Jun 10, 2022

Hong Kong Securities and Futures Commission Says NFTs Might be Securities

Fractional NFTs, NFTs, Securities Attorneys (Securities Act), Securities Tokens By Paul Levites
Magnifying glass over NFT

SEC May Make Similar Determination under Analogous U.S. Securities Law Precedent

In a statement published June 6, 2022, the Hong Kong Securities and Futures Commission (SFC) stated that certain non-fungible tokens (NFTs) might be regulated as securities.  In its release, the SFC indicated that, in general, where an NFT is intended to represent a unique copy of an underlying asset such as a digital image, artwork, music or video, for example, where the NFT is a genuine digital representation of a collectible, the activities related to the NFT’s offer and sale do not fall within the SFC’s regulatory authority. However, the SFC also stated that fractionalized or fungible NFTs might cross the boundary between collectibles and financial assets if they are structured in a form similar to “securities” or a “collective Investment scheme“ (CIS). Under Hong Kong securities law, where an NFT constitutes an interest in a CIS, marketing or distributing such an NFT might constitute a regulated activity requiring the licensing by the SFC of those persons marketing or distributing the NFT.  Additionally, if such an NFT is offered to the Hong Kong public, authorization under the Hong Kong Securities and Futures Ordinance (SFO) might also be required.

CIS and the Howie Test

Under the SFO, a “CIS” is defined generally to be comprised of  four elements:

  1. it must involve an arrangement in respect of property;
  2. participants do not have day-to-day control over the management of the property;
  3. the property is managed as a whole by or on behalf of the person operating the arrangements or the contributions of the participants and the profits or income from which payments are made to them are pooled; and
  4. the purpose or effect of the arrangement is for participants to participate in or receive profits, income or other returns from the acquisition or management of the property.

This definition of a CIS under the SFO is very similar to the definition of an “investment contract” under U.S. securities law. Under U.S. federal and state securities laws, courts often apply the so-called Howey Test from a 1946 U.S. Supreme Court decision to determine whether a particular investment contract is a security. The Howey Test is also characterized by four elements:

  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.

Implications for Fractionalized NFTs under U.S. Securities Law

The U.S. Securities and Exchange Commission (SEC) has been very clear that most (fungible) tokens should be defined as securities applying the Howey test and that the offer and sale of such “securities tokens” is fully regulated under existing U.S federal and state law. Although the SEC has, to date, made no such claim with respect to fractionalized NFTs, it has been reported that the SEC has begun investigating (non-publicly) certain creators of such NFTs and the exchanges (or websites) on which they trade, to determine whether securities laws are being violated. It is only logical to conclude that certain offerings of fractionalized NFTs could very well fall within the four corners of the Howey Test and that one day in the not to distant future the SEC will make public the extension of its regulatory domain over the world of the fractionalized NFT.