On Jan. 23, the White House issued an executive order on cryptocurrency, "Strengthening American Leadership in Digital Financial Technology."
That executive order, with its aggressive timeline for developing a crypto-friendly regulatory environment, appears to have switched all levers of government to "on" when it comes to the world of digital assets. From the digital assets working group created by the executive order, which includes officials from top agencies and government departments, to the halls of Congress, discussion of all things crypto — and especially the development of legislation, such as revamping the FIT21 Act — is at the forefront in Washington.
In this article, we look at one aspect of the discussion: nonfungible tokens as digital assets and the limitations of the current proposed legislation to regulate them.
The Promise of NFTs
NFTs are unique digital assets representing the ownership of a digital item or real-world asset, which is recorded on a blockchain. "Nonfungible" means that, unlike, say bitcoin, where any bitcoin is identical to another bitcoin in the same way any one-dollar bill is identical to another one-dollar bill, an NFT is a one-of-a-kind digital asset showing ownership of a specific and unique asset, like a piece of art.
So, what is so special about NFTs, and why are we interested?
The future of NFTs could be big. There are numerous and interesting use cases for NFTs beyond collectible digital images of apes. The use cases include digital identification, real estate, art and music, healthcare and medical research, metaverse transactions, car ownership, insurance, consumer rewards, banking, and credit. The options are limitless.
By some estimates, the global NFT market could reach $231 million by 2030, at a growth rate of 30% or more.[1] So, getting legislation and regulation on NFTs wrong could be a dealbreaker. NFTs' use of blockchains makes proof of ownership fast, efficient, tamperproof and verifiable.
Legislative Proposals on NFTs
What is the current state of legislative proposals on NFTs? For today's article, we'll focus on the resurrection of the New Frontiers in Technology Act, originally introduced in September 2024 by Rep. William Timmons, R-S.C., and co-sponsored by Rep. Ritchie Torres, D-N.Y.
The NFT Act was reintroduced in December and is aimed to be added to the Financial Innovation and Technology for the 21st Century Act, a crypto bill passed by the U.S. House of Representatives last year. The so-called FIT21 Act is now in the process of being revised in preparation for another attempt to get it through the U.S. Senate.
What is the NFT Act's proposal to deal with NFTs? The answer is: It is limited, and it's complicated.
What the NFT Act Would Cover
The NFT Act expressly removes "covered non-fungible tokens" from how U.S. securities law and the now well-known Howey test define a security or investment contract. Specifically, the NFT Act states that covered NFTs are "not an investment contract," and the offer and sale of a covered NFT is "not a transaction in a security."
What kind of digital assets fall within this category? The NFT Act includes NFTs that are "developed primarily for personal, family, or household consumption" and includes things like art, music, literary works, intellectual property, collectibles, merchandise, virtual land or video game assets, among other categories.
The bill does not define what it means to be developed primarily for "personal, family or household consumption."
This definition appears to focus on the intent of the creator, not the intent of the purchaser.
So, what if the creator just wants to sell content and does not care who purchases the work? How does the creator demonstrate their purposes for selling? What are the consequences, for example, if an NFT representing ownership in a particular painting by an obscure artist is sold to an art collector, but the collector turns around and begins promoting the artist in the hopes that the NFT will increase in value?
However, within that definition, there are specific exclusions that relate to how the NFT is marketed or used. Specifically, if the NFT is a work of art, but the NFT is "marketed by an issuer or promoter … primarily as an investment opportunity" or promises activity designed to increase the value of the NFT, then the NFT is no longer a covered nonfungible token and may be a security.
The challenge here is that there are no definitions for the terms "issuer" or "promoter" in the NFT Act. The general definition of "issuer" includes corporations, governments and investment trusts. So, is an NFT platform an issuer or promoter? Is an endorsement from a celebrity, music mogul or sports star the act of a "promoter"?
In 2023, the U.S. Securities and Exchange Commission charged Los Angeles-based company Impact Theory LLC with the unregistered sale of NFTs, treating them as securities. It would appear that the liability theory brought by the SEC in that case would still apply under the NFT Act. If that is true, is the NFT Act too limited in scope, and will it ultimately fail to provide meaningful protection to the NFT market?
Adding to the confusion, other exclusions also apply. Under another NFT Act exclusion, a covered NFT does not include a long list of specific types of securities. This exclusion includes, among other things, bonds, agreements and contracts involving commodities futures, and securities futures products, including swaps. Again, the application of this exclusion from the definition of a covered NFT narrows the application of the NFT Act to a very limited — perhaps even remote — category of content creators and buyers.
Under FIT21, an NFT would be deemed either a security or commodity. The NFT Act does not appear to create a new class of asset called an NFT. Perhaps the NFT Act ought to consider creating a unique digital asset class called NFTs that creates a safe haven for content creators and collectors. Further, if a digital asset fails to fall within the definition of the NFT Act, then said digital asset will default, definitionally, to either a security or a commodity under FIT21, in its current form.
The definitional conundrum of NFTs is foreshadowed in the NFT Act itself. The NFT Act would require the comptroller general of the U.S. to study NFTs and report to Congress within one year, addressing questions about the NFT market.
More specifically, in the section on what the comptroller is required to study and report back to Congress, we would highlight the following language tasking them with carrying out a study "that analyzes ... the similarities and differences between non-fungible tokens and other digital assets, including payment stablecoins, and how the markets for those digital assets intersect with each other."
This concession reveals the inadequacy of the NFT Act. Perhaps it would be the wiser course to know the distinctions and intersections first before creating legislation. In short, the NFT Act still needs some work.
As drafted, it appears that the NFT Act does not directly address the role of NFT marketplace exchanges. Additionally, the NFT Act is very narrow and provides limited protection for market participants.
For example, if a fine artist paints a picture, creates an NFT through an art dealer who specializes in NFT art for collectors, and an LLC subsequently acquires the NFT, is that a security, a commodity or both? The answer is unclear, and it's complicated.
Hopefully, we receive more clarity from Congress and the relevant regulators as to how NFTs will be treated and how this will all work.
Reprinted with permission of Law360.
