Securities and NFTs: A Legal Guide for Gamers and Game Developers￼
As you’ve likely experienced, games are expensive to build. Gaming companies have traditionally raised money from publishers, crowdfunding platforms (like Kickstarter, Indiegogo, or Gamefound), or by selling equity in the company to venture capitalists (VCs) and angel investors.
But with crypto, there are now two additional ways to raise money: by selling game tokens and/or NFTs.
In this new paradigm, Web3 gaming companies have raised millions of dollars from traditional investors, such as venture capitalists, and a non-traditional class of participants — and the public, via public token sales and NFT mints. However, while Web3 games can open new avenues of fundraising, they may also put restrictions on others. For example, crowdfunding platforms do not currently allow the sale of NFTs or crypto assets, which means some traditional institutional investors may shy away from making token investments due to regulatory uncertainty.
They may also trigger securities law issues not traditionally considered by gaming companies when selling in-game currencies or virtual goods.
What are securities, and why do they matter?
Securities refer to a list of financial instruments that include any note, stock, debenture, certificate of interest or participation in any profit-sharing agreement, and investment contract, amongst many others, according to the Securities Act of 1933 and the Securities Exchange Act of 1934. While many securities may be evident on their face (for example, equities in a company), others are harder to categorize and may qualify as an “investment contract” (despite contrasting appearances) based on the facts and circumstances. For example, purchasing orange groves and the associated land tending services with the expectation of significant profits. If you are deemed to be selling securities, such sale and subsequent interactions (like a transfer) are subject to several requirements and regulations under the Securities Act and the Securities Exchange Act, and are regulated by the Securities and Exchange Commission (SEC). This could include limitations on who, where, and how much you can sell, in addition to disclosures and reporting obligations.
The mission of the SEC is to protect investors from fraud and manipulation, and to promote the fair dealing and disclosure of important market information. Within the crypto industry, we’ve seen the SEC bring suits against issuers for offering unregistered securities without an exemption (e.g., Block.one, Kik Interactive Inc., Telegram Group Inc., Ripple Labs) to fraud initial coin offerings (many) to insider trading (ex-Coinbase product manager). We’ve even seen the SEC charge NVIDIA for inadequate disclosures in its financial reports for the impact that crypto-mining has had on its gaming business, for which NVIDIA paid a $5.5-million penalty. That said, we’ve yet to see formal rules or a clear framework on how to think about fungible and non-fungible tokens. As such, companies and founders are either leaving the U.S., or using best efforts to try to be compliant within the existing laws (which date back to 1933 or in the case of the Howey Test, 1946).
What happens when your asset is classified as a security?
If the asset you’re selling is a security, then you may have to register with the SEC without an exception or exemption. Similarly, if you’re facilitating the sale and exchange of a security, you may have to be registered as a broker-dealer and register as an Alternative Trading System or national exchange, without an exception or exemption. This means that tokens classified as securities would not be tradeable on centralized exchanges like Coinbase or Binance, unless such exchanges obtained the required registrations. Theoretically, the tokens shouldn’t be traded on decentralized exchanges like Uniswap, SushiSwap, or 1Inch either, but there are no central parties to hold accountable to obtain such registrations, thanks to the decentralized nature of the protocols. Profit sharing and crypto (whether fungible tokens or NFTs) are not allowed on crowdfunding platforms, which limits the consideration from the company to perks and benefits, such as goods or access to the game, the game’s assets, etc.
If the asset is classified as a security, the issuer will be subject to certain rules and regulations on how you sell the assets, including who you can sell to, where, how, and for how much. SEC Chairman Gary Gensler recently re-affirmed his predecessor, Jay Clayton’s infamous comment that, from their perspective, “most crypto tokens are investment contracts under the Howey Test.” This is relevant to the gaming industry, especially when dealing with tokens and digital assets like NFTs, to determine whether the sales of the assets and the operations of your platform may be subject to securities laws.
What is an Investment Contract, and what is the Howey Test?
The Howey Test, named after the landmark 1946 Supreme Court case, is the predominant test that is used by courts to define an investment contract, a type of security. The Howey Test consists of four prongs, each of which must be satisfied for an instrument to qualify as a security: (1) An investment of money, (2) in a common enterprise, (3) with the expectation of profit, (4) from the efforts of others. If you’re a gaming company thinking of selling a game currency or asset (the issuer of the currency or asset, including any other affiliated promoters, sponsors, or third parties, collectively, the Active Participant or AP), run through this analysis to make sure you’re not inadvertently issuing an unregistered security.
In an attempt to mitigate U.S. securities law concerns, common token structures will have an issuing entity (usually offshore) and a commercial operating entity that contracts with the issuing entity and performs various services — like marketing, developing, maintenance, and more. While these are separate entities, note that the SEC considers APs to include third-party affiliated entities, and there may be a risk that such entities are collapsed and viewed together as Active Participants. In other words, you shouldn’t assume that setting up separate corporate entities may absolve you from regulatory scrutiny, even if they’re in different jurisdictions. Put simply, the entity selling you the token may not be the entity that is responsible for launch and operation.
So, let’s go through each section of the Howey Test below in detail.
(1) An investment of money
If you’re selling a game currency, token, or asset for money or something of value to the purchaser, inclusive of goods or services, then this prong is usually satisfied. Even if you’re giving something away without cash consideration (in the case of an airdrop, whereby the issuer distributes tokens for free), this prong may inadvertently be triggered if you are receiving economic benefit from such distribution, like (for example) marketing emails from the recipients.
(2) In a common enterprise
A common enterprise looks at whether the fortunes of the purchasers are linked together, usually with pro-rata distribution of profit (horizontal commonality), or to the success of the Active Participants (vertical commonality). There is currently a circuit split in which test courts apply to evaluate common enterprise, so we’ll look at both. The SEC has said that “when evaluating digital assets, we have found that a ‘common enterprise’ typically exists.”
Horizontal and vertical commonality
Horizontal commonality requires the pooling of investor funds together in a common venture such that all investors share in the risks and benefits of the business. Given the non-fungible nature of NFTs, some argue that there is no pooling of investor funds at all, since each NFT is unique and should be treated as an asset on its own; a single asset — one investor. For example, the end result of someone who purchases Punk 8376 and someone who purchases Punk 8377 are independent of one another. The plaintiffs in the Dapper Labs (creators of NBA Top Shots) ongoing lawsuit present a counterargument. They argue that where the proceeds from the purchasers of the NBA Top Shot NFTs are pooled together by the company, and are used to conduct activities that increase demand (both in terms of attention and money) to the platform, and arguably the NFTs on such a platform, all purchasers benefit from the rising price. This is evidenced by the existence and rise of the “floor price,” the price of the lowest NFT within any given collection.
Vertical commonality exists when the fortunes of the individual investors increase or rise with the fortunes of the Active Participant. Most NFTs are structured so that the originator receives a secondary market royalty from the re-sale of the royalty. The higher the price of the NFTs, the higher the revenues received by the originator. These recurring revenue streams exist in perpetuity and often are multiples more lucrative than the original primary sale. Further, some games also run their own marketplaces, which charge transaction fees. In the case of Dapper Labs, which restricts the sale of NBA Top Shots to its own marketplace, they not only receive a resale royalty — but also a transaction fee, so any increase in the price of NBA Top Shots directly benefits the company. Wherever an Active Participant makes money based on the performance of the underlying asset, vertical commonality is likely to exist.
There is a variation of the vertical commonality test (dubbed “Broad Vertical Commonality”) that looks at the investor’s dependency on the Active Participant’s expertise. This test is usually the easiest to satisfy out of the three approaches, as it only focuses on the Active Participant’s expertise, which is usually greater than that of the investor.
(3) With the expectation of profit
When purchasers buy an asset with the expectation of making money, this prong is triggered. To evaluate this prong and the expectations of the purchasers, courts will look at how the asset is marketed, the features of the product, who is making the purchases, why, and for how much. For example, do the marketing materials emphasize returns and how much money can be made through the purchase? Do the assets come with profit-sharing rights? Are the assets sold to expected consumers of the product, in amounts and at prices reasonably correlated to the expected consumption?
Absent any other factors (noted above), where price appreciation results solely from market forces, it’s not generally considered “profit” for the purposes of Howey. Further, this prong should be read in conjunction with the below, in that the profits should be derived from someone else’s work. If the purchaser is generating a profit from their own efforts by using the asset, then there’s less of an argument that the asset is a security.
As part of this prong, courts will also look towards both the “consumptive purpose” of the tokens, and whether the purchasers are the ones expected to consume such a utility. In the Telegram case, where there may have been a use case for the GRAMS tokens (to store and transfer value across the Telegram network), the initial purchasers of the tokens were not potential users but rather financially sophisticated venture capitalists purchasing the tokens in bulk.
Royalties, dividends, and assets that generate income are typically features of investment instruments, and have greater chances of resembling a security. Revenue streams would trigger this prong, especially if promised at the fundraising stage, whereby purchasers would expect to generate streams of income from their investment (for example, songs or IPs that depend on the seller to secure licensing deals to generate revenues, which are then shared with the purchaser).
What happens if income-generating activities and promises were made after the fundraising stage? That depends on who is making the promises, and to whom.
(4) From the efforts of others
Last but certainly not least, the SEC and courts will consider the degree to which purchasers depend on the Active Participants for profits. In the context of digital assets, this is usually the prong with the most room to creatively structure. A simplified way to think about this prong goes like this: The more sellers or developers do to increase the value of an asset, the more the asset will look like a security. This is why you often see mechanics requiring the purchaser to perform an action before the receipt of tokens, like (for example) staking, or other opt-in behavior that requires some effort on their part.
Examples that may indicate “efforts of others” include:
- The Active Participant responsible for the development, improvement, and operation of the underlying network. E.g., Developer sells tokens to be used in a game, but still needs to build the game. Or a game is developed, but needs to be maintained and updated by the developer.
- The Active Participant creates or supports a network for the price of the asset. In one case, the AP actively solicits exchanges to list the asset, and/or maintains a marketplace themselves.
- The Active Participant performs essential tasks and/or a central role in the development of the network or asset. In one case, the Active Participant sets forth a “roadmap” of activities that it will undertake to add value to the asset, inducing the purchaser to make the purchase.
In the context of gaming, where you can only sell assets that integrate in games you build, the purchaser is reliant on your ability to build and maintain that game. This means updates, and allowing the asset to have utility in-game. If the asset can be moved off the game and utilized in other non-affiliated games or environments, then the purchaser is less dependent on you. The strongest case for lack of reliance is if the asset is still able to retain its value without an AP (e.g., Bitcoin), or even if the AP stops contributing and walks away. For example, Vitalik or the Ethereum Enterprise Alliance — to the extent either would be considered an AP — could cease working, but the network would still exist.
Reaching for ‘sufficient decentralization’ with gaming NFTs
These situations are what SEC Director Hinman refers to as “sufficient decentralization.” Even if an asset is first sold as a security, it can be re-evaluated down the road, especially if “sufficient decentralization” is achieved, taking it out of securities classification. But the SEC has yet to provide formal guidance on how to achieve this status, let alone what characteristics it looks for in its determination.
You may then ask: if an asset is sold as a non-security, can it later become a security? The answer, of course, depends. Technically, the Securities Act of 1933 regulates the offer and sale of securities. Each offer and sale of an asset has the potential to turn an instrument into a security or investment contract, since it’s the surrounding facts and circumstances of the event — and not the instrument itself — that determine the end result.
We saw this in the case of Howey with orange groves, and Glen-Arden Commodities with casks of whiskey, where neither the orange groves nor casks of whisky standing alone would be considered securities, and instead required consideration of the surrounding circumstances in each case. The Glen-Arden Commodities court, after citing Howey, noted that it is clear then that the manner in which the Scotch whisky warehouse receipts were sold, the information given, profits predicted, services promised and the obligations to be assumed by the purchasers were at all times relevant to the proceedings before the court.
Similarly, the purchase and sale of a token or NFT already in existence combined with the facts and circumstances noted above, could turn that whole event into an investment contract, but wouldn’t taint the entire class of tokens or NFTs, unless it applied to them as a whole. Furthermore, such securities determination would only apply when all of the facts and circumstances are present, and wouldn’t apply to, for example, the original issuer of the token or NFT, or any existing holders. In other words, the court in Howey found that the facts and circumstances under which he sold the orange groves constituted an investment contract, and not that all orange groves in existence became investment contracts following the case.