On August 28, 2023, the SEC settled enforcement charges against a Los Angeles-based media and entertainment company for conducting an unregistered offering of non-fungible tokens (NFTs). The case represents the SEC’s first foray into the NFT space.

The SEC’s order cites the DAO Report to conclude that the NFTs here were investment contracts under the Howey test. The NFTs here contained various combinations of digital graphics. But the SEC alleged that, in effect, purchasers acquired the NFTs not for their underlying collectability, but rather as an investment and to fund expansion of the NFT issuer’s business. The SEC pointed to a number of statements the NFT issuer made to purchasers about growth of the business and future appreciation in value of the NFTs. The SEC seemed concerned that the NFT issuer collected the proceeds from the NFT sales in a single crypto wallet and used a portion of those proceeds to pay certain vendors. Eventually, the NFTs also began trading on various secondary trading platforms, which the issuer advertised. The SEC also noted that the issuer programmed the smart contract for the NFTs so that the company received a 10% royalty on each secondary market sale, which generated almost $1 million of ETH in royalties for the issuer.

Without admitting or denying the SEC’s findings, the NFT issuer agreed to a cease-and-desist order that it violated the registration provisions of the Securities Act of 1933 and ordering it to pay a combined total of more than $6 million in disgorgement, prejudgment interest, and a civil penalty. Notably, the NFT issuer also agreed to destroy all NFTs in its possession or control, publish notice of the SEC’s order on its websites and social media channels, and eliminate any royalty that it might otherwise receive from future secondary market transactions involving the NFTs. The SEC did not allege that the issuer committed fraud.

Two SEC commissioners issued a public statement about the case calling for further dialogue about the applicability of the federal securities laws to NFTs, positing as follows:

We understand why the Commission was concerned about this NFT sale. Even though we believe strongly that adults should be able to spend their money as they choose, we share our colleagues’ worry about the type of hype that entices people to spend almost $30 million for NFTs seemingly without having a clear idea about how they will use, enjoy, or profit from them. This legitimate concern, however, is not a sufficient basis to pull the matter into our jurisdiction. The handful of company and purchaser statements cited by the order are not the kinds of promises that form an investment contract. We do not routinely bring enforcement actions against people that sell watches, paintings, or collectibles along with vague promises to build the brand and thus increase the resale value of those tangible items.

An SEC case involving NFTs was inevitable. While it remains possible to structure an NFT sale so that no security is created, the SEC’s case here serves as a cautionary tale. The SEC seemed most troubled by the emphasis on future appreciation (particularly through the creation of secondary trading markets) and using proceeds to support growth of the NFT issuer’s business, which ultimately were not consistent with a consumptive purpose for the NFTs.