What to Make of OpenSea’s Wells Notice
The SEC told OpenSea to look out for an enforcement action. Does that mean NFTs are illegal now?
I started Brogan Law to provide top quality legal services to individuals and entities with legal and regulatory questions related to cryptocurrency. Cryptocurrency law is still new, and our clients recognize the value of a nimble and energetic law firm that shares their startup mentality. To help my clients maintain a strong strategic posture, this newsletter discusses topics in law that are relevant to the cryptocurrency industry. While this letter touches on legal issues, nothing here is legal advice. For any inquiries email aaron@broganlaw.xyz.
Note: I’m headed to the mountains for a few days and will be out of service so newsletter this week comes on Thursday.
OpenSea, Case Closed?
OpenSea has been among the most popular secondary markets for non-fungible tokens (“NFTs”) for years. This week, it received a “Wells notice” from the U.S. Securities and Exchange Commission (“SEC”). This means that the SEC has conducted an investigation into OpenSea and expects to charge it with a securities violation.
On Wednesday, OpenSea’s CEO Devin Finzer responded on X, arguing that the move was an attack on creators and artists.
Finzer obviously has skin in this game, but it is fair to wonder if this is actually right. What would an OpenSea action mean for crypto, and what about the creators and artists?
Are NFTs Securities?
The SEC could take a few different avenues in charging OpenSea. It could charge it with failing to register as a securities exchange and bring a claim under Section 5 of the Securities Exchange Act of 1934, identify it as an underwriter of unregistered securities offerings and charge it under Section 5 Securities Act of 1933, or argue that it is an unregistered broker-dealer and bring a charge under Section 15(a) of the Securities Exchange Act of 1934. Ultimately, however, the merits of any SEC case will depend on whether or not the NFTs sold on its market are considered securities.
An NFT is a type of cryptocurrency token that is designed to be unique and non-interchangeable, i.e. “non-fungible.” Rather than representing a unit of something or a piece of something, like money or company stock, the NFT represents itself. On the blockchain these tokens, using, inter alia, the ERC-721 Ethereum token standard, have no distinctive characteristics except that they are distinguishable from one another by design.[1] Piggybacking on this uniqueness, artists and entrepreneurs in the real world have associated possession of certain NFTs with ownership of certain other assets, like JPEGs of art, the art itself, or club membership.
A priori, the NFT structure itself is irrelevant to the question of whether an NFT is a security. The artist Beeple sold an NFT conferring rights to a piece entitled “the first 5000 days” for $69 million in cryptocurrency tokens. That single NFT representing a single piece of art is probably not a security, unless the SEC thinks any piece of art is. On the other hand, you could take stock certificates from some public company, assign an NFT to each one and sell those for the price of the stock while saying something like “ownership of this NFT confers ownership of 1/n of this public company and pays a quarterly dividend.” That would probably be a security.
In ideation the “NFT as digital art” model popularized on sites like OpenSea resemble the Beeple example much more than a stock certificate. You’re buying a piece of art represented by a line of code in the blockchain, res ipsa loquitur—the thing speaks for itself. Buyers’ interest in these tokens is putatively akin to art collectors interest in purchasing physical art—sure it may appreciate in value but ultimately it is a beautiful trinket to own.
The speculative frenzy of the early 2020s may have changed this slightly. A popular model of promoting NFTs is to release them in batches, with each individual JPEG associated with the NFTs in the batch having small visual differences. This allowed creators to essentially sell the same piece of art many times and build hype. As the NFTs’ broader brand recognition (e.g. “Bored Ape Yacht Club”) began to predominate over individual characteristics of the JPEGs themselves, some NFTs might have started to look more like securities.
We talk a lot about the Howey test here, but here’s a quick refresher that helps distinguish the former and latter NFT models. For something to be a security, the buyer must invest money in (1) a common enterprise, with (2) a reasonable expectation of profit, (3) derived from the efforts of others.
Technically, the element that most cleanly distinguishes the Beeple NFT from a stock sale is (1) common enterprise.[2] There are a few kinds of commonality, horizontal between investors, which is clearly not satisfied, and vertical, which, at least in courts governed by the Second Circuit Court of Appeals, requires “a ‘one-to-one relationship between the investor and investment manager’ such that there is ‘an interdependence of both profits and losses of the investment.” Since Beeple retains no interest in art he sells, this strict vertical commonality fails.
This argument may not pertain to Bored Ape style NFTs, however. Horizontal commonality exists where “(1) a sharing or pooling of the funds of investors and (2) that “the fortunes of each investor in a pool of investors” are tied to one another and to the “success of the overall venture.” So to the extent that projects may retain funds raised in selling NFTs and reinvest them in the venture, and the success of the brand may drive the value of individual tokens, notwithstanding their differences, this prong could be satisfied.
From this posture, NFT creators could still argue that the “reasonable expectation of profit” prong is not met. After all, NFTs are supposed to represent art, and users retain them for all kinds of reasons. Using the Bored Ape example, members of the crypto cognoscenti still display NFTs as status symbols. If this is the reason buyers purchase them, then this prong may not be satisfied. Still, this could be a difficult argument given a media environment where NFT asset values were a constant point of interest for years. Courts tend to consider this prong holistically and will look at any marketing indicating that the value of an NFT will go up as nigh-proof positive that a purchaser had a reasonable expectation of profit.
Why OpenSea? What Now?
Generally, it is difficult for the SEC to pursue individual small creators. They have a limited annual caseload and there have been thousands of projects that fit roughly the same criteria described above. This is probably what has left OpenSea holding the bag. As the face of an NFT movement that's lost steam, they are an obvious target for an SEC that views the industry as unsavory.
According to The Verge, there might have been other issues that chummed the securities law waters. An OpenSea employee was convicted of insider trading in 2023 after using his early knowledge of which NFT projects would be listed on the platform to front-run the market. “Users were also angry about website outages, NFT collections that were either spam or deliberately fraudulent, and stolen NFTs.”[3]
Whatever the basis (and the SEC has not made specific charges public yet) the notice has been issued and now the community will wait and see if the SEC moves forward with charges.
The timing of the notice is interesting because it comes less than a month after the SEC dropped claims that Solana, Cardano and other cryptocurrency tokens were securities in its case against Binance. Agnostic of the security arguments of each individual token, it is very likely that a regulator who views NFT projects as security offerings would also see Solana and Cardano as securities, making the coincidence odd. Some commentators had even speculated that the SEC might have pivoted to a softer stance on cryptocurrency in light of the politicization of the issue in the 2024 election. This Wells notice suggests otherwise, though the SEC’s investigation into the matter reportedly began over a year ago and it is still possible that no charges will follow.
If they do, though, it may not be the blow to creators and artists that Finzer suggests. For all the reasons discussed above, traditional art sales, even when settled through the blockchain, likely do not constitute securities offerings.[4]
More than this, the NFT art community has faced a credibility crisis. During the NFT boom of the early 2020s, many commentators were quick to call crypto a speculative bubble, often analogizing to the Netherlands famous 1630s tulip boom. While cryptocurrency tokens have proved resilient, NFTs have never recovered the market cap of their peak. This has led many to believe the accusations that NFT projects were just craven cash grabs by insiders. Maybe some were, but the potential use cases for NFTs are as meritorious today as they were in 2020. Immutably authenticated chains of ownership information have always had obvious value for art, and they will continue to. Perhaps a shake out of the old-NFT institutions like OpenSea will help clear the air for fundamental use cases to blossom. If the SEC does bring charges it may drive platforms like OpenSea and Blur to emphasize the unique nature of NFT art rather than their collection-ness, aiding artists who just want a marketplace for their work.
Today, though, the legal landscape of NFTs and cryptocurrency remains fraught. If you are launching a new project in the space, it’s always a good idea to consult an attorney who can help you minimize structural regulatory risk. Until next week.
[1] It has been noted that strictly, all cryptocurrency tokens are traceable across transactions and could be distinguishable. For instance, there was a first Bitcoin and people can identify its holder. However, this is not an inherent part of fungible tokens’ design, and instead it has to be inferred through a review of the blockchain.
[2] The SEC, for its part, has generally yada-yada’d “common enterprise”, arguing that it “typically exists” in digital assets in its Framework for Digital Assets guide document. That said, courts have sometimes found that common enterprise does not exist generally and so there are certainly instances where it does not for digital assets.
[3] Years ago I tried to serve a demand letter on OpenSea and found that they listed no physical address anywhere, despite being a Y Combinator sponsored enterprise based in New York. I found this… odd.
[4] Though certain variations facilitated by the novel form still might. For example, one proposed feature of NFT art sales is that the artist could mechanically receive a percentage of future re-sales of the art, internalizing a greater share of its eventual value. No doubt this is a great idea for artists, but it also sounds uncomfortably like the vertical commonality that Beeple may have avoided.
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