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What Are the Rules for Promoting Crypto or NFTs on Social Media?

If you are a crypto token or NFT promoter, you may inadvertently be advertising securities. If you are, you have obligations under the federal securities laws, and even if you are not, there are “best practices” to protect yourself. At a minimum, if you are promoting a security, you must disclose the paid promotion and how much you are getting paid. And as Kim Kardashian learned today, the price tag for failing to do so can be steep. In her case, it is a $1 million fine from the SEC, forfeiture of compensation, interest, and a cease and desist order that precludes her from promoting any crypto asset securities for the next three years. In June 2021, the social media “influencer” with over 200 million Instagram followers posted about the EthereumMax (EMAX) token and linked to its website, which contained instructions for purchasing the asset. However, contrary to Section 17(b) of the Securities Act, she failed to disclose that she was paid $250,000.00 for the post.

Some Cryptocurrencies and NFTs May Be Securities – But Not All of Them.

Promoting crypto or NFTs on social media or Discord can be lucrative, even if you are not getting six figures for it. There are thousands of accounts that are touting the latest and greatest token or NFT project every day. However, many who do so may not realize that the same securities laws that apply to stocks and bonds can also apply to crypto tokens and NFTs. Federal law also regulates advertising of these instruments – not the just the offer and actual sale.

As with any emerging technology, there is no bright line in the law. Not all tokens and NFTs are considered securities – the analysis is a case-by-case application of the Howey test established by the United States Supreme Court in 1946 in the context of investment contracts to purchase a fraction of an orange grove farm operation. The test has since been applied to many other investing permutations. Recently, it has been applied to emerging blockchain-based products, including various crypto assets, tokens, schemes, and similar Web 3.0 endeavors.

Generally, if the crypto asset is being marketed as an “investment” or for its potential to go up in price, profit-sharing, or dividends, there is a good chance the SEC will consider it a security. The EMAX token that Ms. Kardashian promoted was a clear-cut security, with its marketing materials making numerous direct references to increased value through the company’s efforts, token enhancements, sponsorships, and future rewards and staking programs. Accordingly, the disclosure provisions of Section 17(b) applied and the paid promotion disclosures were mandatory to avoid misleading potential investors.

Separately, crypto promoters may also face more serious charges of aiding and abetting the sale of unregistered securities or even investor fraud. In August 2022, the SEC charged three U.S.-based promoters with engaging in an unregistered offer and sale of securities and participating in a scheme to defraud investors. The promoters touted a blockchain-based smart contract operation called Forsage, which in fact was a textbook pyramid scheme that rewarded “investors” for recruiting others into the scheme. The promoters were not engaged in any sales themselves – but rather, they posted interviews, posts, testimonials, and other promotions on YouTube and Facebook. The Forsage case is an extreme example – due to the promoters’ aggressive marketing tactics, denials of liability, and alleged direct involvement in the pyramid itself – but it is a timely reminder to all promoters that they are not immune just because they are not selling directly.

Best Practices for Crypto Asset Promoters.

What are some best practices or rules for promoters advertising crypto tokens or NFTs on social media? The number one best practice is to engage a knowledgeable and experienced attorney to consult you because each token and NFT is its own individual analysis. Additionally:

  • Negotiate a written independent contractor agreement with the token/NFT platform that you are promoting and make sure the platform is willing to indemnify you for any liability related to their offering.
  • If the issuer insists that their offering is a “utility token” or is otherwise exempt from securities regulations, obtain a copy of a legal opinion to that effect or obtain your own legal consultation.
  • If the issuer is based in a foreign country and you are being hired to advertise to a U.S. audience, ask for assurances (including a legal memo) that show the activity is legal in the United States. Countries have varying laws and regulations regarding crypto assets and you should not assume that the promoted asset is legal to offer in the United States.
  • Alternatively, assume that the token/NFT is a security and disclose that you are getting paid to promote it, as well as the amount of compensation. For example, link to or include the following disclosure:

[Promoter] has received compensation from the token/NFT issuer for publicizing the offering of the issuer’s token/NFT. Payment is made in cash and is billed [monthly]. As of [date, but not more than 30 days prior] the promoter has received [$_____] for its services, which began on [date]. [Promoter] may have received additional fees since that time.

  • Negotiate a flat fee for your services that is not a “commission” or otherwise dependent on how many tokens or NFTs are sold. Otherwise, you may be accused of directly profiting from the sale of an unregistered security or aiding and abetting investor fraud.
  • Use caution if you are being compensated with the promoted tokens or NFTs. If the developer is later accused of securities law violations or even a garden variety “pump-and-dump” or “rug-pull” scheme, you as the the promoter may be accused of profiting from the illegal conduct.
  • Use your own best judgment and do your research. If a token or NFT project seems too good to be true or something seems suspicious, you are better off without it. Also, do some basic research on the people involved with the project and determine they have any prior involvement with similar ventures. For example, the individuals involved with Forsage has a prior history of multi-level marketing schemes and similar suspicious associations.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

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Do Play-To-Earn Games Sell Unregistered Securities?

Play-to-earn game developers that sell in-game currency tokens or NFTs to their players may be inadvertently selling unregistered securities. Offering unregistered securities is illegal and the Securities and Exchange Commission (“SEC”) may prosecute developers and obtain injunctions, civil penalties, and orders to refund all investor funds (disgorgement). Further, the investors themselves can sue developers (including as a class action) for securities laws violations, all of which can be financially devastating. Securities laws are a major factor to consider, but there are other applicable laws and regulations that determine whether a play-to-earn game is legal. Accordingly, it is absolutely critical to consult with an attorney specializing in play-to-earn and obtain a legal opinion regarding legal compliance before offering and selling any fungible or non-fungible tokens.

What do securities laws have to do with gaming?

Securities are traditionally associated with stocks and bonds traded on various exchanges. However, “securities” is actually a much broader term and includes virtually anything that a company sells to raise funds, whether to the general public or to a select group of high net worth individuals in a private placement. In the play-to-earn context, either the in-game currency token or the game asset NFT can be considered securities. Crypto/blockchain/NFT regulation is still at the early stages, but the SEC has taken an active enforcement role in pursuing fraud and illegal token offerings in the digital assets market.

Not all tokens or digital assets are securities. The uses a four-prong analysis called the Howey test to determine whether an offering is a security. More precisely, courts apply the Howey test and examine whether something is an “investment contract,” which is a type of security. The United States Supreme Court created the test in SEC v. WJ Howey, 328 U.S. 293 (1946), when it determined that a company selling shares in an orange grove farming operation was actually selling unregistered securities. If a token does not qualify as a security under the Howey test, it is generally considered a “utility token” and may be sold without the constraints of securities laws (but may still be subject to other regulations).

How do securities laws apply to gaming tokens or NFTs?

An “investment contract” has four elements: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profit; (4) derived from the efforts of others. With digital assets, the SEC generally assumes the first two prongs are met. Most, if not all, play-to-earn tokens involve an investment of money (either fiat currency or cryptocurrency with value) in a common enterprise (i.e. the game project). Thus, whether an offering is an exempt “utility token” or an unregistered security depends on whether the purchasers are led to expect profit derived from the efforts of others. In other words, does the purchased token function as a passive investment that pays dividends?

Of course, this is a very fact-specific inquiry. The SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) has a rather complex set of guidelines and guideposts for the analysis, called the “Framework for Investment Contract Analysis of Digital Assets.” The SEC also relies on the DAO Report, which was a 2017 investigation of the Swiss-based DAO Project that explains the SEC’s application of Howey to digital assets.

In general, the determining factor is how the tokens are used. Do players actively use the NFTs they acquire to play the game and earn rewards? For example, an owner must manually enter the racehorse NFTs in Zed.Run (a hugely popular play-to-earn horse racing game) into various races, deciding on the best course type and distance suited to that particular “racehorse.” If the NFTs “wins,” the owner wins a prize, just like in real-life horse racing. Axie Infinity is another example of where players must actively manage their NFTs and “battle” them before earning rewards. Active in-game management likely negates both the third and forth prongs of Howey, as players purchase the tokens for in-game use and any rewards are not from the efforts of others – they come directly from the efforts of the player/owner. The same logic applies to in-game currencies that can be used to acquire in-game assets, pay entry fees, upgrade NFTs, and for other purposes. Simply put, while the in-game currency may certainly fluctuate in value on the secondary market, it is not a passive investment vehicle. It is an active “utility” component of a play-to-earn game.

Do staking and lending features affect the securities analysis under Howey?

As play-to-earn games become more sophisticated, so does the analysis. Many games now offer “staking” – which rewards players with in-game currency for parking their tokens or removing them from circulation for a set period of time. Additionally, NFT renting and lending are becoming more common, where owners let third parties to borrow their NFTs, actively use them within a game, and in return, receive a share of any winnings. The staking and lending mechanisms effectively enable passive income for token owners. Passive income is a hallmark of a security under the Howey test.

Play-to-earn games are a rapidly growing sector of the overall crypto and NFT market. It is critical for developers to ensure legal compliance, not only to protect themselves and their companies from crippling lawsuits, but to also make their product attractive to potential investors. In 2022, a comprehensive legal analysis of the play-to-earn project is a must-have for any pitch deck. Note that even if the token or NFT is not a security under federal law, state level “Blue Sky laws” may apply. Additionally, a token or NFT may be regulated as a commodity or under money transmission laws. In other words, the securities analysis is only part of a full legal evaluation.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

What is a Security Token Offering (STO) and How Do I Use It In My Business?

Photo by Alesia Kozik on Pexels.com

A security token offering (or STO) is a 21st century blockchain-based alternative to a traditional equity or debt sale to raise company funds. Instead of selling units or shares, a company sells digital tokens to investors. Instead of selling SAFE (simple agreement for future equity) notes, companies can offer a SAFT (simple agreement for future tokens).

But why would a company want to sell tokens in the first place? STOs and traditional equity offerings fall within securities laws and must either be registered with the SEC or comply with exemptions (Regulation A+, D, or S for example). State-level “blue sky” laws may also apply. Also, like traditional securities, STOs represent fractional ownership in a tangible asset, either an equity interest in the company, a profit share, or debt instrument.

An STO does have certain benefits over selling traditional securities:

  • Unlike traditional securities, the STO eliminates third parties and middlemen inherent in a traditional securities offering, leading to greater efficiencies, lower costs, and a faster issuance process.
  • Blockchain technologies are inherently transparent, as the digital ledger is public. This makes the offering inherently more secure.
  • By selling tokens, companies can tap into financial markets across the world that would not be normally accessible. An investor from Asia or Europe can easily buy into a company STO, just as an investor from the United States.
  • Security tokens are considered more liquid because investors can buy, sell, and trade tokens around the clock.
  • The digital nature of the tokens makes corporate governance and voting easier and more transparent.

Another distinguishing characteristic of an STO is that a company can tokenize and sell fractional ownership in almost any real world asset – such as real estate, a machine, or even intellectual property. This opens up a host of possibilities and financing options that would otherwise be limited or unavailable with traditional securities. This is especially attractive to high-tech startups whose business model is already based on or related to the blockchain.

STOs should not be confused with ICOs (initial coin offerings). ICOs boomed in 2017, as some companies turned to unregistered token sales to raise funds outside of the traditional securities disclosure, registration, and other legal requirements. In 2017, the SEC issued an investor bulletin and clarified that these digital token sales constitute “investment contracts” that meet the SEC v. W.J. Howey Co., 328 U.S. 293 (1946) test and therefore must be registered as securities under federal law. ICOs also are associated with several high-profile “exit scams,” where cryptocurrency promoters claimed big plans for a new crypto project, collected funds from investors, and then simply disappeared with the funds. Other ICOs purported to be “high-yield investment programs” that turned out to be nothing more than Ponzi schemes.

As cryptocurrency, NFTs, and other blockchain-based technology became more mainstream in 2021, it is important to recognize that the STO is a new way for innovative companies to raise funds. While these are still securities offerings that must comply with applicable regulations, the flexibility, transparency, and efficiency that these digital instruments offer are certainly attractive.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

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