Business NFT Tokenization And Its Legal Implications In Canada – Securities

To print this article, all you need is to be registered or login on Mondaq.com.

Business NFT tokenization and its legal implications in Canada

Can you breach securities law by trading or issuing non-fungible tokens (NFTs)? An individual was recently arrested in the US for insider trading in NFTs.1 This article focuses on the securities law implications of NFTs and their tokenization.2

NFTs are a growing digital asset class that raises novel legal issues. NFTs can be tokenized to allow for part ownership of the particular NFT to be transferred to others. Recently, tokenization has been heralded as the “future of Canada’s digital economy” with “the potential to unlock immense value and liquidity for many investors”.3

NFTs and tokenization

NFTs are a type of digital asset. They identify an asset such that the asset, or a fraction of the asset, can be held and transferred on a blockchain. An NFT can be used to certify ownership over an asset that exists in the “real” world or it can be a digital asset. In either case, the asset is uniquely represented as a NFT on a blockchain; it cannot be duplicated. Whereas cryptocurrencies and tokens are fungible like cash, NFTs are not.

NFTs can be tokenized (or fractionalized / f-NFTs) to allow for part ownership of the particular NFT to be transferred to others. Tokenization can provide investors with a means to purchase, hold and trade assets that are perceived to have underlying value. It can also provide owners of such assets improved liquidity to realize some value from the asset without completely relinquishing ownership.

The emerging NFTs space is susceptible to the same forms of misconduct observed in cryptocurrency markets. According to a blockchain research firm, there are signs that wash trading (a form of market manipulation involving frequent trading between non arm’s length blockchain addresses) is being used to artificially boost the perceived value of certain NFTs. The research firm also found signs of money laundering.4

Canadian securities law that may apply to NFTs

Canadian securities regulators have yet to definitely take a position on whether and in what circumstances NFTs could constitute securities. Limited guidance from the Canadian Securities Administrators (CSA) in 2018 endorses the expansive four-pronged test from OSC vs. Pacific Coast Coin Exchange (modeled closely on the US Supreme Court’s “Howey Test”) to determine whether an NFT may be an “investment contract” and therefore included in the statutory definition of “security”.

To determine whether an NFT is an investment contract, the issuer must consider whether the NFT involves (1) an investment of money (2) in a common enterprise (3) with an expectation of profit (4) to come significantly from the efforts of others. The CSA’s 2018 guidance states that NFTs that are valued “as a mode of entertainment or as a collectible item” where “any objective future market value of the token is primarily based on market forces and not on continued development of a business by the issuer” may not be a security because ”

More significantly, the CSA emphasized the importance of form over substance in its assessment of whether an investment contract exists:

“In determining whether or not an investment contract exists, the case law endorses a purposive interpretation that includes considering the objective of investor protection. This is especially important for businesses to consider in the context of offerings of tokens where the risk of loss to investors can be high…In analyzing whether an offering of tokens involves an investment contract, businesses and their professional advisors should assess not only the technical characteristics of the token itself, but the economic realities of the offering as a whole, with a focus on substance over form.”5

The CSA’s guidance may be difficult to definitely apply in the significant new use cases of NFTs and their tokenization since 2018. Whether or not a particular NFT, or its tokenization, is caught by Canadian securities law will depend on the specific facts. Issuers of NFTs should consider questions such as:

  • Are proceeds from the NFT sale being used to develop an asset or platform that does not exist or will be completed with proceeds from the sale of the NFT?

  • Do the NFTs represent fractionalized ownership of a real world asset or another NFT? If so, is it possible for the holder of such an NFT to enforce their ownership rights with it?

  • Does the NFT carry rights to receive passive income?

  • Are investors buying the NFT as an investment dependent on the efforts of a promoter instead of as a collectible?

  • Is there a secondary market for the NFTs? Is the creation of such a market imminent? If it exists, how active is the secondary market? Who controls the secondary market? What role does the issuer of the NFT play in the secondary market?

  • What representations did the issuer or the owner of the NFT make to investors about the nature of the asset, its investment potential, and the existence or development of a secondary market?

  • How reliant will owners of NFTs be on the endeavors of the party who tokenized the NFT? Does anyone play a “managerial”-type role to enhance the value of the NFT?

Even if an NFT is not a “security”, depending on the facts, it could be considered a “derivative”, the underlying interest of which is a commodity. In most jurisdictions in Canada, the provisions of securities legislation relating to fraud, market manipulation and misleading statements apply not just to the trading of securities but also derivatives and trading of the underlying interest of a derivative (commodity).

Also, regardless of whether NFTs are securities, derivatives or commodities, they may be a “virtual currency” under anti-money laundering laws, as we explained previously.

Recent developments in the US

Four recent developments in the US concerning NFTs are also noteworthy:

  1. The U.S. Securities and Exchange Commission (SEC) has not provided definitive guidelines on whether and when NFTs and their tokenization will implicate securities law. However, the SEC is reportedly investigating certain NFTs, their issuers and the crypto exchanges where they trade to determine if federal securities laws have been breached.6 This is not surprising given the remarks of SEC Commissioner Hester Pierce in 2021 cautioning issuers of NFTs to consider whether they are creating investment products when tokenizing NFTs and reducing the uniqueness of the underlying digital asset.7

  2. Even without tokenization, regulators have taken enforcement action against the issuer of NFTs. Recently, the Texas and Alabama securities regulators issued cease-and-desist orders against the issuers of NFTs to fund the development of casinos in the metaverse.8th The securities regulators alleged that the issuers were offering and selling unregistered securities as NFTs. The impugned NFTs were allegedly represented as entitling owners to various benefits, including a pro-rata share of profits generated by the metaverse casino, and as an investment whose price would increase over time.

  3. A class action has been commenced against Dapper Labs, Inc. in the Southern District of New York for selling unregistered securities as NFTs to class members.9 The impugned NFTs are short video clips of highlights from NBA games. Each NFT video is unique, marketed as a collectible, and based on its perceived significance will (in theory) have a different underlying value. The NFTs can also be traded on a secondary market controlled by Dapper Labs, which received a 5% fee for all secondary market transactions. A motion to dismiss will be determined this year where the court will assess whether, at the preliminary stage, it can determine whether the NFTs are investment contracts and thus securities. Among other things, the court will consider whether investors’ fortunes are tied to (a) those of other investors by the pooling of assets, along with pro-rata distribution of profits, or (b) those of a promoter or third party.

  4. More recently, the Department of Justice charged an employee of a large online marketplace for NFTs with insider trading, among other things.10 The employee allegedly purchased several NFTs that he knew would be featured on the marketplace’s homepage and sold the NFTs shortly after they were featured.

take away

Issuers of NFTs and owners who intend to tokenize their NFTs should not assume that NFTs are unregulated. The substance of the NFT and its surrounding circumstances will inform whether Canadian securities law applies, not its form. We expect Canadian securities regulators to increasingly scrutinize the burgeoning use of NFTs and commence enforcement action when the circumstances, in their view, engage Canadian securities law .

footnotes

1 https://www.justice.gov/usao-sdny/pr/former-employee-nft-marketplace-charged-first-ever-digital-asset-insider-trading-scheme

2 For a discussion of NFTs and intellectual property rights, please see the following post by our colleague Barry Sookman.

3 https://www.theglobeandmail.com/business/commentary/article-tokenization-not-crypto-is-the-future-for-canadas-digital-economy/

4 https://www.advisor.ca/investments/market-insights/evidence-of-wash-trading-money-laundering-emerges-in-nfts/

5 Emphasis added.

6 https://www.bloomberg.com/news/articles/2022-03-02/sec-scrutinizes-nft-market-over-illegal-crypto-token-offerings

7 https://markets.businessinsider.com/currencies/news/sec-crypto-mom-hester-peirce-selling-nft-fragments-illegal-2021-3-1030250153?form=my01sv&ocid=my01sv&form=my01sv&ocid=my01sv

8 https://www.jdsupra.com/legalnews/think-an-nft-is-not-a-security-don-t-1105763/

9 https://www.dandodiary.com/wp-content/uploads/sites/893/2021/06/Dapper-Labs-lawsuit-complaint.pdf

10 https://www.justice.gov/usao-sdny/press-release/file/1509701/download

To view the original article click here

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

.

Leave a Comment

Your email address will not be published.