Proof of State is the Wednesday edition of Fortune Crypto where Leo Schwartz delivers insider insights on policy and regulation.
Any chances for crypto legislation further narrowed yesterday, with Rep. Patrick McHenry (R-N.C.), the bowtied chair of the House Financial Services Committee, announcing that he would retire at the end of next year. While his impending departure will create more urgency for passing key bills out of the House, it also means that crypto will lose one of its strongest champions when it seems like the two chambers of Congress are stuck in gridlock.
The inevitable result is a continued slog of regulatory uncertainty around digital assets, with any guidance instead pieced together through enforcement actions, mostly brought by the SEC. I'm often skeptical of the crypto industry's complaints about Gary Gensler (a friendly reminder to check out our new profile here), but I was reminded last week of a tangible area where a lack of clarity could have a real impact: the pesky question of whether collectibles like Pokemon cards are securities.
As the umpteenth recap, the SEC has been steadily expanding its definition of what constitutes a security—an investment in a common enterprise with the expectation of profits derived from the efforts of others—in the world of crypto, and therefore what falls under its jurisdiction. The latest frontier has been non-fungible tokens, or NFTs, like the memorably named Stoner Cats project backed by Mila Kunis.
The idea that digital collectibles are an investment contract seems to strain the Howey Test, the Supreme Court precedent that established the legal definition of a security. The SEC has argued that entrepreneurs behind NFT projects have promoted the assets as investments that would increase in value alongside the success of the firm, thus satisfying one of the key prongs of the Howey Test. Dissenting commissioners, including “crypto mom” and aspirational bee keeper Hester Peirce, have retorted that this could open a whole new can of worms. When you buy a Pokemon card, aren't you expecting that it will increase in value because of the marketing success of its parent company? What about non-crypto digital collectibles like skins in video games such as Fortnite?
The topic came up repeatedly at a policy summit hosted in D.C. last week by the Blockchain Association, a leading industry trade group. Crypto advocate and congressman Ritchie Torres (D-N.Y.) recalled his notable exchange during House testimony with Gensler, where the SEC chair said that buying a Pokemon card would not be a security transaction, but it might if it were tokenized on the blockchain. "In his view, the process of tokenization magically transforms a nonsecurity into a security," Torres said.
Later in the day, Peirce brought up the same debate, questioning whether promoters saying an asset would go up in value turns it into an investment contract. "We can end up regulating a lot of the economy, and I don't think that really makes a lot of sense," she said, adding that she had broader concerns about Howey in general, and not just how it applied to crypto.
In a futile attempt to seek my own clarity around the question, I spoke with Gary DeWaal, senior counsel at the law firm Katten and a former senior trial attorney with the CFTC. He pointed to two reasons why NFTs, and collectibles in general, are not securities, at least in his view. First, their nonfungibility, or uniqueness, sets them apart from traditional securities like stocks and bonds, meaning they don't really represent the investment in a common enterprise, but instead the purchase of a discrete asset. Second, their rise in value is not necessarily tied to the underlying project—think baseball cards or beanie babies, for example, where any speculation around price has been an independent market.
As always, DeWaal admitted that the question could come down to the legal world's favorite crutch—facts and circumstances. In some collectible projects, where any value is wholly created and maintained by the promoters, the assets could resemble securities, like the SEC's first NFT case against an L.A.-based entertainment firm. The only remedy would be clear guidance around how to think about the classification of collectibles, and how the SEC will approach enforcement actions. With Congress as far away from passing legislation as ever, don't expect it anytime soon.
Leo Schwartz
leo.schwartz@fortune.com
@leomschwartz
