Transcript - The Legit Ledger Episode 2

The Legit Ledger, Episode 2:

The Current State of NFT Regulation: What Market Participants Need to Know with Jim Gatto and Gabe Khoury

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Listen to the original podcast released June 13, 2022 here: https://www.sheppardmullin.com/multimedia-405

In this week's episode of The Legit Ledger, Sheppard Mullin attorneys Jim Gatto and Gabe Khoury discuss the current state of NFT regulation, including misconceptions regarding the regulatory status of NFTs, the conditions under which an NFT might be considered a security, which regulatory agencies market participants should be watching, and more.

Guests:

Jim Gatto is a partner with the Intellectual Property Practice Group in Sheppard Mullin's Washington, D.C. office, where he co-leads the Blockchain & Fintech Team. His practice focuses on blockchain, interactive entertainment, digital art, AI, and online gambling. He advises clients on IP strategies, development and publishing agreements, licensing and technology transaction agreements, and tech regulatory issues. Jim has been involved with blockchain since 2012 and has been recognized as a thought leader by leading organizations, including Best Lawyers in America 2021-2022; Cryptocurrency, Blockchain and Fintech Trailblazer, The National Law Journal, 2018; and Thought Leader on Blockchain & Cryptocurrencies, National Law Review, 2018.

Gabe Khoury was an associate with the Corporate Group in Sheppard Mullin's Washington, D.C. office. As Lead Associate of the Blockchain and Digital Assets team, he handled regulatory compliance issues relating to the use of blockchain technology, social media, Web3.0, video games, online gambling, virtual goods and currency, social tokens, decentralized autonomous organizations, decentralized exchanges, cybersecurity, privacy, Esports, the metaverse, money transmission, financial technologies, NFTs, and artificial intelligence. Gabe holds certifications in NFT technology, Metaverse Technologies, and Blockchain Law from the Blockchain Council.

Transcript:

Gabriel Khoury:

Welcome to another episode of The Legit Ledger. My name is Gabriel Khoury, the lead associate of Sheppard Mullin's blockchain team, and I'm here with Jim Gatto, the lead partner of the blockchain team. As some of our listeners may know, there are many legal issues with NFTs, and we'll be covering many of them in various episodes of this podcast.

Gabriel Khoury:

In this specific episode, we will discuss the current state of NFT regulation, and in future episodes, we're going to be covering crypto regulation more broadly. But at least for this episode, we're going to keep it narrow in scope. With that introduction out of the way, let's get into it.

Gabriel Khoury:

So Jim, people often think that NFTs are not subject to many of the same regulatory issues that are relevant to cryptocurrencies. Do you think that assumption is accurate?

Jim Gatto:

Not so. There's many misconceptions out there about anything related to crypto and NFTs. I think there's a great misperception that NFTs are really not subject to regulation. I think the bigger picture answer is that there's very few, if any, new, at least federal laws, that cover really any crypto assets, whether it's NFTs or otherwise.

Jim Gatto:

Primarily, what we're dealing with for now is the existing legislative and regulatory framework. Those laws apply to any activity, whether it's specifically mentioned NFT or not, if that law is applicable. I'll give you some examples in a second, but in general, while some of the agencies have issued guidance on some aspects of crypto, whether they mentioned NFTs by name or not, that guidance is really just a way to help interpret the law under certain factual circumstances.

Jim Gatto:

So, if we look at some of the agencies that are involved here, of course, the SEC has been pretty active and they address securities law issues. Everyone's heard of the Howey test by now. There are many situations like during the ICO boom, where the SEC has said a lot of initial coin offerings were securities offerings subject to securities laws, and in the NFT realm, we can touch on later, there may be situations where NFTs are secured.

Jim Gatto:

FinCen has issued guidance on certain aspects of cryptocurrency. They deal with the Bank Secrecy Act, the anti-money laundering, OFAC, which is the Office of Foreign Asset Control, deals with sanctions and sanction avoidance issues. The IRS, of course, any income from whatever source derived, is taxable. They've issued some guidance around cryptocurrency and some other aspects, but whether something is specifically covered or not, if you're generating income, generally it's going to be taxable in the US.

Jim Gatto:

The CFTC has said, under some circumstances, different crypto assets can be commodity and subject to their jurisdiction. You've got all these different regulatory frameworks out there, and the key thing I think that's important is you need to understand in the context of NFTs, what does the NFT represent and what are the potential regulatory issues that can arise once you understand what they represent.

Gabriel Khoury:

Wow, thanks, Jim. So I guess the answer to that is clearly no, but in light of that, have there actually been any regulatory enforcement actions that are NFT related?

Jim Gatto:

Yes. There's been a number of private lawsuits, but as far as regulatory enforcement, there was one very well publicized one just recently. There was an individual who worked for one of the marketplaces. As I understand it, that person's job was to identify collections of NFTs that would be profiled on the marketplace homepage.

Jim Gatto:

Typically, when those collections were profiled on that homepage, there'd be more interest and the value would go up, and allegedly this individual bought some items from those collections ahead of time, before the news became public, and profited from this. Just recently, there was an indictment unsealed against that individual and he was charged with wire fraud and money laundering. So, that's one of the very recent examples of regulatory enforcement related to that.

Jim Gatto:

That's just one example of where issues can arise, even though the wire fraud statutes and money laundering statutes don't specifically reference NFTs. It doesn't really matter. If you meet the elements of the crime, the fact you're doing it with an NFT doesn't change it.

Gabriel Khoury:

So Jim, earlier you mentioned that the SEC might have released guidance involving NFTs. Could you elaborate a little bit about that?

Jim Gatto:

Sure. The SEC has issued guidance and it's probably one of the most important documents is their framework analysis of digital assets. In that document, it is an expression of the views of the SEC on how they interpret the applicability of existing law to certain digital assets. They really don't go into great detail about NFTs, per se, but arguably NFTs are digital assets.

Jim Gatto:

To the extent there's guidance in there that's relevant, it's worth paying attention to. But more broadly, it's important to understand that guidance is not law. It is just the agency's interpretation, and there are situations where people challenge an agency's interpretation, but if you're going to go against agency guidance, you better be sure you have a pretty solid legal position, because once they issue guidance, they use that in part as a basis for taking regulatory action against you.

Jim Gatto:

So with respect to that guidance, they essentially go through the elements of the Howey test, and they describe how in different factors that are relevant to the different components of the test, and they do a breakdown of that. But again, there's not really a lot of anything specific about NFTs there. It's useful to look at.

Jim Gatto:

In my view, that guidance came out on the heels of the end of the ICO boom, and it appears to me as I read it that what the SEC was most focused on, although not exclusively, was ICOs and cryptocurrency offerings and how the Howey test an existing securities law applies to that. But clearly, they made a conscious decision to refer to digital assets more broadly and not just cryptocurrency. So certainly, there was an intent for it to have broader applicability.

Gabriel Khoury:

You mentioned the possibility that some NFTs could be securities. Could you elaborate a little bit for NFT market participants as to what they should know about that?

Jim Gatto:

So, first and foremost, it's important, just as a cautionary note, is that in each situation, the specific facts matter. I'll give you some examples of things that could potentially implicate securities laws, but these are not immutable truths, that each of the facts and circumstances of any individual situation is what's going to govern. But the SEC has clearly come out, and there's been various statements where they believe that fractionalization can implicate securities laws.

Jim Gatto:

Fractionalization essentially is taking a high valued asset, creating multiple NFTs that represent a share of that asset, so you have a shared asset there. That concept of fractionalization, depending how it's implemented and managed and offered, can be subject to securities laws. That's one area.

Jim Gatto:

Another area where we have seen the SEC investigate a situation where a company made public statements that they were going to use in NFT as a way to fund a media project, for example, and the way that offering was positioned was the NFT was going to represent maybe some digital asset associated with the property, but there was going to be a revenue share associated with the NFT.

Jim Gatto:

If you bought the NFT, part of the funds would go to help fund the media production, and assuming it was produced and commercialized and revenue flowed from it, a portion of the ongoing revenue would be paid back to the NFT owners. So, you can think of that in some respects as being like a dividend on a stock, and so that's an area, again, depending on how it's structured, could implicate securities laws.

Jim Gatto:

The third category that I've seen, where there's arguably an issue with securities laws under some circumstances, is the presale of certain NFTs that are designed to have some functionality, but the functionality is not really usable when the NFT is sold. The money raised from the NFTs is used to build the platform that will make the NFTs functional. So one example, this goes back. This is analogous to like ICOs where in that whole time frame, people were creating cryptocurrencies that often were going to be used on some platform as a platform currency or other means of payment on that platform.

Jim Gatto:

They were issuing the currency, using the funds to go build the platform, and once the platform was built, assuming it was, and there was greater demand than the value of the cryptocurrency would go up. That's one of the classic patterns that the SEC looked at, and said, "Hey, that's a security. You're doing fundraising." And the fact that you're doing it through a cryptocurrency versus shares of a company in their mind, it didn't really make a difference, if you met the elements of the Howey test.

Jim Gatto:

In this context of presales, for example, if you have something that is a game item, so an NFT represents a game item, and it's something that's functional in the game and the game doesn't exist yet. You offer NFTs for these items at a certain price and people buy them, not because they can use them today, but because, assuming the game is built and there's demand for these things, if the value likely goes up based on the fact that the publisher built the game and launched it and commercialized it, then you have a similar situation.

Jim Gatto:

Now, a number of people look at this and say, "Well, there's a lot of times where game companies will do a presale of items or other companies do presale." Again, you still have to meet the Howey test. So, if something has a fixed price and people aren't buying it because they're going to make a profit, but just they're getting a discount if they buy early. If there's no way to resell these, which in many traditional games, items can't be resold, then you might not have a situation where you meet the part of the Howey test that says, there has to be an investment for profit.

Jim Gatto:

All of the factors are still relevant. So I don't want anyone to misconstrue and say, "If you pre-sell a game item, it's a security." All I'm saying is under certain circumstances, it might be if it meets the Howey test.

Gabriel Khoury:

Wow, thanks, Jim. For market participants, it seems like the SEC and securities laws in general seem to be a crucial area for them to watch, but I know that there's others, so let's discuss those. In 2011, FinCen issued guidance on the applicability of the Bank Secrecy Act to cryptocurrency. Could you discuss a little bit about what that is covered and how it relates to NFTs?

Jim Gatto:

Sure. FinCen is under the Department of Treasury, and they're charged with administering, as you mentioned, the Bank Secrecy Act, which includes some of the anti-money laundering provisions and certain aspects of KYC associated with that under certain circumstances. Part of that, if you look at the Bank Secrecy Act, there's fine terms such as money service business, and money transmitters.

Jim Gatto:

What the guidance did from FinCen was, again, provide their interpretation of how those requirements apply to convertible virtual currencies. They describe in that guidance what a convertible virtual currency is. To the extent, again, this is where NFTs can vary. I would say most NFTs are not a currency as we traditionally think about it. I think one of the threshold questions is, is that guidance applicable to NFTs if they're not convertible virtual currencies? And the answer may be that it's not specifically applicable.

Jim Gatto:

But I think the other thing to keep in mind that's important is that whatever the guidance is, to the extent that there's parallels to be drawn between a CBC and NFTs, you may want to take that into account. That's one thing. Because in 2011, NFTs really weren't a thing. They came on the scene really in '13 or '14, depending what you look at, and so the guidance came out before that.

Jim Gatto:

But the other thing I think that's important to underscore is that whether or not the guidance covers NFTs is really somewhat secondary. There are money laundering laws that apply, regardless of whether you're using US dollars or cryptocurrency or NFTs or art or anything else. Even if there's nothing that specifically talks about what constitutes money laundering in connection with NFTs, the money laundering laws apply. If what you're doing, whether it's through wash trading or some of the things that we know that are out there that people are doing in an effort to launder money through NFTs, if the law applies, it applies, regardless of the guidance.

Gabriel Khoury:

Along the same lines as money laundering, another agency to watch is the Department of Treasury. Recently they released a study on the facilitation of money laundering and terrorist financing through the art trade. Could you talk a little bit about how this specifically relates to NFTs?

Jim Gatto:

So if you think about physical art, fine art in general, there's a lot of anonymous sales, a lot of cash sales, often the sales are not reported. This report highlights the fact that the physical art has been used, and it's not just theoretically that it can be used, but it addresses the fact that there are situations where it has been used to actually engage in money laundering. That's just an issue with high valued art in general.

Jim Gatto:

Now, the report does reference digital art, which has become a more popular thing, and there's been some digital works of art that have gone for many millions of dollars, and you've probably seen those in the news. Anytime you have a high value asset, it is potential it can be used for money laundering. The subject of the NFT is digital art that has been used in some situations for money laundering as well.

Jim Gatto:

That's what that report relates to, and it really is nothing shocking or new there, it's just that there's evidence that, from the report based on their study, that this is actually happening. It's not just theoretical. So, I think the key thing to understand is that if you're engaging in wash trading or other things that are designed to take something and launder it, so you have clean money, so to speak, or it appears if something came from a clean source, that can still be money laundering.

Gabriel Khoury:

Something else that's recently made its way around the headlines are sanctions issues, and are there any sanctions related issues that relate to NFTs?

Jim Gatto:

Yes. There have been a number of situations where NFTs have been involved in sanctions-related issues. One of the I think more well-known and probably one of the earliest situations where this arose was OFAC basically sanctioned a Latvian-based exchange called Chatex for facilitating certain financial transactions involving ransomware actors.

Jim Gatto:

What they ended up doing, which was interesting, was they designated not just the exchange, not just Chatex itself, but there were 57 specific cryptocurrency addresses associated with digital wallets. They designated those as SDNs, which in general, once something is designated property or individuals, US persons can't transact with them. That's part of what the, at a high level, what the sanction schemes provide.

Jim Gatto:

What's important to understand is that if some of those wallets were associated with specific NFTs that were traded, and so going forward, once those are designated, you can't interact with those wallets for that exchange. Part of the regulatory compliance framework that many marketplaces will adopt is creating or accessing a list of blacklisted wallets to ensure that those wallets are not transacting via their platform.

Jim Gatto:

There's other situations as well. I mean, certain countries, there's sanctions that apply. So in some cases it's wallet-based exclusions and in other cases, it can be country-based exclusions. To the extent that something is an NFT or wallet is subject to sanctions, you need to find a way to comply with the requirements of not dealing with those properties.

Gabriel Khoury:

Shifting focus here to games, one of the applications where there is a growing use of NFT is in fact in games. There's been many cases against traditional video game companies that allege that they are using gambling mechanics. Could you discuss a little bit about that and how the use of NFTs plays into that?

Jim Gatto:

Sure. Again, in addition to being involved with the blockchain team here, I've led our games team, and that's an area that's near and dear to my heart. There has been, as you mentioned, a growing number of lawsuits against game companies alleging that they're involved with illegal gambling. Many of these lawsuits, what's interesting, as we mentioned, we're shifting. We are shifting in that these are typically not regulatory actions.

Jim Gatto:

In the US, many states that have gambling laws also have what's called the gambling loss recovery statute. Under these statutes, if you engage in activity that's illegal gambling, you can often sue to get back the money you lost, under the theory that a gambling contract is illegal or void, and so a party can't keep any ill-gotten gains.

Jim Gatto:

With that framework, one of the things that's been a real hot button with traditional games is loot boxes. Loot boxes, as many of you know, are you typically paying to unlock the loot box, and you don't know what you're getting until you unlock the box. Some people, some of these plaintiff's attorneys have alleged, that's a gambling mechanic. At a very high level, gambling is if you pay money for a chance to win something of value, money or something else of value, if you pay that for a chance to win either money or something else of value, that's gambling, if those three elements are present.

Jim Gatto:

The argument that some of these plaintiffs lawyers have tried to make is that, because you don't know what you're getting, there's a chance as to what it's going to be, and because you're paying money and you're getting something at the end, that that's gambling. Now, what's happened in most of these cases, and we've been involved in some of them, is that they've been dismissed on motions to dismiss at very early phases.

Jim Gatto:

In part, because with traditional games, the in-game items that you win are typically not owned by users. They're only licensed and the terms of service prohibit users from selling or trading them on a secondary market. Many of the courts that have addressed this have said, basically what you're getting is entertainment value only. It's not something that you can profit from. They've largely looked at that and said, "You're not winning something of value when you use these mechanics in games."

Jim Gatto:

Most of the traditional video game companies have avoided liability under these claims. There was one case in Washington state that applied to some casino games that had slot machine-like mechanics. That was a special case because Washington state law is a little bit different in the facts of casino games, where you run out of chips and the game ends if you don't have more chips. Those factors came into play, but putting that aside, for the most part, traditional game companies have avoided liability because of the way they license and limit the sale.

Jim Gatto:

I know that's a big lead up, but how does that relate to the blockchain game? Well, in most blockchain games, instead of having a publisher manage a game inventory, users can buy NFTs and they manage what they have through their wallets. In most cases, NFTs are inherently tradable, unless a platform does something to prevent the trading. Typically, the platform does not prohibit users from reselling their NFTs.

Jim Gatto:

The traditional arguments that have applied to why video games that use chance-based mechanics don't invoke gambling, arguably in many cases will not apply to an NFT-based economy of a blockchain-based game where users own the NFT. They can resell it. There's no limitations on resale.

Jim Gatto:

There's also another potential argument that one of the other factors the courts have looked at in these traditional video game cases is that as long as the publisher doesn't participate or facilitate the secondary market, that's another factor that is deemed to be important in their assessment. Of course, with NFTs, if you're a game publisher, and you issue NFTs, just like with any other NFT, you can, if you want, specify or resale royalty that you will get on each resale. While there hasn't been a case on that yet, I think there's at least some thinking that if you are a publisher selling NFTs and you're collecting a resale royalty, that you are participating in to some extent the secondary market.

Jim Gatto:

For all those reasons, I think it's going to be really challenging to use chance-based mechanics to the level that they're used in video games. If you're going to use a chance-based mechanic, either it has to be something that's free, where users don't pay for it, you just drop stuff. It can be random, but if users have to pay for it, then they're not paying money upfront for it. Or it's not an NFT they're getting. they might put up an NFT, and it may convert into, let's say, something that could only be usable in the game, for example. That might be a scenario that's relevant.

Jim Gatto:

So, it's pretty complicated. Blockchain games create a very different factual scenario from traditional games. This whole gambling issue is a big factor, which is in part why what we're seeing with a lot of the blockchain based games, instead of using monetization that's chance-based like traditional games, we're seeing more play to earn, where you have to use skill and/or grind to earn things in the game. We're also seeing a lot of user-generated content where users are using their own creative faculties to create things which they might monetarily benefit from.

Jim Gatto:

So, it's a very different business model for blockchain games. We'll see how this continues to evolve and what people do to straddle this line that exists with chance-based mechanics as they move more into the blockchain games.

Gabriel Khoury:

Wow. Thanks very much, Jim. That's been a fantastic primer in some of the high-level regulatory issues. But before we wrap up this episode, do you have any final thoughts or advice that you would give about some of the regulatory compliance issues to entities or individuals that are engaged in this space?

Jim Gatto:

Yeah, I'd say it's the same thing we say on all the issues in this space is that a lot of people don't fully understand what all the laws are that might apply to their business model. That's fine, because many CEOs or CTOs or creative contents, they're not lawyers. There's a lot of information out there on the internet and Discord on other channels, and half of it's wrong, half of its right.

Jim Gatto:

It's hard for someone who's not a lawyer to know which half is which, and the law constantly evolves. Even if something was right yesterday, it may no longer be right today. I think that what is really prudent for companies to do, if you're jumping into this space, any aspect of blockchain, it's just really important to sit down with a lawyer early on, who has a broad perspective of legal issues that can apply here.

Jim Gatto:

Get an assessment of your business model to understand what issues might apply to you, because while people are generally aware of some of the general securities issues, cryptocurrencies, etc., and DOAs and all that, each business model is different. Some of the factual nuances of what you do could implicate legal issues you're not thinking of. The sooner you get the advice and understand, are you heading down a path that is not legally viable, it's easier to make a change upfront to modify your business model.

Jim Gatto:

That's part of what, as you know, we do with a lot of clients. They come to us. If something doesn't quite work legally, we try where we can to make some suggestions and say, "Here's how you might be able to restructure it and have a better argument." There's always going to be some gray area, because regulatory issues always lag behind new technology and new business models. Often, there are certain black and white, there's certain things that are clearly illegal and certain things that would be clearly legal, but many of these new and innovative business models end up in a gray area.

Jim Gatto:

I think that's where it's really important to get good lawyering and to understand the risks, how to manage them, how to mitigate them and to make sure that if something is not clearly black or white, that you've got a solid legal argument for what you're doing being legal. It may be that a regulator doesn't agree with you down the road.

Jim Gatto:

But I think that in general, if you've tried to do something legally, if you've sought proper legal counsel from a recordable law firm, and it just turns out an agency doesn't agree with you. Often, that's going to be viewed very differently than if they've issued guidance and you've ignored that guidance. They're going to take a different view of you. So I think that there's always going to be some uncertainty in these bleeding edge areas, but working through the business and legal issues hand in hand, you can try to mitigate that.

Gabriel Khoury:

That is it for this week's episode. Thank you to Jim and thank you to our listeners. If you have any questions about the topics discussed today, please reach out to either one of us. Our contact information will be in the show notes below. Also in the show notes, you'll find various blog posts written by our blockchain team about many of the guidance pieces, and topics that we discuss on this episode. Make sure to check that out as well.

Resources:

Sheppard Mullin’s Law of the Ledger blog is designed to provide breaking news, insights, legal analysis, and resources on legal issues related to blockchain technology and the digital asset sphere. Subscribe now!

Contact Information:

James G.Gatto

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