The value of assets on the blockchain has soared to billions of dollars, stored everywhere from Bitcoin to Bored Ape Yacht Club NFTs to play-to-earn gaming. Some of those assets, though, have crashed and burned in the wake of market manipulation, evidence that regulators are just catching up to the complexities of Web 3.0. This post provides an overview of key recent decisions in blockchain and securities law and where the rules are likely headed.
How to Tell When A Blockchain Project Is An Unlawful Security
Under the Securities Act of 1933, securities are defined to include stocks, bonds, notes, and, notably, investment contracts—a catchall that is the most likely category for unconventional businesses like blockchain projects.[1] Under the Supreme Court’s Howey test, an offering is an “investment contract” if there is a transaction or contract where “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”[2] The SEC has not and likely will not issue specific rulemaking or guidance on which cryptocurrencies and NFT projects fall within its purview, but caselaw on the topic is emerging.
Initial Coin Offerings
In one of the most-watched recent decisions, the U.S. District Court for the Southern District of New York (S.D.N.Y.) found in 2023 that Ripple Labs, makers of the XRP token, were liable for securities violations involving a small subset of XRP tokens distributed.[3] Ripple had been selling XRP tokens on open exchanges, providing it in exchange for services, selling it directly to investors, and marketing it to the public without filing disclosures with the SEC.[4] Applying the Howey test, the court primarily examined whether purchasers reasonably expected to profit from the effort of Ripple based on its promises and marketing.[5] The court found that direct sales to institutional investors constituted unregistered sales of securities, but blind bid/ask transactions on public exchanges were not (purchasers on an open market would not know the seller was Ripple and thus would have no expectation that their purchases would fund Ripple’s future growth and value).[6] Likewise, distributions of XRP to employees and developers lacked any investment of money, so could not be investment contracts.[7]
The same court previously found that Telegram’s initial coin offering of Gram tokens (sold directly to initial purchasers with a lockup agreement and promised floor prices) likely constituted a sale of unregistered securities.[8] In Kik, it found that Kik sold unregistered securities when it created and sold Kin tokens directly to purchasers for dollars or ETH, all the while promoting how early purchasers of Kin tokens could “make a lot of money.”[9] A lesson for developers is to sell blind on the open market and not promise or imply financial returns in their marketing.
Non-Fungible Tokens
Organizers of NFT projects are vulnerable to the same securities concerns. Courts have found that NFT projects might constitute securities under the Howey test. In Friel v. Dapper Labs, Inc., S.D.N.Y. held that a securities case could continue against Dapper Labs, maker of NBA Top Shot Moments NFTs.[10] The court considered Dapper Labs’s direct sales of NFTs to purchasers and marketing materials showing rocket ships and stock market “up” emojis, which the court said “objectively led purchasers to expect profits.”[11] The case is also expected to address questions of “consumptive utility,” whether an NFT project is a security if consumers purchase it as artwork or for the experience, rather than as a store of value.[12] The SEC also recently ordered NFT seller Impact Theory to pay fines and refund sales of its Founder’s Keys NFTs, emphasizing that they were marketed as having potentially “tremendous value” for purchasers.[13]
Conclusion
Those offering blockchain-based assets for sale (whether cryptocurrency, NFTs, or decentralized finance applications) should be mindful that these sales could constitute unregistered sales of securities. To reduce the risk, blockchain-based businesses should sell blindly on open marketplaces (not mint on their own websites) and should refrain from marketing their assets as an investment or as something that will increase in value (such as promising floor prices or using “moon,” “rocket,” or stock market “up” emojis to signal future value).
ENDNOTES
[1] The Securities Act of 1933, 15 U.S.C. § 77b(a)(1).
[2] S.E.C. v. W.J. Howey Co., 328 U.S. 293, 299 (1946).
[3] S.E.C. v. Ripple Labs, Inc., No. 20 CIV. 10832 (AT), 2023 WL 4507900, at *1 (S.D.N.Y. July 13, 2023).
[4] Id.
[5] Id. at *6.
[6] Id.
[7] Id. at 13.
[8] S.E.C. v. Telegram Grp. Inc., 448 F. Supp. 3d 352, 379 (S.D.N.Y. 2020) (granting motion for preliminary injunction against Telegram).
[9] S.E.C. v. Kik Interactive Inc., 492 F. Supp. 3d 169, 174 (S.D.N.Y. 2020); see also id. at 179 (“The economic reality is that Kik, as it said it would, pooled proceeds from its sales of Kin in an effort to create an infrastructure for Kin, and thus boost the value of the investment.”). The court also found that pre-sales to accredited investors also violated the securities laws because they were part of an integrated offering with the non-compliant public sale. Id. at 181. Kik raised $100 million through the various initial sales of Kin and faced an injunction and a $5 million fine following the court’s order. S.E.C. v. Kik Interactive Inc., Case No. 1:19-CV-05244, Dkt. 90 (S.D.N.Y. Oct. 21, 2020). “[W]hen defendants convey to potential purchasers of an asset class that the anticipated return on their investment will be the result of those defendants’ efforts to commercialize the asset, this can be enough” to render an asset a security under the Securities Act. De Ford v. Koutoulas, No. 6:22-CV-652-PGB-DCI, 2023 WL 2709816, at *14 (M.D. Fla. Mar. 30, 2023) (finding Let’s Go Brandon Coin could constitute an unregistered offering of a security in a class action litigation for violations of the Securities Act).
[10] No. 21 CIV. 5837 (VM), 2023 WL 2162747 (S.D.N.Y. Feb. 22, 2023).
[11] Id. at *17
[12] Id. at *18. The court also suggested that in some cases intellectual property rights transfers could form the basis for some consumptive utility if the NBA Top Shots Terms of Use had offered that, but the terms restricted purchasers from making unapproved uses of the Moments. Id.
[13] S.E.C. Release No. 11226, In re Impact Theory LLC, Order Instituting Cease-and-Desist Proceedings (Aug. 28, 2023), https://www.sec.gov/files/litigation/admin/2023/33-11226.pdf; Elizabeth Napolitano, SEC Issues First Enforcement Action Targeting NFTs, CoinDesk (Aug. 28, 2023), https://www.coindesk.com/policy/2023/08/28/sec-issues-first-enforcement-action-targeting-nfts/.
This post comes to us from Professor Christa J. Laser at Cleveland State University College of Law. It is based on her recent article, “Legal Issues in Blockchain, Cryptocurrency, and NFTs,” available here.