A Blog About Online Gaming and Entertainment Regulations
Ifrah on NFTs: New iGaming Tokens Raise Novel Securities Questions
Non-fungible tokens (“NFTs”) are becoming increasingly prominent in the broader blockchain and cryptocurrency market, as new projects rush to incentivize buyers with offerings of “unmatched benefits.” These utilities, however, do not come without potential legal drawbacks.
In the first article of this series, we covered the basics of NFTs—unique virtual items recorded with immutable characteristics on the blockchain. We also introduced the concept of Utility NFTs, which serve some function beyond their value as collectible digital artifacts. Part II in our series highlighted newly developing applications of Utility NFTs in the online gaming space, detailing potential pitfalls of blockchain gaming and play-to-earn models under federal and state gambling laws.
The third installment in this series examines NFTs that grant holders ownership rights in crypto casinos and casino networks. In light of this type of “utility,” we review the precedent and approach of the Securities and Exchange Commission (“SEC”) and examine whether these igaming-related Utility NFTs qualify as regulated investment contracts.
Federal Securities Laws and Digital Assets
The previous article of our series described one source of risk for companies seeking to integrate NFTs into their products and business model: When Utility NFTs are implemented in the play-to-earn gaming context, operators must be cognizant of the risk that a regulator or court could seek to enforce federal or state gambling laws.
But NFTs can raise other questions, too. From the earliest years of widespread trading of blockchain products—mostly cryptocurrencies, until recently—federal agencies have grappled with how to regulate blockchain products, whether as securities, commodities, or some other type of agreement. In recent years, the question of whether blockchain products, including NFTs, constitute securities has risen to particular prominence.
The answer to that question begins with the so-called Howey test, which establishes a framework for identifying what constitutes an “investment contract,” the broadest category of securities. In Securities and Exchange Commission v. Howey, 328 U.S. 923 (1946), the Supreme Court stated that a product constitutes an investment contract (and therefore a security) if it involves (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit (4) by means of the effort of others.  All four of these prongs must be met for a product to be an investment contract.
In 2019, the SEC offered its clearest guidance to date on the regulation of blockchain products with its Framework for “Investment Contract” Analysis of Digital Assets, in which the agency applied the Howey test to blockchain-based products.  As such, this framework provides a useful starting ground on which to lay out the legal framework in analyzing whether some utility NFTs may be considered securities.
According to this guidance, the SEC views digital assets as commonly meeting the first two prongs of the Howey test. Per the report, Howey’s first prong—an investment of money—is typically satisfied in an offer and sale of a digital asset since the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of currency or other type of consideration.  With respect to the second prong, the SEC has found that a “common enterprise” typically exists, too, because buyers’ fortunes rise and fall together (or along with the promoter’s efforts).
That leaves the last two prongs—whether there is (3) a reasonable expectation of profit (4) through the efforts of others—as the main issues to assess under the Howey test. Those factors are heavily fact-dependent in the NFT context (as in any Howey analysis). Generally, though, the third prong is met when a promoter, sponsor, or other third party provides “essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts.”  As for the fourth prong, the SEC notes that a purchaser may reasonably expect to realize a return on their investments in a variety of ways—through participation in distribution of profits or other methods of realizing appreciation on the asset, such as selling at a gain in a secondary market. 
New Guidance and Enforcement Efforts
More formal interpretive guidance on issues dealing with digital assets and blockchain technology has been indefinitely forthcoming. In August 2021, for example, SEC Chairman Gary Gensler indicated that he wanted to rein in the cryptocurrency industry, going so far as to analogize it to the Wild West. In particular, Chairman Gensler cited his concerns for investor protection: “This asset class is rife with fraud, scams, and abuse in certain applications. There’s a great deal of hype and spin about how crypto assets work. In many cases, investors aren’t able to get rigorous, balanced, and complete information.”  In January 2022, Chairman Gensler told CNBC that securities laws are in play whenever an investor anticipates a profit based upon a promoter’s efforts.  SEC Commissioner Hester Peirce, an avid cryptocurrency supporter, has also called for guidance from the agency, adding that using NFTs to represent shares in a company would likely bring them under the SEC’s jurisdiction. 
Beyond taking cues from the SEC’s guidance papers, the market has had little to draw from when it comes to enforcement actions. In 2021, the SEC filed suit against Ripple Labs, alleging that the defendants violated federal securities laws by not registering its cryptocurrency XRP as a security with the SEC.  In particular, the SEC considered XRP a security because the cryptocurrency was used to finance Ripple’s platform, which facilitates money transfers for retailers. Even further, Ripple’s executives realized profit through sales of XRP. While the matter is still ongoing, many expect the lawsuit to be highly instructive in demonstrating how the SEC is able to regulate cryptocurrencies and other blockchain technologies.
While the Ripple Labs litigation percolates, another ongoing matter could give the clearest indication yet as to whether NFTs constitute securities. In May 2021, a group of plaintiffs filed a purported class action lawsuit against Dapper Labs, the creator of the popular NFTs “NBA Top Shot Moments,” alleging that these NFTs involved the sale of unregistered securities. The complaint alleged, among other things, that investors “purchase this type of digital asset with the hope that its value will increase in the future as the project grows in popularity, based upon the managerial efforts of the issuer of the asset or token and those working to develop the project,” and as such, the digital assets should be registered as securities in compliance with federal securities laws to protect investors. A motion to dismiss in Friel v. Dapper Labs remains pending before the Southern District of New York—Part IV of our series will take a closer look at the specific arguments raised in that context. 
NFTs as Ownership Stakes (and Securities)
If we haven’t yet made it clear that the question of whether NFTs are securities is unsettled, retirement is knocking. But certain types of NFTs—granting “ownership” privileges to NFT holders—seem to invite unique consideration of how the federal securities laws can apply.
As we discussed in Part II of our series, “gamified” Utility NFTs are tradeable items in online video games whose purchase serves as a requirement for play. While their functions and qualities vary from purely aesthetic to totally essential for gameplay, these NFTs nevertheless hold value that is accrued, accessed, and traded among players as part of the gameplay.
Recently, various operators have begun to release NFTs that do not serve an express function inside of an online video game atmosphere—aesthetic, instrumental, or otherwise. Instead, they grant a range of privileges that often accompany ownership stakes, including revenue sharing. In the i-gaming context, this has involved sharing in the profits of certain online casinos, with marketing language advertising the opportunity for NFT holders to “be the house.” Revenue share methods vary by operator. For example, some distribute profit share based on the rarity of the NFT, in which the rarer the NFT the more that is distributed, while others allocate them evenly per NFT. In the latter case, for example, 70 percent or more of profits may be distributed evenly across the NFTs in the collection, so the only way to accrue more is to own more NFTs.
To assess whether NFTs advertised as offering ownership utility (which we’ll call “Ownership NFTs”) constitute securities, we turn again to the Howey test.
- An investment of money: In alignment with the SEC’s broader guidance in 2019, the first prong is easily met, as owners must purchase the NFTs.
- In a common enterprise: Courts have multiple ways of assessing commonality, which we will discuss further in Part IV of our series. For now, we will highlight two aspects of Ownership NFTs that suggest commonality. First, proceeds from NFT sales are generally pooled into the projects; management teams use these funds to expand the projects’ profit-seeking ventures, and a portion of profits is realized by NFT owners. In other words, the fortunes of each project’s NFT holders are intertwined with each other and the overall success of the project. Second, in certain instances, management collects a commission on secondary-market resales of Ownership NFTs.
- With a reasonable expectation of profit: In the Dapper Labs case, the “NBA Top Shot Moments” creator has argued that its NFTs are offered strictly as collectibles, not as investment vehicles. But it would be difficult for Ownership NFT operators to make this assertion, given that the explicit utility of these tokens is to provide ownership interests (with accompanying profits) to NFT holders. An NFT that offers the opportunity to “be the house” seems to generate substantial support for a “reasonable expectation of profit.”
- By means of the effort of others: This is the factor that seems to involve the greatest amount of variation. In certain instances, Ownership NFTs offer profit sharing only in relation to entities (online casinos, in this context) that are not formally affiliated with the endeavor’s management company. In this context, the company establishes partnerships with other casinos, and Ownership NFT holders draw revenue from each partner. In that context, NFT holders can expect profit only as a result of the efforts of management. On the other hand, other Ownership NFTs involve the sharing of profits of in-house (affiliated) casinos. This factor seems somewhat closer: NFT holders will earn profits based on the popularity of the affiliated casino itself, which seems mostly driven by management’s efforts but potentially also connected to word-of-mouth efforts by NFT holders.
An initial defense may invoke the non-fungibility of NFTs, in apparent reference to today’s prosperous securities markets that rely on the interchangeability of securities for depth and liquidity to settle transactions. Fungibility, however, is not an essential characteristic of a security. Indeed, as the SEC notes, the Howey test analyzes not just the form of the instrument but also the manner in which it is offered, sold, or otherwise acquired in addition to the efforts of the relevant parties that led to the transaction.  Whether the contract, scheme, or transaction has the characteristics typical of securities is irrelevant to its classification as an investment contract.
As the NFT landscape evolves, the SEC and other agencies will continue to wrestle with various types of tokens. Our analysis identifies important considerations for any company (in i-gaming or otherwise) considering offering new NFTs that offer ownership and profit-sharing benefits. Before launching any NFT project, companies must walk through the Howey factors and make an honest assessment of whether their new tokens might meet the definition of investment contracts and trigger heightened scrutiny and registration requirements.
*Jake Gray is a graduate of Columbia University and an established technology researcher, currently working in the betting and futures space as a consultant to a variety of operators.
 SEC v. Howey Co., 328 U.S. 293 (1946)
 See also: Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO. https://www.sec.gov/litigation/investreport/34-81207.pdf
 This last week, documents from 2012 were unsealed, which some consider as supporting both sides of the case. On one hand, Ripple Labs stated that the documents showed legal analysis that Ripple received in 2012 that XRP is not a security. On the other hand, one document has shown attorneys advising Ripple not to sell the proposed XRP crypto coins, because various circumstances could subject them to being regulated as securities (or commodities). See: https://investorplace.com/2022/02/ripple-labs-v-sec-xrp-usd-and-crypto-could-lose-if-the-sec-wins/
Part I — Ifrah Law on NFTs: What is an NFT?