Don’t Offer Unregistered Securities
Being able to programmatically collect royalties is one of the unique selling points of NFTs. But if you redistribute those royalties via a pooled or similar arrangement to other NFT or token holders you might be violating U.S. securities law. Here’s why…
In Part 1 of How NOT to Promote Your NFT or Metaverse Project, I talked about how using “enter for a chance to win” giveaways as a promotional vehicle for an NFT or Metaverse project might turn your otherwise legally compliant web3 venture into an illegal lottery.
Now, in Part 2, I’m going to talk about how promoting “passive income” opportunities via something like a shared royalty stream may get you into legal hot water under U.S. securities laws.
Although many NFTs and NFT marketplaces allow creators to set and collect royalty payments on secondary sales, I’ve seen several web3/metaverse projects which offer NFT or token holders a share of the royalties (or other income) generated by the collection or the project as a whole. The problem with this sort of arrangement from a legal perspective is that depending on how it is structured it could be considered an “investment contract” as that term is defined in Section 5 of the Securities Act of 1933.
The Howey test, named after the U.S. Supreme Court case S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946), requires the following elements to be present for a “contract, transaction or scheme” to be considered an “investment contract” (and therefore a security):
- An Investment of Money
- In a Common Enterprise
- With a Reasonable Expectation of Profits
- Derived from the Efforts of Others
Taking each of these in turn:
- If the project requires people to pay to mint their NFT, the first element is satisfied.
- If the passive income is being paid out of a shared pool of assets or royalty stream then the second element is likely satisfied.
- If the project has promoted the fact that the royalties will be shared among NFT or token holders then the third element is satisfied.
- If there is a team behind the project with managerial control then the fourth element is likely satisfied.
I’m not suggesting that every web3 or metaverse project which offers passive income to its NFT or token holders is violating U.S. securities laws, and so far none of these types of projects have been the subject of an SEC enforcement action (at least not yet), but as with virtually everything in the crypto space, regulators are always several steps behind the “innovators,” so it wouldn’t surprise me to see some enforcement and/or settlements with these sorts of offerings in the foreseeable future.
Until next time.