By Adarsh Vijayakumaran
Non-Fungible Tokens (“NFTs”) represents assets that are either digital or real property which are encoded in a blockchain. Unlike Fungible Tokens such as Bitcoin, Ethereum, etc. that can be replaced for one another, each NFTs represents a unique non-interchangeable unit of data whose value depends on the end buyer. The idea behind NFTs is that, while anyone can read the article or view the tweet, NFTs would give the owner a representation of “ownership” through that particular NFT.
With increased popularity and evolved use cases for NFTs developing every day, the question of applicability of securities laws to NFTs becomes important. While the general notion is that since buying of most of the NFTs does not qualify as an investment contract under the Howey’s Test, the securities laws do not apply to them. The present article attempts to analyze the latest developments happening in the NFT-verse to re-evaluate if the above notion still holds true.
You selling me memes?
The reason why the applicability of securities laws to NFTs is mostly overseen is because the NFTs that are typically available in the marketplace today are art-based. For example, almost all the NFT platforms known to users sell digital collectibles like minted Jpgs, trading cards, crypto—kitties, monkeys and bears. This being the case, why would anyone even close to assume applicability of securities laws to random pictures of monkeys and kitties that are floating in some NFT website?
The applicability of securities laws to NFTs is not something that has not been pondered before. The common misconception regarding NFTs is that since NFTs derives its value from the underlying instrument (that could be off-chain or on-chain), they can be regarded as a derivative under the securities law. But the problem with this concept is that derivatives by nature are contract for differences. While certain marketplaces like NFT20 allows speculative trading for NFTs, this may not be true for the vast majority of NFTs available. Furthermore, unlike exchange-traded derivatives like futures and options where securities law applies, the NFT derivative contracts are neither standardized nor liquid. This means, even with sufficient contractual freedom an NFT derivative could mean nothing more than a “forward type contract” representing a unique token that are traded over the counter and are not regulated under the securities law. So, when does securities law come into play?
The NFTs in the normal scenarios does not come under the securities law framework. But between May 2014, when the first one-off NFT avant la lettre was minted and March 2021, when the Everydays: The First 5000 Days, created by @Beeple was sold for a whopping $69.3 million— a lot of things about NFTs have changed.
The large-scale acceptance of NFTs today have attracted more users to enter into the NFT market places to mint as well as buy and sell NFTs. But the problem is that with the massive flooding of NFT marketplaces with millions of NFTs, not all tokens are well received. Even if a person burns away, let’s say 120 gwei in gas fees in minting an NFT, it is very rare that his NFT is going to have buyers after listing it in the marketplace unless the person has some fame in either the real or virtual world. Because of this, most buyers prefer NFTs that have already got some reputation in the metaverse. However, all the NFTs that have already got some repute in the virtual space are exorbitantly high in price thus discouraging new market participants.
It is in this above background that the concept of fractionalization of NFTs and the introduction of DAO vehicles to buy and sell, and fund NFTs came in.
Fractionalization of NFTs
The fractionalization of NFTs refers to splitting up of ownership in an NFT so that many people can part-own a single NFT. While different blockchain players provide various ways to split ownership in an otherwise unique token, the crux of the process is locking the particular NFT into a vault and issuing fungible tokens on its behalf. Each of these fungible tokens will represent a fractional ownership and has a uniform democratized value just like a price feed for each BTC or any other fungible token. These fungible tokens can be later listed in a crypto-exchange and traded like listed crypto-currencies or just sold via private placements. The sum total value of these tokens will determine the average price of the original NFT.
But the problem with the fractionalization of NFTs is that it is not always necessary that the fractional NFTs (“F-NFTs”) are diluted at a truly democratic level. With the earlier full owners acting as “promoters” (or managing the vault) for the original NFT or advertising the fraction as a speculative investment, accompanied by the suggestion that the original NFT or the F-NFT will increase in value (view to profit) as a result of the actions of the issuer or the promoter, the F-NFTs might as we be treated as units of a collective investment scheme as defined under section 11AA of the SEBI Act or as an “investment contract” under the Howey’s test.
Nevertheless, the using of ERC20 standards to dictate a number of rules and actions that a token or a smart contract must follow and steps to be able to implement it, for e.g. set parameters for opening the vault; and having reserve prices for deciding buy-outs; and availability of different product builders for fractionalization that uses a variety of methods to split ownership for e.g. “smart contracts that split the original NFT itself” could all significantly mitigate the potential exposure of F-NFTs to securities regulations.
Just like how F-NFTs make it possible to distribute ownership, the Decentralised Autonomous Organisations (“DAOs”) in NFTs also came in with a view to democratize buying and selling heavy priced NFTs. However, unlike F-NFTs that are made by fractionalizing a vaulted NFT that was brought by the token issuer, the DAOs in NFTs work a bit differently. In DAOs, the funds are pooled in first and tokens are issued based on the fund contribution, and using the proceeds of the pooling, NFTs are bought and sold.
What makes DAOs better than F-NFTs is that DAOs are what really makes democracy in the metaverse truly possible. In structure, a DAO is like a public limited company but instead of having Articles of Association, a DAO has a self-executing code to govern it. And like the word decentralized indicates, decisions in DAOs are not made by a board of directors but voted by the token holders directly.
However, even though DAOs gives the token holders a better say in the affairs of the organization, DAOs are something that came under the securities law framework as early as in the year 2017 itself with the Securities Exchange Commission (SEC) of United States (US) releasing an investigative report on the offering of tokens by a group known as “the DAO” and concluding that securities law requirements will apply “regardless of whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology.”
Moreover, very recently, the US state of Wyoming passed a law that recognizes DAO as a limited liability company. This means, the law in Wyoming has now clearly recognized a DAO as a legal person, and token holders are protected under the corporate veil as long as the situation doesn’t demand lifting that veil.
The Indian Picture
In terms of global cryptocurrency ownership, India stands at 5th spot with 7.30% of the total population of showing an exponential increase in interest in cryptocurrencies ever since the Reserve Bank of India lifted its ban in March 2020 with Indian exchanges clocking impressive user additions and a sustained surge in daily trading volumes. But unlike the crypto craze that has been happening since last year back, the NFT bandwagon came to India only in 2021 with leading Indian celebrities from the world of Bollywood and cricket launching digital memorabilia through NFTs. While it is true that India still has a long way to go in terms of blockchain-based asset adoption, the massive surge in interest in NFTs since this year and the launching of more and more NFT marketplaces in India hints that NFTs are going to be in India for a very long time.
However, unlike the US, the Indian securities market is yet to see NFT based securities disputes to score regulations. While the concept of fractionalization and DAO-lization has caught Indian media’s attention, India has so far not witnessed actual use cases of these democratizing mediums. It is also very unclear as to how Indian regulators will deal with matters connecting F-NFTs and DAO. For one thing, all the unregulated deposit schemes are required by law under the Unregulated Deposit Schemes Act, 2019 to be banned. Secondly, Indian law does not recognize the unregistered association of persons as a separate “legal entity”. This means, liability in case of any violations knowingly or unknowingly committed under the garb of F-NFTs and DAOs could shift to individual token holders. Moreover, the concept of “Law of Code” is still foreign to India.
The coming of F-NFTs and DAOs in NFT-verse has enabled all the market participants who were otherwise discouraged from buying and selling NFTs to now part-own some of the heavy-priced NFTs. While the legal treatment of each of these new mediums of asset democratization has left regulators perplexed, there is no single formula to decide how to go about any of these instruments. The law should decide matters based on the facts and circumstances of each case. On appearance, it may appear that Indian securities law is not matured to deal with these novel instruments, but with the presence of sandbox schemes that provide certain regulatory exemptions in a controlled environment for most of the new products and businesses, and having perceptive lawmakers who are ambitious to prepare India for the 4th industrial revolution indicates that there is always a space in India for innovation. Moreover, the Securities Exchange Board of India’s recent circular barring registered investment advisors from advising on unregulated financial instruments indicates that the regulators are conscious of the latest developments happening and want the investors to be cautious before they pour their hard-earned money anywhere. Nevertheless, despite whatsoever happens in the short term it’ll be interesting to see how different stakeholders, regulators, lawmakers, and different market participants will come together in taking these crypto-revolutions to the next level.
 The author is a B.A.LLB (Hons.) Student at the National University of Advanced Legal Studies, India.
 See Robyn Conti & John Schmidt, What You Need To Know About Non-Fungible Tokens (NFTs), Forbes (May 14, 2021), https://www.forbes.com/advisor/investing/nft-non-fungible-token.
 The empirical constraint of owning an NFT is different from the traditional ownership of assets. This is because owning an NFT by itself doesn’t grant the right to print or distribute the work. The rights that a person will behest as part of owning an NFT would depend on a combination of on-chain contracts and off-chain contracts relating to the particular token. For more information. See Adarsh Vijayakumaran, NFTs & Copyright Quandary, Journal of Intellectual Property, Information Technology, and E-Commerce Law (pending publication).
 See generally S.E.C. v. Howey Co., 328 U.S. 293 (1946).
 See Media, Entertainment and Technology Litigation Update – Non-Fungible Tokens (NFTs), Gibson Dunn (Apr. 19, 2021), https://www.gibsondunn.com/media-entertainment-and-technology-litigation-update-april-2021.
 See, e.g., Abhinav Kaul & Neil Borate, Non-fungible tokens are now in India, but mind the legal pitfalls, Live Mint (Apr. 8, 2021), https://www.livemint.com/money/personal-finance/nonfungible-tokens-are-now-in-india-but-mind-the-legal-pitfalls-11617557315927.html.
 Financial Derivatives, SBSC, https://www.sbsc.in/pdf/resources/1587985025_FINANCIAL_DERIVATIVES.pdf (last visited Oct. 20, 2021).
 See NFT Liquidity Protocol, NFT20, https://nft20.io (last visited Oct. 25, 2021).
 Forward contract vs Futures contract: What’s the difference?, Times of India (Jan. 25, 2019), http://timesofindia.indiatimes.com/articleshow/60461912.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst.
 Bo Franklin, Did an avant-garde French artist sell the first NFT?, Economist (Apr. 29, 2021), https://www.economist.com/1843/2021/04/29/did-an-avant-garde-french-artist-sell-the-first-nft.
 A digital artist just sold a jpg file for $69 million, Live Mint (Mar. 12, 2021), https://www.livemint.com/news/world/this-digital-collage-of-5-000-individual-images-fetches-rs-500-crore-11615516650126.html.
 See Samantha Ayson, What is Gas?, Help Foundation, https://help.foundation.app/en/articles/4743017-what-is-gas (last accessed Oct. 2, 2021) (“‘Gas’ refers to the fee required to successfully conduct a transaction on Ethereum. This fee goes directly to Ethereum miners who provide the computer power that’s necessary to verify transactions and keep the network running; Foundation does not receive a percentage.”).
 See What are NFTs and why are some worth millions?, BBC News (Sept. 23, 2021), https://www.bbc.com/news/technology-56371912.
 See Mehab Qureshi, Fractionalised NFTs: Know Your NFTs? You Can Own One Too! At Least a Part of It, The Quint (Sept. 21, 2021), https://www.thequint.com/explainers/what-are-fractionalized-nfts-how-do-they-work-who-can-benefit#:~:text=Chandra%20explained%20that%20the%20process,type%20are%20called%20fungible%20tokens.
 See id.
 See id.
 See Prabhjote Gill, Fractionalisation of NFTs — the newest crypto craze explained, Business Insider (Sept. 9, 2021), https://www.businessinsider.in/investment/news/fractionalised-non-fungible-tokens-are-the-newest-craze-of-the-crypto-art-world/articleshow/86062930.cms.
 F-NFTs in normal scenarios ticks all the requirements to be classified as a collective investment scheme under §11AA of Securities and Exchange Board of India Act, 1992. See §11AA, Securities and Exchange Board of India Act, 1992, https://www.sebi.gov.in/legal/acts/jan-1992/securities-and-exchange-board-of-india-act-1992-as-amended-by-the-finance-act-2021-13-of-2021-w-e-f-april-1-2021-_3.html (last accessed Oct. 2, 2021); see also Framework for “Investment Contract” Analysis of Digital Assets, SEC, https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets (last accessed Oct. 3, 2021).
 See, e.g., Edward Wilson, What are fractionalized NFTs?, Argent (Sept. 3, 2021), https://www.argent.xyz/learn/fractionalized-nfts/#:~:text=Fractionalized%20NFTs%20are%20NFTs%20split,locked%20into%20a%20smart%20contract.
 The reverse could also be possible, where tokens are made for a previously bought NFT similar to the fractionalization process. However, with increased use cases for a DAO in comparison to the limited purpose of the normal fractionalization process, the established practice proceeds with pooling of funds first as it allows the DAO to be used for broad purposes not limiting to just fractionalization. See Kam (Exhuman), The Emergence of NFT DAOs – Overview, Niftex (June 9, 2021), https://blog.niftex.com/nft-dao.
 Samer Hassan & Primavera De Filippi, Decentralized Autonomous Organization, Policy Review (Apr. 20, 2021), https://policyreview.info/glossary/DAO.
 See id.
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO (Release No. 81207), SEC (July 25, 2017), https://www.sec.gov/litigation/investreport/34-81207.pdf.
 SF0038 – Decentralized autonomous organizations, https://www.wyoleg.gov/Legislation/2021/SF0038 (last accessed Oct. 2, 2021).
 See India has highest number of crypto owners in the world, Live Mint (Oct. 13, 2021), https://www.livemint.com/market/cryptocurrency/india-has-highest-number-of-crypto-owners-in-the-world-at-10-07-crore-report-11634110396397.html.
 See Prasid Banerjee, NFTs, the new craze in cricket and Bollywood, Live Mint (Sept. 23, 2021), https://www.livemint.com/technology/tech-news/film-stars-cricketers-join-nft-bandwagon-11632333214229.html.
 The Banning of Unregulated Deposit Schemes Act, 2019, https://egazette.nic.in/WriteReadData/2019/209476.pdf (last accessed Oct. 1, 2021).
 See Gorakh Hilal Patil v. Parit Samaj Seva, Civil Revision Application No. 202 Of 2007, High Court of Bombay (India).
 Lines of programming codes are to the virtual-world what the laws of physics are to the Real-world; they determine what is possible and, in turn, what can be regulated. See, e.g., Programming Language Converts Laws Into ‘Provably Correct’ Computer Code, Discover Magazine (Mar. 23, 2021), https://www.discovermagazine.com/technology/programming-language-converts-laws-into-provably-correct-computer-code; William Li et al., Law Is Code: A Software Engineering Approach to Analyzing the United States Code, 10 J. Bus. & Tech. L. 297 (2015); Dr. Michael Jünemann & Dr. Udo Milkau, Can Code Be Law?, Bird & Bird (Aug. 2021), https://www.twobirds.com/en/news/articles/2021/germany/can-code-be-law.
 See Dealing in unregulated products by SEBI registered Investment Advisers, SEBI (Oct. 21, 2021), https://www.sebi.gov.in/media/press-releases/oct-2021/dealing-in-unregulated-products-by-sebi-registered-investment-advisers_53370.html.
Image Source: https://decrypt.co/66046/the-next-big-thing-in-nfts-breaking-them-apart