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In late August, the SEC announced charges against Impact Theory, LLC, an LA-based media and entertainment company, for conducting an unregistered offering of crypto asset securities in the form of NFTs. The cease-and-desist order is novel, in that this is the first time that the SEC has applied the Howey test to NFTs. But, guess what? There’s already been a second time! (More on that below.)

This Dechert alert describes the Impact Theory order, but first starts with this reminder:

NFTs are digital asset tokens similar to cryptocurrency. However, each NFT possesses unique characteristics that distinguish NFTs from each other, such as being tied to ownership of a specific piece of art. Many NFTs operate on the Ethereum (“ETH”) blockchain.

The SEC cited a number of statements by company representatives when discussing the elements of the Howey test:

[T]he SEC provided facts purporting to show that the sale of KeyNFTs constituted a “common enterprise” or “scheme” between investors. Specifically, according to the SEC, Impact Theory claimed that a purchase of a KeyNFT constituted an investment in what would be a “thriving community” in Impact Theory’s vision.

Last, the SEC claimed that investors possessed an expectation of profits to be derived from the efforts of Impact Theory because the company repeatedly told investors that their money would be put into development efforts and create additional projects to add value to the company. Per the SEC, Impact Theory expressed that such development efforts would enrich investors, including statements that NFTs were the “mechanism by which communities will be able to capture economic value from the growth of the company that they support” as well as claims that investors would be ecstatic that they would be “getting all this value” from their investment.

As a result of these findings, the SEC concluded that investors “understood Impact Theory’s statements to mean that the company’s development of its projects could translate to appreciation of the KeyNFTs’ value over time.”

In accepting the settlement offer, the SEC considered remedial actions taken by the company — including instituting repurchase programs in December 2021 and August 2022, in which it offered to buy back NFTs — and the company’s undertaking to revise programming code underlying the NFTs to eliminate any royalty that Impact Theory might otherwise receive from any future secondary market transactions.

The second NFT enforcement action I alluded to above involved an $8 million offering of “Stoner Cat NFTs” to finance an animated web series — each of which “was associated with a unique still image of one of the characters in the Stoner Cats web series, with different expressions, apparel, accessories, and backgrounds.” SEC Enforcement Division Director, Gurbir S. Grewal, is quoted in the press release as saying: “Regardless of whether your offering involves beavers, chinchillas or animal-based NFTs, under the federal securities laws, it’s the economic reality of the offering – not the labels you put on it or the underlying objects – that guides the determination of what’s an investment contract and therefore a security.”

Commissioners Peirce and Uyeda, who dissented in both settlements, fear that this stifles fan crowdfunding, which is much needed by artists, creators, and entertainers. Pointing to the unique images and exclusive content that purchasers received, the dissent likened these NTFs to 1970s Star Wars collectibles:

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.

– Meredith Ervine