Second SEC NFT-Enforcement Action Finds Another NFT to Be a Security

On September 13, 2023, the SEC charged and entered into a settlement with Stoner Cats 2, LLC (SC2), finding that SC2’s non-fungible token (NFT) called Stoner Cats (Stoner Cats NFTs) was a security, and therefore SC2 had engaged in an unregistered offering of a security. The SEC brought this action less than a month after its first-ever NFT-related enforcement action. NFTs are unique digital identifiers that may be used to certify authenticity and ownership of an associated right or asset. Ownership of an NFT may also provide its holder with a right to a digital file that is separate from the NFT or it may provide the holder with a right to asset that is not a digital file, such as the ownership of a physical item.

According to the SEC, the purpose of the Stoner Cats NFT offering was to fund the production of the animated web series, “Stoner Cats,” which told the story of cats that become sentient after exposure to their owner’s medical marijuana. The SEC alleged that SC2 designed the Stoner Cats NFTs so that it would receive a 2.5-percent royalty for each transaction on a certain secondary market platform. This incentivized SC2 to encourage individuals to buy and sell the NFTs on the secondary market, and helped assure owners of the NFTs that SC2 would stay committed to the show post-offering. Furthermore, if the show was successful, the price of the NFTs could rise alongside the royalties. SC2 also promised on its website that if all of the NFTs were sold that would lead to the creation of a decentralized autonomous organization (DAO) of Stoner Cats NFT holders, and SC2 would work with the DAO to “develop at least one new animation project a year for the next three years.”

SC2 compensated its production team of writers, animators, and actors through the offering proceeds and royalties generated by the sales of the NFTs. SC2 also paid programmers associated with the NFTs and social media managers associated with the Stoners Cats show through the proceeds from the sales of the NFTs.

SC2 sold 10,320 NFTs for 0.35 ETH (approximately $800) each. The offering sold out in 35 minutes and generated gross proceeds in ETH worth approximately $8.2 million. Of the NFTs purchased in the offering, 20 percent were resold before the first episode of Stoner Cats, and the majority of the NFTs purchased in the offering were resold in the secondary market before the release of the second episode of the show.

In the eyes of the SEC, SC2 engaged in an “extensive media campaign” to promote the NFTs both before and after they were sold to the public. The NFTs were promoted on the Stoner Cats website as well as via social media, including YouTube, Instagram, and other platforms. SC2 offered potential investors: (1) exclusive access to Stoner Cats content, along with additional access to any other content the Stoner Cats producers created; (2) exclusive access to the Stoner Cats community on Discord, which included events, contests, and opportunities to engage with the creators of the show; and (3) the option for holders to resell their NFTs. The SEC focused on this third factor in the settlement, noting the Stoner Cats Twitter account encouraged investors repeatedly to buy and sell the NFTs on the secondary market.

SC2 also emphasized its teams’ credentials to potential investors. The show was incomplete at the time of the offering, and SC2 touted its team’s skills in Hollywood and crypto projects to investors. This led investors to expect profits from SC2’s efforts according to the SEC “because a successful web series could cause the resale value of the Stoner Cats NFTs to rise in the secondary market.”

As a result of SC2’s conduct, the SEC found that SC2 had violated Sections 5(a) and (c) of the Securities Act, which prohibit the unregistered offering of securities. The SEC required SC2 to pay a penalty of $1 million and destroy all Stoner Cats NFTs in its possession within 10 days of the settlement.

Howey Analysis – Why Are These NFTs Securities?

Once again, similar to the first NFT-enforcement action, the SEC did not explicitly explain how the NFTs in question qualified as securities under the Howey test. In 1946, the Supreme Court established the standard for determining whether a particular economic arrangement can be classified as an “investment contract,” in other words a security, and thus regulated by the SEC. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (Howey).

Under the Howey test, an “investment contract” under federal securities law is any “contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Id. at 298-99. Pursuant to SC2’s settlement, it appears the Stoner Cats NFTs qualify as securities because (1) investors purchased the NFTs using ETH for (2) a “common enterprise” whereby the investors’ fortunes were linked with that of SC2, and (3) the investors had a “reasonable expectation of obtaining a profit based on SC2’s managerial and entrepreneurial efforts.”

Commissioners Peirce and Uyeda’s Dissent

Following publication of this second NFT-enforcement settlement, SEC Commissioners Hester Peirce and Mark Uyeda issued a statement outlining their dissent. They disputed the application of Howey here as creating implications for all kinds of creators. Once again, as with their dissent in the first NFT-action, Commissioners Peirce and Uyeda called for clear guidelines for NFT creators to avoid the SEC “arbitrarily bringing enforcement actions.” In their view, NFTs for fans are akin to artists selling numbered versions of physical prints. Peirce and Uyeda declared that the action against SC2 involved activity that they believed constituted “fan crowdfunding—a common phenomenon in the world of artists, creators, and entertainers.” They compared the Stoner Cats NFTs to Star Wars collectibles where a toy company sold “Early Bird Certificate Packages” that were redeemable for future toys and membership in a fan club. Peirce and Uyeda wondered whether under the settlement with SC2, if those certificates had been resold, they would also now be considered securities.

Conclusion

There have now been two SEC enforcement actions in quick succession against NFT creators. In both cases, the NFT creators were made to pay significant penalties and destroy any NFTs in their possession. The question for NFT-creators now is how to avoid future SEC enforcement actions.

In the press release for Stoner Cats’ settlement, Gurbir Grewal, Director of the SEC’s Division of Enforcement, stated that “it’s the economic reality of the offering – not the labels you put on it or the underlying objects – that guides the determination of what’s an investment contract and therefore a security.” Grewal noted “that 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. It’s therefore hardly surprising, as the order finds, that Stoner Cats sold its entire supply of NFTs in just 35 minutes, generating proceeds of over $8 million, most of which were then resold – not held as collectibles -- in the secondary market within months.”

This final point may be a key fact for NFT creators moving forward. The SEC appears focused on NFT creators touting the reselling of NFTs in the secondary market for profit. NFT creators should therefore be careful with their marketing efforts and engage legal counsel to review marketing and offering materials to avoid running afoul of the SEC on this particular issue.

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