SEC Investigates Suspicious NFT Project | Latham & Watkins LLP

In its third action involving NFTs, the SEC targets a restaurant membership token tied to fundraising and promises of potential price appreciation for buyers.

On September 16, 2024, the Securities and Exchange Commission (SEC) issued a cease-and-desist order (the Order) against Flyfish Club, LLC (Flyfish) for an unregistered offering of crypto asset securities relating to Flyfish’s sale of $14.8 million worth of non-fungible tokens (NFTs), in violation of Section 5 of the Securities Act of 1933 (and no exemption from registration was available). The SEC alleged that the NFTs were issued to the public to finance the construction and operation of a members-only restaurant and club in in New York City.

Flyfish neither admitted nor denied any wrongdoing as part of the settlement, which does not include any allegations of misleading or fraudulent statements.

The SEC obtained this settlement roughly a year after its first and second enforcement actions against NFT issuers (for more information, see this Latham blog post on the first enforcement and this Latham blog post on the second enforcement), and less than a month after issuing a Wells Notice against one of the industry’s largest NFT marketplaces.

Key Facts and Findings

The SEC alleged that in December 2021, Flyfish minted 3,035 “Flyfish Club” NFTs. Between December 2021 and May 2022, it offered and sold 1,620 of the NFTS at two distinct price points[i] to the public (in the US and abroad) for ETH valued at approximately $14.8 million at the time of sale. The proceeds were purportedly used to finance the costs of the project and members-only restaurant (the “Flyfish Club”).

According to the SEC, possession of a Flyfish NFT was to be the exclusive means of obtaining membership and benefits in the Flyfish Club, and the SEC noted that associated fish artwork in the collection was not unique to each NFT. No other membership-eligible NFTs were to be sold after the initial sales. The Flyfish NFTs were freely transferrable, and if a Flyfish NFT was sold or transferred in the secondary market, membership and benefits would transfer to the new holder. Notably, Flyfish seems to have later allowed for non-NFT holders the right to purchase non-transferable memberships in the Flyfish Club, although this fact was not cited in the SEC Order.

Investment Contract Analysis

According to the SEC, Flyfish offered and sold the Flyfish NFTs as investment contracts, and therefore securities, pursuant to the framework in SEC v. W.J. Howey Co.[ii] and its progeny. Under that test, a contract, scheme, or transaction involves an investment contract if a purchaser (1) invests money, (2) in a common enterprise, and (3) is led to expect profits solely from the efforts of the promoter or third party.

Fundraising

The Order emphasized the fundraising nature of the offering. In particular, the SEC cited a statement made by a Flyfish principal in March 2022: “Our intent is to build a large business around this with multiple clubs, ancillary offerings, other social experiences, pop-up events, and build a whole world around Flyfish Club.” The SEC also noted that Flyfish “spent a substantial portion of the proceeds from the offering to pay for the costs of leasing space and designing and building the physical club.”

Marketing, Managerial Effort, and Expectation of Profit

The SEC also heavily emphasized the marketing statements of Flyfish personnel to further the investment contract argument. According to the SEC, “Flyfish led investors to expect profits from the entrepreneurial and managerial expertise of Flyfish and its principals in building and running the restaurant.” The company did this, according to the SEC, through a marketing campaign conducted via social media, web, television, and podcasts, communicating to prospective investors that they could potentially profit from reselling or leasing their NFTs on the secondary market.

The SEC flagged at least 13 marketing claims and statements by Flyfish that may have contributed to the overall arrangement being an investment contract[iii] under established securities laws, including:

• promises of asset ownership and appreciation;
• claims of resale potential;
• explanation of investment, monetization, and passive income strategies;
• assertions of association of the restaurant’s success with the NFT’s future value;
• claims of association of the project’s overall success with the “operators and team” behind it; and
• management’s intention “to create endless value” for investors.

As evidence of buyers’ reasonable expectation of future profit from reselling or leasing their NFTs, the SEC cited multiple instances of buyers trumpeting the NFT’s potential as an investment opportunity.

The SEC asserted that nearly half of buyers purchased multiple NFTs in the offering, although one was sufficient for club membership, indicating the speculative nature of such purchases. The SEC highlighted the fact that “[s]ix months after the public sale, 75% of the NFTs sold to the public had been resold one or more times in the secondary market, suggesting that the original owners bought them with investment intent and not for consumption.”

Issuer Fees and Buyer Expectation of Profit

According to the Order, when investors sold Flyfish NFTs in the secondary market, Flyfish benefited: “Flyfish received a 10% fee payment each time a Flyfish NFT sold on certain NFT-trading platforms, with proceeds totaling over $2.7 million by early 2023.” The SEC alleged that Flyfish facilitated secondary market trading by verifying the NFTs on certain digital asset trading platforms to assure purchasers of authenticity and ensure collection of fees. As with the 2023 NFT enforcement actions, the Order implied that the secondary-market fee structure had incentivized the issuer to build value in the NFTs (higher NFT value equals increased fees for Flyfish) and to encourage their active trading on secondary markets (higher trading volume equals increased fees).

Remedies

Flyfish agreed to settle without admitting or denying violation of the registration provisions of the Securities Act of 1933. It agreed to pay a civil monetary penalty of $750,000 to the SEC into a Fair Fund created pursuant to Section 308(a) of the Sarbanes-Oxley Act of 2002. It also agreed to cease and desist from committing or causing any violations and any future violations of Sections 5(a) and 5(c) of the Securities Act. Notably, Flyfish agreed to destroy all implicated NFTs in its possession, custody, or control, and to cease accepting any further fees from secondary market sales.

Dissent at the SEC

Commissioners Hester Peirce and Mark Uyeda issued a strong statement of dissent following the Order (as they had in the previous NFT cases here and here), calling the SEC’s many enforcement actions against digital asset industry an “endless series of misguided and overreaching cases . . . that undermines trust” in the SEC.

They maintained that the Flyfish NFTs “are utility tokens, not securities,” and that application of the Howey Test in such a case is “inapt” because the primary expectation of buyers is to obtain the benefits of club membership (in this case, access to an exclusive restaurant and ancillary experiences). Whether or not some buyers intended to trade the NFTs for a profit is for them irrelevant, as, they assert, “[t]he intent of a buyer cannot transform a non-security into a security.”

They noted that no fraud was alleged in the Order, and that such membership tokens pose no threat to investors. They stated that creative experimentation with NFTs by artists, musicians, and chefs should be encouraged, and that the SEC, rather than misapplying the securities laws, should make an effort to develop guidance for non-security NFTs.

The dissent also highlighted that the SEC has addressed the issue of club memberships extensively in the past, and has consistently committed not to recommend enforcement based on the unregistered sale of memberships in other club memberships. However, prior cases involving club memberships and seat licenses differed from the Flyfish offering in several respects. Prior membership offerings have typically:

• stated specifically that purchase of a membership should not be viewed as an investment;[iv]
• included restrictions on transfers, even when offerors proposed to facilitate transfers of memberships;[v]
• allowed users to receive benefits immediately, and the proceeds of such sales were not used to develop a future product.[vi]

Key Takeaways

As in previous SEC enforcement actions targeting NFT projects, this Order highlights the perils of marketing and communications in an NFT offering. In determining whether a particular NFT offering is a securities transaction, the SEC has repeatedly emphasized certain factors that may increase the likelihood of implicating the securities laws, including:

• whether the offering is marketed as a speculative investment or as a sale of digital collectibles for the holder’s enjoyment;
• whether the NFTs are truly non-fungible collectors’ items, or whether, as the SEC Order notes, they have no unique characteristics;
• when issuers are conducting fundraising to build a project, as opposed to selling a product that is fully functional for its intended purposes;
• the presence of a structure that feeds back fees to the issuer, encouraging it to build value and promote secondary market resale transactions;
• the promise of managerial and entrepreneurial efforts by the issuer or third parties to drive the project’s success; and
• buyers reasonably expecting asset appreciation based on such managerial efforts.

Fundamentally for the SEC, the sale of the Flyfish NFTs was deemed a fundraising exercise to build the restaurant and platform. The tokens and platform were not fully functional at the time of sale, so even their utility was limited initially. And without any other unique characteristics, Flyfish had difficulty arguing the tokens were purchased as fully functional, unique (non-fungible) products and not for future investment potential that relied entirely on the efforts of the issuer for their value. In addition, Flyfish’s numerous marketing statements were deemed sufficient to convey to buyers that the proceeds from the sale and resale of the NFTs would be used to build the restaurant and related experiences.

However, whether enforcement in the NFT membership and utility space is warranted remains to be seen. As the dissent wryly noted, the American investor may be better off if the SEC “change[d] its menu to include a healthy serving of guidance to give non-securities NFT creators the freedom to experiment.”

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