Non-fungible tokens (NFTS) are powerful tools with numerous use cases, including as collectibles, for ticketing and more. One utility use case that’s rising in popularity is fractionalized ownership. Dividing the ownership of a specific asset, such as a watch or precious gem, may seem straightforward on the surface, but there are numerous things you’ll need to consider before offering these kinds of NFTs. Depending on where you reside, there may be regulatory hurdles and legal risks involved. If your NFT is considered a “security”, it will be subject to regulation under the US securities laws by the US Securities Exchange Commission (SEC). This added layer of regulation will affect your timeline, costs and resources, so you’ll need to plan accordingly.
What is fractional ownership?
Fractional ownership is a concept in which numerous individuals own a percentage of an asset. Ownership rights to diamonds, gold, property, paintings and other assets can be fractionalized. In many cases, non-fungible or fungible tokens are used to represent partial ownership of an asset. When the value of the underlying asset increases or decreases, so does the value of the fractionalized ownership tokens. The asset is held, and the NFTs are managed by the owner or company.
Why use the blockchain for fractional ownership of a precious material?
Purchasing a diamond or other precious asset is both expensive and cumbersome. You have to source the material yourself and have a secure place to store it. [The blockchain can address these issues], as NFTs allow anyone to make a purchase, and subsequently transfer their interests, with the click of a button. Ownership rights are represented with a digital token and don’t require physical storage. Additionally, the transaction process is transparent and secure.
Are fractionalized ownership NFTs securities?
The principal US securities law, the Securities Act of 1933 (Securities Act), defines a “security” as “any note, stock, treasury stock, security-based future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” Instruments or rights that in form are not one of the other enumerated types of securities, may be found to be securities by reason of being an “investment contract” which is a term included in the definition. Thus the meaning of “investment contract” is key to evaluating assets that are not in the traditional form a security such as, here, an NFT.
The Howey Test
In the case of SEC v. WJ Howey Co., 328 U.S. 293 (1946) (“Howey”), the US Supreme Court articulated a definition of “investment contract” to determine whether a particular instrument constitutes a security under the Securities Act, and US lawyer, regulators and courts generally rely on this definition to this day. Howey defined “investment contract” as a “contract 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”. This definition embodies a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”.
The definition set forth in Howey has evolved in subsequent judicial decisions into an accepted test (the “Howey Test”), which requires demonstrating that there exists: (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the entrepreneurial or managerial efforts of others. In order to be considered an investment contract and thus a security under this test, all four factors must be met.
The SEC has stated that the focus of the Howey analysis is not only on the form and terms of the asset itself (here, the NFT) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold or resold (which includes sales in a secondary marketplace).
In summary, under the Howey Test, an “investment contract” exists when there is (1) the investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) to be derived from the efforts of others. Whether a particular digital asset at the time of its offer or sale satisfies the Howey Test is highly dependent on the facts at hand.
Securities and fractionalized ownership NFTs
It’s important to understand if your fractionalized ownership NFTs can be considered a security in order to determine applicable regulatory requirements. First, it is important to understand how the project is managed. For example, selling an NFT that represents partial ownership of a diamond or piece of gold isn’t necessarily a security. On the other hand, an investment contract may exists if the sponsor or manager of the NFT selects specific diamonds which the NFT will represent, trades them and shares the trading profits with NFT holders. This type of arrangement likely would satisfy the Howey Test since a typical NFT holders would have expectation of profit to be derived from the efforts of others (i.e., from the efforts of the sponsor/manager).
According to Walter Van Dorn, a partner at the Dentons law firm, “the question it really comes down to is whether the investor buying an interest in a fixed pool of diamonds is counting on the expertise of another person (such as a professional manager) in selecting diamonds, buying diamonds, managing diamonds, curating diamonds, perhaps trading diamonds? Say you raise $100 million and hire someone with expertise in precious metals who goes out and identifies, selects and buys $100 million worth of diamonds. Next that person trades the diamonds for the account of the NFT holders. What I’ve described is similar to the operation of a mutual fund...the investor is counting on the skills and abilities of that manager (i.e. “efforts of others” under the Howey Test). Such as an arrangement is likely to cause the NFT representing an interest in diamonds or a pool of diamonds to be deemed a security.”
There also are other ways the NFT offering could be considered a security. If, for example, the NFT represents partial ownership of an asset, and a manager advises the NFT holders when it would be a good time to sell the underlying diamonds or other assets. Such an EFT also is likely a security. Even though there is no active trading (buying and selling) of the asset, holders are still relying on the expertise of another person, the manager, to help them generate a profit from the underlying asset.
What should you do if your fractionalized NFT project is likely to be considered a security?
First, it’s always a good idea to consult with counsel if you believe your NFT could be considered to be, and regulated as, a security. It’s unlikely that any amount of online research will compare to sitting down with a lawyer and discussing your project.
If you believe your NFT is likely to be considered a security, you may want to alter your plan to avoid the additional compliance burden. For example, if your initial plans involved selling the assets for your holders or instructing them when to buy or sell, eliminating that portion of your business plan may be a good idea. Additionally, if there are any profit-sharing elements, you may want to eliminate those elements.
If you want to proceed with your project even though the NFT is likely to be a security, you’ll need to comply with various rules and regulations of the SEC, including the requirement that the offer and sale of any security (here, the NFT) must be registered with the SEC. Still, according to Van Dorn, “there are exceptions to this registration requirement. The most common exception is if you offer and sell the security in a private transaction only to “accredited investors”. If you do so without publicity and only offer and sell to accredited invests (i.e., people who are relatively wealthy or entities or institutions generally with at least $5 million in asset value), you can do so without SEC registration of the transaction. Such a transaction normally should be documented to confirm to industry standard, avoid liability and maintain the exemption, but this approach is often followed and is doable.”
Fractionalized ownership NFTs are an excellent way for investors to buy a stake in an expensive asset. The blockchain removes many of the barriers that previously existed with fractional ownership. Still, there are numerous regulatory concerns you need to consider before offering fractionalized ownership NFTs. Doing your research and consulting a trusted legal advisor are the best ways to create the best plan to manage compliance issues and successfully sell your fractionalized NFTs. For more information on creating a branded NFT marketplace for your organization, visit Anterdit.