tremendous value” to Founder’s Key purchasers. The order finds that the NFTs offered and sold to investors were investment contracts and therefore securities. Accordingly, Impact Theory violated the federal securities laws by offering and selling these crypto asset securities to the public in an unregistered offering that was not otherwise exempt from registration."

‍

This language pretty closely echoes what we heard just a few weeks ago from the U.S. District Court for the Southern District of New York on stablecoin issuers Terraform Labs and Ripple. In brief, the court found that both firms did indeed offer investors a verbal promise of profitability that was explicitly tied to the success of the company itself. 

‍

Check out our discussion on the subject here, where we explain the Howey Test, which is used to determine whether a transaction qualifies as an investment contract (which would therefore also qualify it as a security that must be registered with the SEC). Then check out our discussion on why the courts ultimately agreed with the SEC.

‍

In the simplest terms, the position of the courts at the moment is very much what it has been for the last century. Re: Investment Contracts—If it walks like a duck and talks like a duck, it’s probably a freakin’ duck. 

‍

It doesn’t matter if you sell shares in that duck with invisible tokens, invisible collectibles, or magic beans. It comes down to a matter of intent. As the buyer, I was told that the duck was a golden goose.

‍

Deep Impact

While neither admitting guilt nor professing innocence, Impact Theory settled out of court with the SEC. In addition to paying $6.1 million in fines, Impact Theory was forced to destroy all of its Founder’s Key NFTs and create a “Fair Fund” to compensate impacted investors. The firm announced that it will regroup and soon issue a new round of NFTs that are for “utility” rather than “financial purposes.” Impact Theory was also forced to forego the possibility of earning further royalties from sales on the secondary market.

‍

Naturally, the vast majority of crypto firms will view this outcome as highly problematic. The terms used to classify the Founder’s Keys as securities could easily apply to an extremely wide variety of NFT offerings already out there in the wild. Critics of the decision also argue that it would have a chilling effect on innovation in the Web3 space. 

‍

Among the critics are two SEC Commissioners—Hester Pierce and Mark Uyeda—who wrote the dissenting opinion on the SEC’s charges. Agreeing that the decision could have far reaching implications, they noted that “the SEC does not routinely bring enforcement actions against the sellers of ‘watches, paintings, or collectibles’ that also give out vague promises to ‘build the brand’ and increase the resale value of the items."

‍

Dapper Dan Man

As it happens, this false analogy will soon be tried in a court of law. 

‍

The Impact Theory charges may be the first legal action raised against NFTs by the SEC, but the question has already come before the courts. Once again, our old friends at the U.S. District Court for the Southern District of New York were the first to tackle the question. 

‍

In 2021, a group of NFT collectors sued Dapper Labs, charging that the company had netted hundreds of millions by selling unregistered securities. Dapper had issued a set of collectibles called Top Shot NFTs, which featured short clips of famous NBA highlights. 

‍

Though Dapper motioned for dismissal, the District Court indicated that the suit could move forward. 

‍

Dapper maintains its position that “Courts have repeatedly found that consumer goods—including art and collectibles like basketball cards—are not securities under federal law…We are confident the same holds true for Moments and other collectibles, digital or otherwise.”

‍

Of course, there is a big difference between NFTs and basketball cards. If Dapper Labs ceased to exist, so too would the Flow Blockchain over which it exercises sole control, and upon which the value of its NFTs is based. Your Top Shots would now be worthless.

‍

If the Topps Trading company ceased to exist, your Lebron James rookie card would still be worth a goddamn fortune. And that’s kind of the point. No investment contracts were implied or issued connecting Lebron with the success of the issuer. 

‍

The Dapper Labs case is as yet unsettled, but one wonders how the Impact Theory case might apply.

‍

Gray Area

Even as the smoke clears from the Impact Theory agreement, another decision came down from the courts this week. The Impact Theory case feels like a win for the Commission.

‍

But we wouldn’t go so far as to call it a hot streak.

‍

On Tuesday, the U.S. District of Columbia Court of Appeals issued the Commission a firm smackdown. In brief, last year crypto asset manager Grayscale Investments sought approval with the SEC to convert spot Grayscale Bitcoin Trust (GBTC.PK) into an ETF. 

‍

The ETF would then be listed on the NYSE Arca market. This, says Grayscale, would make it possible for everyday investors to gain exposure to Bitcoin without full ownership.

‍

It isn’t that revolutionary an idea. After all, the SEC has already approved several Bitcoin futures ETFs, which track Bitcoin buy and sell transactions based on “a pre-agreed price.”

‍

But for reasons that are truly known only to those within the SEC, Grayscale’s application was rejected. The Commission claimed the new ETF would be far too vulnerable to manipulation at the expense of everyday investors.

‍

Grayscale is one of several firms who saw similar applications rejected. But Grayscale is the only one that sued the Commission. The District Court of Appeals agreed that the Commission’s position made no goddamn sense.

‍

In fact, analysts say that Grayscale’s proposed spot ETF would have the exact same guardrails against manipulation as do the already approved futures ETFs. As the court explained, the surveillance and data sharing mechanisms for spot EFTs relative to futures ETFs are “identical and should have the same likelihood of detecting fraudulent or manipulative conduct in the market for bitcoin.”

‍

The Court found the SEC’s application rejection “capricious and arbitrary.” 

‍

Whether the SEC will appeal this decision, taking it to the Supreme Court, is unclear. Whether this decision will have a bearing on the countless other applications for bitcoin ETFs currently before the SEC is unclear. Whether the Commission has any kind of coherent plan for managing the future of blockchain technology is unclear.

‍

Maybe you’re picking up on the theme here…

.

The Ball Is in the SEC’s Court Now

Many say the SEC has simply not done an effective job of defining the rules for crypto products or of providing guidance to those creating, issuing, and facilitating the exchange of such products. 

‍

This is a fair accusation. Clearly, the SEC isn’t actually writing the rules. They’ve chosen to let the courts do that for them. Those on the receiving end of legal action probably have a point when they say that real guidance has been severely lacking. 

‍

Is it because the Commission simply can’t wrap its head around this new frontier in finance? It certainly feels that way. 

‍

Once again, we’ll just wait to see who actually gets to define crypto products in the long run. Will it be the Commission, the Courts, or Congress? Despite the tidy alliteration, the answer is clouded in uncertainty. 

‍

That said, the rules defining an investment contract are pretty clear, and have been for a long time. Until future notice, it looks like that’s the precedent on the table. For companies issuing unregistered NFTs, the warning shots have been fired. 

‍