SEC vs. BAYC: US Securities and Exchanges Commission targets NFTs

Image source: nftplazas.com

The US Securities Commission won’t stop trending. At the end of September, they announced that all Ethereum network transactions fall under its jurisdiction. Now they are interested in one of the most popular NFT collections Bored Ape Yacht Club.  Whether this will be a high-profile precedent for the entire art market of non-fungible tokens or just an attempt to regulate a new industry, read in the article.

Why the SEC is interested in the BAYC collection

In late October, an anonymous source told Bloomberg that the U.S. Securities Commission had begun its investigation into Yuga labs. The company is known for creating one of the most popular NFT collections. The authority is trying to find out whether NFTs with the image of monkeys are securities.

In addition to the art collection, the regulator is studying the distribution of ApeCoin, the company's utility token. According to the tokenomics of the project, 150 million tokens are distributed among the holders of two collections BAYC and MAYC. This is 15% of the total emission. These two factors probably make the SEC want to bring NFTs under its jurisdiction.

Expert opinion is divided. Some believe that the investigation into BAYC is pointless since each token is unique and therefore cannot be a security. Others believe that tokens are bought not for the artistic value of each element, but as a good investment in the brand of the company. Both sides agree that the precedent can have huge consequences for the entire industry.

What NFTs can be classified as a security

NFT is understood not as a subject, but as a technology that is used in many areas. The SEC will not be able to try to regulate all kinds of NFTs. If Elon Musk turns his next hype tweet into a token, the SEC is unlikely to knock on his door.

Most likely, collections of NFTs that can be verified by the Howey test would fall under possible jurisdiction. Since the first precedent in the US Supreme Court in 1946, any financial instrument is tested according to four criteria:

1. An investment of money
2. In a common enterprise
3. A reasonable expectation of profit
4. Derived from the efforts of others

Lawyers do not believe that the collection of Yuga Labs fits these criteria. Yes, you can invest in BAYC and it brings profit to their owners. However, the NFT creators transfer all commercial rights to their buyers and do not profit from the subsequent increase in the value of assets. Therefore, it is not yet clear how the collection can be adjusted to the second point.

The situation with fractional NFTs may be different. The fractionalization of NFTs is an opportunity for investors to share the cost of an expensive token with other buyers. It appeared thanks to blue chips such as BAYC, Crypto Punks, Moonbirds, Doge, and others. The NFTs in these collections became so expensive that few investors could afford the cost of entry.

To fractionate an NFT, a limited amount of fungible tokens is created that represents ownership over that NFT. For example, an ERC-20 standard token, if NFTs are on the Ethereum blockchain. Such tokens can be bought on special platforms and the secondary market, for example, on Uniswap.

There are several services for NFT fractionation, such as fractional.art, Unic.ly, and NFTX. Each service has its conditions and features for sellers and buyers. Usually, the NFT owner can divide it into as many fungible tokens as he likes and dispose of them at his discretion. Some services offer owners a percentage of each transaction with a fraction of their NFT. Perhaps this moment of profit may be of interest to the SEC, given their ambitions to become the chief sheriff in the crypto community.

What could be the aftermath for the NFT market

There will be no consequences for Yuga Labs likely because their collections are difficult to compare with securities. As Yuga commented to Bloomberg, the regulator is not trying to accuse them of any malicious activity they have sought to learn more about the market. Most likely, the NFT companies, which promise higher profitability to the investors, and fractionalization services will be targeted.

And even though, in some cases, the SEC may have reason to throw its forces into the defense of potential investors, I doubt that we will immediately see a show trial. Most likely, the public will be presented with another attempt to regulate the NFT market. Although, this will prove to be a difficult task because in this case, it will not be easy for the SEC to explain how the art NFT market differs from the regular art market.