Are NFTs securities?

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Imagine a video game. There’s an online multiplayer video game, MattQuest, made and run by a video-game company, QuestCo. In the game you play a character, and the character can wear a hat. QuestCo periodically releases exciting new limited-edition hats for characters, which you can buy, from the company, with real money. You give them your credit card and they bill you $10 and now your character has a purple hat or whatever. Some hats are common and cheap; others are rare and expensive.

There is an active secondary market for hats, in which players can sell the hats they own or buy hats from others, for real money. This market is administered by QuestCo, and QuestCo does not allow trading outside of its own platform. So someone who has a rare teal hat might list it for sale for $1,000, and if you covet that hat for your character you can pay $1,000 for it. You use your credit card or a bank transfer to put $1,000 into your account at QuestCo, and then you click to buy the hat, and QuestCo takes the $1,000 out of your account and transfers it to the seller’s account. Actually QuestCo collects a 5% fee on the trade, so the seller gets $950. She gets $950 in her QuestCo account, that is. If she wants to take that money out — to put it in her bank account — QuestCo will send her a bank transfer, but it will take another fee for cashing her out. Also maybe there will be a delay of a few weeks between when she asks to withdraw the money and when she gets it. QuestCo is a video-game company, not a bank, and it might not be super-efficient at processing withdrawals.

The more popular the game is, and the more active and successful the company is at promoting the value of having a cool hat for your character, the more valuable the hats will be. If you buy a burgundy hat on the secondary market for $20, and then MattQuest becomes vastly more popular and lots of celebrities go on talk shows to talk about how they covet a burgundy hat for their MattQuest characters, then you might be able to resell your hat for $10,000. And then of course this will be self-reinforcing: You can go on talk shows, or at least YouTube, and talk about how you got rich trading MattQuest hats, and other people will see you and say “hey I want that” and buy hats and push the price still higher.

Are the hats “securities,” under US law? The relevant definition is the Howey test, which says that something is a security if “there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” Here I think the analysis would go like:

  1. You invested money, by putting money into your account to buy hats.
  2. There is a common enterprise, in the sense that you and everyone else are giving the money to QuestCo, playing MattQuest and trading hats on the QuestCo-controlled market.
  3. There is possibly an expectation of profit, in the sense that you might be buying the hats because you think the price will go up. This one is fuzzy, I think: Maybe you buy a hat because you think that it looks nice on your character. But if QuestCo is going around telling everyone, like, “buying MattQuest hats is a great way to fund your retirement, they have gone up by 18% every quarter” or whatever, then that sounds like an expectation of profit.
  4. The profits are derived from the efforts of others, in the sense that QuestCo is in charge of developing and promoting the game, and the hats.

So, I mean, I dunno, maybe. If the hats are securities, then QuestCo has to register them with the US Securities and Exchange Commission — meaning that it has to provide a lot of public disclosure, including risk factors, audited financial statements, and management discussion of its business — if it wants to sell them to the public in the US. You might be interested in that disclosure! For instance, if you are about to transfer a million dollars into your QuestCo account to fund a hat-buying spree, you might want to take a look at QuestCo’s audited balance sheet and see how much money it has. If the balance sheet is like “LIABILITIES: $100 million in customer hat accounts; ASSETS: some imaginary hats,” you might worry. You might think thoughts like: “Wait, if they owe customers $100 million, do they actually have $100 million in cash?” Or like: “Wait, if I put my $1 million into QuestCo, and then do some profitable hat trading and end up with $3 million, will I actually be able to cash it out?” The hats are an investment in QuestCo in the sense that you give QuestCo money, and then you wait, and then you hope it will give you back your money, so having some disclosure about its financial circumstances would be useful.

I am a gamer, but I am not actually a securities lawyer. However, my vague sense is that (1) there are games that work kind of like this, (2) they do not register their in-game items as securities and (3) no one gets particularly worked up about that. You can see the argument that the hats are securities, but, you know. They are hats in a video game. They don’t really feel like securities.

On the other hand if you call the hats “non-fungible tokens” and replace the words “$1,000 in your account at QuestCo” with the words “$1,000 worth of tokens on the Quest blockchain,” then:

  1. For like 15 minutes in 2021 you could have sparked a speculative frenzy where the hats were selling for millions of dollars; and
  2. When the prices inevitably crashed, people would inevitably sue you for securities fraud.

Those things are linked: The speculative frenzy is what made you all the money, but the speculative frenzy is also what convinced everyone that the hats were securities. NFTs were a new thing — though they were also kind of like hats in video games — which made people open to believing that they might be worth millions of dollars, but which also made people open to believing that they might be securities. And the main problem with securities is that, if you sell them to the general public and you don’t register those sales, the buyers can demand their money back. If you sold millions of dollars’ worth of unregistered securities during a huge bubble, and then the bubble popped, that’s bad.


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