#234: The End of the Beginning for NFTs
PLUS: 😢 I lied in my last post
Before jumping in, I want to make clear that I’m not a lawyer (duh) and these are just my opinions. Also, I don’t like the SEC and its ‘regulation by enforcement’ approach towards this industry.
Despite this, I believe this is a step (in the least ideal way, but a step nonetheless) towards regulatory clarity and there are interesting nuggets that make this development worth following outside of the larger potential implications. If you couldn’t tell, I’m a glass-half-full kind of guy, but I try to be realistic about how full the half-full is 🥛
Also, I believe it’s important to explain traditionally complex concepts, even ‘boring’ legal ones, in ways that are more comprehendable.
SEC vs. NFTs
Real quick, what’s the SEC?
It is a college sports conference, the Southeastern Conference.
It’s also the US Securities and Exchange Commission, also known as the boring SEC (jk). They enforce the law against market manipulation, like stocks, financial advisors, and they are trying to bring crypto and NFTs into their purview as well.
As some of us probably saw yesterday, there was a big headline from the SEC:
This isn’t the first time the SEC has come after a NFT project, although this is a newer developing area of crypto it seems that the agency is coming after. A few weeks ago, the SEC charged Impact Theory for their NFT sale.
As much as I dislike the SEC for its unfriendly stance towards this space, the Impact Theory charge made sense. When a team makes statements like:
“Our goal is to make sure that as Impact Theory is enriched, as [its founders] are enriched, as our team here at Impact Theory is enriched, that you guys also are enriched. And so that is why we are so aggressively behind NFTs.”
or
“Everyone here is an early adopter! Buying a founders key is like investing in Disney, Call of Duty, and YouTube all at once.”
you becoming low-hanging fruit.
During my time working at a fintech robo-advisor company several years ago, I learned a lot more about the SEC and the limitations around marketing for user acquisition. I spent a considerable amount of time working with the legal department to understand what was and wasn’t allowed in terms of language that could be used to advertise our app and acquire users.
I initially approached these conversations with naive frustration, as someone who was used to rapid creative testing and aggressive user acquisition tactics in mobile gaming and rideshare. I slowly shifted that frustration from viewing my legal colleagues as blockers to understanding how the space and rules came to be. I even forced myself to read the 38-page Investment Advisers Act of 1940. That’s an 84 year old document, almost as old as my grandparents! 🧓🏼
One of the biggest takeaways was you cannot make promissory statements in your marketing.
No “to the moon 🚀” BS, disclosing that charts of returns are illustrative and hypothetical, and providing the proper disclosures in ads and statements. It’s clear that Impact Theory’s marketing efforts breached rules related to this, which the SEC is attributing to the Securities Act of 1933, and also arguing that this specific collection should be regarded as securities.
Ok, I’m getting too pseudo-lawyery here. So what did Stoner Cats do?
They did a watered-down version of what Impact Theory did, but enough to get them into the SEC crosshairs:
Investors were told that the Stoner Cats NFT was analogous to a “ticket” and that “if people don’t appreciate it, you can take that ticket and sell it.” Investors were also told that “the more successful the show, the more successful your NFT” will be.
This meme didn’t help either:
Point is, the NFT space needs to get their act together (and they have for the most part) on the marketing side, and I believe that is a fair criticism. We aren’t in the Wild West era anymore, and it’s clear that these types of tactics will not be (and shouldn’t be) tolerated.
What is concerning though
…Is the details in the SEC’s press release on the Stoner Cats settlement:
“The order finds that, as part of the marketing campaign, the SC2 team emphasized its expertise as Hollywood producers, its knowledge of crypto projects, and the well-known actors involved in the web series, leading investors to expect profits because a successful web series could cause the resale value of the Stoner Cats NFTs in the secondary market to rise”
“Stoner Cats marketed its knowledge of crypto projects, touted that the price of their NFTs could increase and took other steps that led investors to believe they would profit from selling the NFTs in the secondary market.”
This is something that pretty much all NFT projects do. How else do you expect to sell a NFT collection, regardless of the supply and price? You need to market it. You need to promote it. They can’t control whether the consumers expect a profit or not and this is assuming all consumers expected to profit from it.
I minted 3 Stoner Cats during the launch of the project on July 27, 2021. I was excited about the involvement from Ashton Kutcher and Mila Kunis, the token-gated show concept, and the prospect of the value of the NFT value increasing (this was not the sole or even dominant reason for purchasing them). I genuinely enjoyed the show and it was cool to experience the newish concept of token-gated media at the time.
The most concerning part of the press release was the vague statement that crypto assets are securities:
“Registration of securities, including crypto asset securities, protects investors by providing them with disclosures so they can make informed investing decisions,” said Carolyn Welshhans, Associate Director of the SEC’s Home Office. “Stoner Cats wanted all the benefits of offering and selling a security to the public but ignored the legal responsibilities that come with doing so.”
Some definitely are, but the statement suggests most if not all NFTs are due to the marketing and the ability to resell, without providing further clarification.
Basically, THIS SPACE IS SCREWED.
Hope is not lost
Ok, too dramatic.
It’s easy to get caught up in the ‘pack it up, it’s over’ mindset, but by now many folks in the space know the games that the SEC plays and understand that it intentionally tries to overreach.
Shortly after news broke, there were much more qualified opinions that shared their thoughts:
Preston Byrne, a partner at Brown Rudnick, shared his opinion about the Stoner Cats settlement. TLDR:
His post previewing the piece was great: “Impact Theory was an obvious example of an entrepreneur trying to dress up an investment contract as an NFT. Stoner Cats is an example of the SEC trying to dress up a collectible as an investment contract."
Stoner Cats promised to develop content in the future, which is exactly what artists would do in a TV series
Do you need to create the content first before selling collectibles and merch?
Buying film stills before the movie releases is a thing
Buying merch and collectibles and merch from existing TV series is a thing
When is a show considered “complete”, allowing sales of NFTs permissible?
Colleen Sullivan, co-head of venture at Brevan Howard Digital, noted that Roblox recently incorporated similar royalty mechanics for creators with a large % of these items being resold for higher:
And probably most importantly, 2 SEC Commissioners dissented against the Stoner Cats enforcement. There are 5 Commissioners (Gary Gensler is one and is also the Chair) in the SEC, so in this case the enforcement was a 3-2 split. The dissent centers around the enforcement suggesting that NFTs are securities.
TLDR:
If securities laws were applied to physical collectibles, artists would suffer tremendously
There needs to be clear guidelines for artists and creators who want to leverage NFTs as a way to support their endeavors
NFTs offer an additional avenue for artists to monetize their talents. The involvement of money does not turn NFTs into securities.
The Stoner Cats NFT sale is analogous to crowdfunding, which is commonplace
Sales of some NFTs may be securities. However, this instance discourages content creators and creates more legal ambiguity.
Glad to see that there are level heads in an agency that our industry has grown to dislike…a lot.
What else is interesting
There is a lot at stake with this enforcement and the ripple effects that come with it, especially as a Stoner Cats minter. However, what else is interesting?
The company behind Stoner Cats lives on!
Big Head Club, the company that worked on Stoner Cats, will continue its operations. The team will see through several initiatives it’s already been working on, and may eventually get back in the NFT ring.
Respect to the team for seeing things through.
How will this impact existing NFT efforts and prospective ones?
I’ve heard of reports that founders and projects are deleting old social media posts, spooked that they might have unwanted guests at their doorstep in the future.
On the other hand, there is now another reason for creators and brands to hesitate before entering this space. Some ways folks are working around these risks:
Conduct a free mint: There isn’t really an ‘investment contract’ if there’s no investment of money (one of the four requirements for the Howey Test) to be made in the first place. This works for companies that have already received funding or large brands, but handicaps creators. This is why the arguments are vital for the broader space and why I believe the dissent is coming from this angle.
Art: Art is art, that’s it 🖼️. If digital art somehow gets categorized as a security, I hope Da Vinci, Frida Kahlo, Picasso, and all the greats rise from their graves and haunt the SEC as the Ghosts of Art Past.
Tighten up marketing compliance: No more dumb shit. No need to expand on this.
How will injured investors be reimbursed?
Towards the end of the enforcement statement, more details were shared about ‘injured investors’.
Without admitting or denying the SEC’s findings, SC2 agreed to a cease-and-desist order and to pay a civil penalty of $1 million. The order establishes a Fair Fund to return monies that injured investors paid to purchase the NFTs.
I’m curious how the $1 million fund will established and how it’ll be paid out to these investors:
Will the fund be established onchain via a wallet that will transfer ETH (the original currency used to mint the NFTs?) Will there be fiat options? What if some of the investors were from outside the US?
Who qualifies as an ‘injured investor’? Only the minters? The current holders Anyone that purchased a Stoner Cat at any point in time? What if a Stoner Cat was bought and sold 100 times to unique buyers?
How will injured investors be notified?
Do investors need to KYC and reveal their identity? Everything can be tracked onchain so hypothetically that’s not needed. Can investors connect their wallet and prove they own the wallet, providing sufficient proof that they should be compensated?
If I recall correctly no one had to provide any info (email, name, address, etc.) in order to mint, and buying and selling NFTs is permissionless. Will there be requirements to be eligible for the Fair Fund like providing PII?
If one of the methods of notification will be onchain, it would actually make a lot of sense to use wallet messaging like XMTP to contact all the wallets
Blockchain improves this type of process
Ironically, this situation shows why blockchain is valuable. With the Stoner Cats Fair Fund, you have transparency into all the wallets that minted, and you can programatically refund these wallets with set parameters and requirements.
In the physical world it’s much harder.
Let’s say there was a toy recall. You don’t know who purchased the toys and have to send out a notice of the recall through traditional channels. As you can imagine, that’s a lot less effective.
Either way, I am a Stoner Cats minter, so many of these questions will be answered soon-ish.
As dark as the implications of this enforcement action are, I believe an announcement like this was inevitable (especially seeing the warpath the SEC has been on recently). Now the real fight for clarity, reason, and creators begins.
And here’s the glass-half-full take: This is not the beginning of the end for NFTs. Rather, this is the end of the beginning for NFTs.
Clarity will come, and it will lead to this space flourishing as a result.
So about the lying in my last post — I said I would do part 2 of my roundup of a few interesting things, but I also didn’t expect to write 2,200 words about stoned cats. I’ll get to it soon, maybe when the SEC provides some more clarity 🙄
See you next week!
Tom Bileyu has never been more than a cheap tech bro version of Simon Sinek.
Very in-depth! Thanks for this