Okay let’s start with the basics:

One key characteristic of NFTs is provable control thanks to the blockchain.

Given the reliability of blockchain technology and decentralized ledgers, an NFT holder can be confident that control of their underlying asset(s) is secure.

NFTs are also commonly accompanied by “smart contracts,” which allow the seller to place conditions or use cases (utility) on the token-holder’s rights such as royalty payments to the original NFT creator or discounts on certain events for being an NFT holder.

The conditions or utility of an NFT’s underlying smart contract are designed decentralized and therefore to be automatically enforced by the NFT’s code on the blockchain.

NFTs are not, however, limited to something digital. They can also represent any type of physical asset, acting as a kind of ‘digital twin’ that allows us to create/copy tangible or intangible physical assets of the real world into only one digital version. For example, a T-shirt in real life is tokenized into a digital version which is unique and irreplaceable. And, the interesting thing is, the digital twins of this T-shirt would be an NFT of a T-shirt.

The SEC has explained that crypto tokens, coins, or other digital assets issued on a blockchain may be securities under the federal securities laws, identifying a few major areas in which NFTs might be considered securities under existing regulations.

What makes them illegal securities?

The biggest red flag for illegal securities is fractionalizing, which means that you allow for multiple investors to buy portions of [an] NFT.

With offerings across a growing number of online platforms and increased trading volume, NFT issuers, promoters, and buyers should consider the legal and regulatory implications relating to NFTs and federal securities laws.

There’s already plenty of legal precedent here and using the Howey Test — a multi-part rubric for determining whether or not something qualifies as an investment contract we discuss in more detail below — a security is defined as an investment in a “common enterprise” with the expectation that someone else is going to make your investment go up.

The SEC’s inquiry will likely be focused on whether certain NFT projects are being used to raise money, in the manner of traditional securities, rather than sold as more traditional memorabilia or art.

So lets get into the Howey test?

The Howey test for securities:

• It is an investment of money
• There is an expectation of profits from the investment
• The investment of money is in a common enterprise
• Any profit comes from the efforts of a promoter or third party

Orange Groves (yes the fruit) actually helped set the precedent for whether an asset falls under the purview of the Securities Act. Today, “the Howey test,” which has been refined over the years, has four aspects the SEC used to determine whether a product is a security: whether the offering involves:

(1) an investment of money

(2) a common enterprise

(3) a reasonable expectation of profit

(4) whether it originates from an entrepreneurial effort.

In Howey’s case, instead of simply selling oranges, he sold leaseback agreements for his orange farm, which turned his farming effort into a security in the eyes of the court. The orange groves themselves were not securities, but the leaseback agreements were.

Today’s regulators who are looking at illegal NFTs and other digital assets appear to be using that same standard to draw many of their conclusions. This likely means that some NFTs will be viewed as oranges — not a security — while other NFT transactions will be viewed similarly to an orange-grove leaseback — a security. The difference is in the packaging, which is why fractional NFTs are under scrutiny; and they are looking a lot like orange-grove leasebacks.

The US government’s Office of Foreign Assets Control recently declared that numerous NFTs, and even one entire exchange, are now forbidden.

What does this mean for us?

There’s been many debates about whether certain non fungible tokens, digital assets that can be used to denote ownership of things like a painting or sports memorabilia, are being utilized to raise money like traditional securities.

Attorneys in the SEC’s enforcement unit have sent subpoenas demanding information about the token offerings hidden in NFTs.

The SEC is seeking information on so-called fractional NFTs, which involve breaking down the assets into units that can be easily bought and sold. Fractionalized NFTs are more at risk because you have a user or individual that is investing money in a common enterprise.

Some NFT marketplaces have taken steps to remove projects that might put them in regulators’ crosshairs, such as those that offer royalties or that involve raising funds for a business.

A key legal question is whether digital assets including NFTs are securities, and therefore subject to the same rules as stocks.

While the SEC has said that many tokens fall under its purview, some crypto enthusiasts argue regulations meant to police the equity markets shouldn’t also apply to virtual currencies.

So, if you own a NFT now is the time to ensure that it is not illegal.

Learn more about illegal NFTS on our podcast; Spilling THE NFT