Non-fungible tokens (“NFTs“) broke into the mainstream in the first quarter of 2021 as retail interest in the digital asset grew and news headlines highlighted the sale of NFTs for enormous sums, including: (i) just under US$70 million for the piece by digital artist, Beeple, titled, “Everydays: The First 5,000 Days”, (ii) US$2.9 million for the first tweet by Twitter’s CEO, Jack Dorsey, and (iii) over US$230 million for digital collectibles sold as NFTs via the NBA’s “Top Shot” blockchain-based trading card system. In recent weeks there have been several other examples of NFTs aiming to revolutionize the art, fashion, sports and entertainment industries, with many experts forecasting that the age of NFTs may only be in its infancy.
Although most NFTs currently in existence do not resemble securities, Canadian securities regulators have consistently stated that such a conclusion depends on the specific nature of the token and the representations and marketing efforts of the issuer. Accordingly, it is critical that crypto issuers and related businesses, as well as investors and other market participants, are aware of and consider the securities law requirements that may apply to their activities in order to avoid costly regulatory surprises.
This Insight explores the application of Canadian securities laws to the distribution, acquisition and resale of NFTs.
Background: what are NFTs?
Non-fungible tokens are a subset of cryptocurrency issued on a distributed ledger such as a blockchain. Unlike other cryptocurrencies, they are unique, and, therefore, “non-fungible”. While each bitcoin is the same as every other bitcoin (or every dollar is the same as every other dollar – assuming the same currency), each NFT is distinct from each other NFT. Currently, most, but not all, NFTs are issued via the Ethereum blockchain; however, the market for blockchain platforms continues to develop and evolve. NFTs are useful because the underlying content is linked to a single token contained in a smart contract on the applicable distributed ledger and, as such, ownership can be irrefutably authenticated; others may have copies of the same content but only one person can own the token that authenticates ownership.
Are NFTs securities?
Whether any asset is a security is a question of fact under Canadian securities laws, to be answered on a case-by-case basis. At first glance, the NFTs capturing recent headlines – those that represent authenticated ownership of digital art, trading cards and other collectibles – do not appear to be securities and more closely resemble any other product that is created and sold; the future value of the asset is unrelated to any efforts of third-parties aimed at maintaining or increasing its value. However, as NFTs continue to grow in popularity, the dollar amounts involved gather attention and commercial adoption increases, it is likely, that NFTs will be used to distribute digital property rights in a manner that causes the tokens to more closely resemble securities.
- NFTs can be created – or minted – in a manner that allows the issuer to receive a share of proceeds each time the NFT is sold and it is likely such issuers will eventually want to sell such rights on a secondary market or package them together with other assets;
- Insurers have contemplated issuing policies in NFT form since insurance policies are unique assets based on specific variables; and
- NFTs can be used as collateral to borrow other cryptoassets and, in fact, platforms have already emerged allowing for such capability.
Guidance from the Canadian Securities Administrators (the “CSA”) with respect to cryptocurrency offerings and the offerings of tokens provides the basis for the securities analysis related to NFTs. As noted above, whether or not a token is a security is a question of fact and is to be determined on a case-by-case basis. An offering of tokens may involve the distribution of securities if it satisfies any of the following criteria: (i) the offering involves the distribution of an investment contract, (ii) the offering and/or the tokens issued are securities under one or more of the other enumerated branches of the definition of security, or (iii) the tokens may be a security that are not covered by the non-exclusive list of enumerated categories of securities.
With respect to the first category, in analyzing whether an offering of tokens involves an investment contract, businesses and their professional advisors should assess not only the technical characteristics of the token but also the economic realities of the offering as a whole, with a focus on substance over form and consideration of whether the offering involves: (i) an investment of money, (ii) a common enterprise, (iii) the expectation of profit, (iv) to come significantly from the efforts of others.
Regarding NFTs, specifically, the CSA noted that, where tokens are not fungible or interchangeable and each token has unique characteristics that result in the purchaser exercising their personal preferences to value the token as a mode of entertainment or as a collectible item, there may be an inference that the value of the token is based on its unique characteristics and not on the efforts of others and, therefore, there may not be a common enterprise necessary for an investment contract. In such circumstances, an objective future market value of the token is primarily based on market forces and not on the continued development of a business by the issuer. Many of the NFTs representing digital art, trading cards or other collectible items would seem to fit this description given the unique characteristics and scarcity of each token, the lack of representations made with respect to utility or liquidity of the tokens and the fact that the value of the tokens are not primarily based on the development of any business or platform but, instead, the preferences of the purchaser and the value that purchaser places on the underlying asset.
Even though the CSA guidance indicates purchasers valuing tokens as a mode of entertainment or collectible item based on unique characteristics may suggest that NFTs are not securities, another key consideration in such analysis is whether the tokens are reasonably expected, or are marketed, to trade on one or more cryptoasset trading platforms (including decentralized or “peer-to-peer” trading platforms), which may indicate that purchasers are purchasing the tokens with an expectation to resell them at a profit. As such, how tokens are marketed to purchasers and market expectations regarding secondary trading are critical factors in determining whether a specific token is a security. In assessing whether purchasers are acquiring the tokens with an expectation to resell, regulators will consider representations made by the issuer either formally or informally (including through social media channels) and whether the existence of secondary trading is critical to the success of the offering of tokens or is featured prominently in the marketing of the offering. Businesses and token issuers must, therefore, be mindful of their marketing efforts and public representations with respect to liquidity and future value of tokens as such efforts and communications will impact whether the tokens are deemed securities.
In addition to the above noted factors related specifically to NFTs, businesses and token issuers should be aware of a number of factors, including the following factors related to all tokens, which will be considered by regulators in determining whether a token is a security:
- the stage of development of any software, platform or application necessary for the proposed function of the token;
- the timing of delivery of tokens to purchasers;
- the stated purpose of the offering and use of proceeds;
- the establishment of any “bounty” or similar programs that offer free tokens or other benefits to persons who promote the offering;
- whether the issuer’s management team retains a significant number of unsold tokens from the offering or “pre-mines” a significant number of tokens before they are publicly available;
- whether the token is intended for use as a currency or to have utility beyond the issuer’s platform but there is no demonstrated acceptance or wide usage;
- whether management’s skill or expertise will likely increase the value of the token (or if management has made such representations);
- whether the token has a fixed value on the applicable platform that does not automatically increase over time or change based on non-commercial factors;
- limits on the number of tokens issuable;
- the target market of the tokens;
- statements from management as to the expected appreciation in value of the tokens; and/or
- whether tokens are distributed for free.
Issuers should also note that, with respect to so-called “utility” tokens – those that have one or more specific functions – the fact that a token has a utility is not, on its own, determinative as to whether an offering involves the distribution of a security.
Consequences and takeaways for businesses and investors
Whether an NFT or any other token or cryptocurrency is a security will have significant impact on, among other things, the marketing efforts of crypto issuers, the ability to distribute the NFT or other cryptocurrency, liquidity, and the ability of purchasers to resell purchased assets. Accordingly, businesses and investors should be aware of the following conclusions drawn from CSA guidance:
- If a token is a security, distribution of such token will be subject to the prospectus requirement under securities laws and applicable re-sale restrictions;
- Tokens distributed in multi-step offerings may nevertheless be deemed securities if they have the features described above under “Are NFTs Securities?”;
- If a distribution of a token is the first of multiple steps and is made without complying with securities laws, the issuer will remain in default of such requirements even though subsequent steps have occurred;
- A person or company in the business of trading in tokens that are securities is subject to the dealer registration requirement under securities laws;
- A person or company in the business of promoting a token that is a security may be deemed a promoter of the security; and
- CSA is conducting active surveillance of coin and token offerings to identify past, ongoing, and potential future violations of securities laws and intends to take regulatory and/or enforcement action against businesses that do not comply with securities laws.
Given the above, businesses and issuers should be mindful of the securities laws considerations applicable to the issuance or acquisition of tokens, including NFTs, and the corresponding implications for the issuer, its business and other market participants.