Thread by @dhoesq

***LONG THREAD WARNING***

Everyone in web3 has heard of the SEC's Howey test - the framework used to determine if an asset is a security or not...but most don't understand the "balancing test" the SEC uses...or how that might apply to NFTs.

1/18

The Howey Test comes from the 1946 case SEC v. W.J. Howey Co., in which the SC held that an "investment contract" is a security...and therefore subject to securities regulation.

2/18

So, what is an "investment contract"?

The SC defined it as: (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) from the efforts of others.

3/18

So let's break that down...

"Money" can be anything of value - fiat currency, digital currency, or even goods or services.

"Common enterprise" means that the parties are pooling their resources - whether it's money, labor, or skills - in order to achieve a common goal.

4/18

"Expectation of profits" means that the parties involved are looking to make a profit from their investment. This can be done through appreciation of the asset, dividends, or other methods.

5/18

"From the efforts of others" means that the success of the enterprise is not dependent on the efforts of any one party - it requires the work of multiple parties in order for it to be successful.

6/18

NFTs easily meet three prongs of the test - NFTs are purchased with money (or other assets of value), they are part of a larger project/ecosystem, and the efforts of others are intended/expected to increase the NFT's value.

7/18

The most wiggle room lies in the "expectation of profits" element - specifically, whether or not the NFT purchaser is reasonably expecting to profit from the efforts of others. This is where the "balancing test" comes in.

8/18

The SEC drafted a "Framework for 'Investment Contract' Analysis of Digital Assets" back in 2019 - originally intended to regulate fungible tokens from an ICO, but now also being used to regulate NFTs.

9/18

This framework lists more than 25 factors about the specifics of the project that are determinative, such as:

- Who are the "Active Participants" and what are their backgrounds?

- What are the terms of the NFTs being offered?

10/18

- How is the NFT going to be used within the project?

- Are there any restrictions on who can purchase the NFTs?

- What rights come with the NFTs being offered?

- What role will holders of NFTs have in governance of the enterprise?

11/18

For example, it'll shock most in NFTs that the SEC expects a project's roadmap to be final and complete BEFORE launching your project ("The more the...characteristics are present, the more likely it is that there is a reasonable expectation of profit...

12/18

the digital asset is marketed, directly or indirectly, using...the future (and not present) functionality of the network or digital asset, and the prospect that an Active Participant will deliver that functionality.")

13/18

Similarly, several projects are promising to use revenues from their mint to build a future benefit - which also goes against this framework: ("The promise (implied or explicit) to build a business or operation as opposed to delivery currently available goods or services

14/18

for use on an existing network.") I can literally think of dozens of projects, big and small, that are doing this as we speak...the 800-lb gorilla in the room, so to speak...

15/18

The key takeaway is that NFT projects need to be very careful when structuring their project...and should always consult with experienced web3 counsel beforehand.

16/18

While the SEC has yet to bring any enforcement actions against an NFT project, they have made it clear that they are paying attention to this space...and in their eyes, NFTs are not immune from securities regulation.

17/18

So if you're thinking about launching an NFT project, make sure you do your homework first - otherwise you might find yourself on the wrong side of an SEC investigation.

-end