A digital art gold rush? – the regulators are watching

Article 01 April 2021 Experience: Art

In a demonstration of the new economics impacting the art market, Christie’s accepted cryptocurrency, in this case Ether, in addition to standard forms of payment for the sale of the singular lot.

The NFT mania has spread well beyond the usual corners of the art world. Twitter CEO Jack Dorsey sold his first tweet for cryptocurrency valued at $2.9 million on March 22nd. Billionaire entrepreneur and Dallas Mavericks owner Mark Cuban is building a new gallery for digital art and collectibles, a platform that will enable users to share their collections on social media. Tesla and SpaceX CEO Elon Musk entertained a $1.12 million offer for a short techno music track to be sold as an NFT. Wealth managers are adding NFTs to their high net worth clients’ portfolio as a growing asset class. So, the inevitable question arises: will the buyers and sellers of digital art NFTs see their net worth explode, or will they ultimately go home with empty pokes? In what appears to be a super-heated digital art gold rush, one thing is certain: the Securities and Exchange Commission (SEC), Financial Crimes Enforcement Network (FinCEN), IRS and other regulatory agencies are watching closely. The intersection of cryptocurrency and NFTs may give rise to potential civil and criminal liability even to the sophisticated buyer or investor in this new medium. Based on the federal government’s interlocking enforcement regimes, we can anticipate the impact of federal regulations on transactions involving the use of cryptocurrency to purchase digital art NFTs.

As a threshold matter, there has been much discussion whether the SEC will deem NFTs to be securities subject to the SEC’s rules and regulations. The answer—as is true in most areas of law—is that it depends. If an NFT is connected to a singular, unique work of digital art or collectible on the blockchain, the answer is that the SEC will probably not view the NFT as a security. If, however, that same NFT is fractionalized, meaning that it is sold to the general public in shares as a passive investment subject to the continuing services of the issuer of the NFT, then the SEC is likely to view the NFT as a security. The SEC essentially takes the position that if you only own only a fraction of an asset and not the entire asset yourself, then what you own is a security.The analysis set forth in the seminal 1946 U.S. Supreme Court case SEC v. W.J. Howey Co. will determine whether a digital art NFT will be deemed by the SEC to be a security. In Howey a Florida corporation offered units of an orange grove coupled with a contract for cultivating, marketing and remitting the proceeds to an investor. In what has become known as the Howey test, the Court held that “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party” creates an “investment contract” subject to the regulations of the Securities Act of 1933. Consequently, if investing in one share representing one orange in an orange grove can be considered to be part of an investment contract, then so, too, will offering one share representing one image of the 5,000 days constituting Beeple’s EVERYDAY-THE FIRST 5000 DAYS NFT be considered part of an investment contract subject to federal regulation.

In fact, that is exactly what Vignesh Sundaresan a/k/a “Metakovan,” the Singapore-based blockchain entrepreneur and purchaser of EVERYDAY-THE FIRST 5000 DAYS, has done. In January of this year prior to his $69 million purchase at Christie’s, Sundaresan launched a fractionalized investment vehicle offering shares of other digital art by Beeple he had previously purchased through a digital token called B.20. This fractionalized investment vehicle has all of the hallmarks of an investment contract: an allocation of 10 million shares, a vesting period, a buyout process, the promise of profitability. Whether Sundaresan will do the same with EVERYDAY-THE FIRST 5000 DAYS is unclear. What is clear is that he has created an investment vehicle which, had it been offered in the United States, would have triggered the numerous SEC reporting requirements relating to the registration, marketing and sale of the NFT fractional interests. NFT offerings could be held to be in violation of the anti-fraud provisions of the securities laws if determined to be misleading to investors, resulting in civil and criminal penalties to the issuer. Non-compliant NFTs could also cause shareholders to mischaracterize the asset for tax purposes, resulting in civil fines for underreporting taxable income.

Using cryptocurrency to purchase NFTs adds another layer of potentially even more serious consequences for the unwary purchaser or investor. On their face, transactions involving the use of cryptocurrency provide a platform for international bad actors to launder illicit funds. FinCEN, an agency of the US Department of the Treasury, is primarily responsible for and has spearheaded the United States’ anti-money laundering (AML) efforts. In the past, these efforts have been primarily focused on the traditional financial institutions, such as banks. However, over the past decade FinCEN has been expanding its regulatory reach to entities in the crypto-finance space. This expansion has caused friction as, on the one hand, AML regulations require that entities collect and preserve customer identification information and, on the other, crypto transactions on decentralized blockchains are inherently pseudo-anonymous.

Despite pushback from the crypto community, FinCEN recently consolidated a decade’s worth of piecemeal guidance and solidified its expanded jurisdiction. Additionally, the concern that cryptoassets facilitate money laundering has received bipartisan support from US lawmakers. If Democrats and Republicans are aligned on any single issue, it is the need, real or perceived, to curb the use of cryptoassets for illicit financing, such as laundering profits of online drug traffickers and financing terrorism. As part of the National Defense Authorization Act of 2020, Congress enacted (with bipartisan support and over President Trump’s veto) the Anti-Money Laundering Act of 2020 (AMLA) to strengthen the Government’s tools to combat these issues. The AMLA expanded the definition of financial institutions to include “dealers in art” for this purpose. Although virtual currency traders and NFT platforms are not specifically mentioned in this legislation, it is more than likely than not that FinCEN will ultimately issue regulations applicable to them as well.

What would this mean for “dealers in art” who accept cryptocurrency in exchange for NFTs and for individuals or entities who use cryptocurrency to purchase digital art NFTs? If dealers in NFTs are deemed to be “dealers in art” for purposes of the AMLA, they will have to, among other compliance measures, register with FinCEN; establish robust internal AML protocols and policies; and comply with rigorous recordkeeping and reporting requirements, including the filing of suspicious activity reports and currency transaction reports with the Government. Depending on the presence of certain aggravating factors, violators could be subject to criminal fines up to $500,000 or 10 years in prison or both. The regulations imposed on NFT “dealers in art” would have the further effect of unmasking the identity of the ultimate beneficial owner of the digital art.

Imagine 5,000 ultimate beneficial owners of Beeple’s EVERYDAY-THE FIRST 5000 DAYS, each one owning one image of the digital art and having paid for it in cryptocurrency. Imagine further that these fractionalized interests are bought and sold internationally. The opportunity for money laundering on a global scale would appear to be limitless. With the disclosure of the ultimate beneficial owner of these fractionalized interests, FinCEN could decide to issue regulations designed to gain access to the ultimate beneficial owner’s cryptocurrency wallet—an app where one can store cryptocurrency to be used to purchase NFTs—to uncover whether the source of the cryptocurrency is tied to money laundering activity. The AMLA has already provided for the equivalent enforcement mechanism in the traditional banking context: the US Department of Justice’s subpoena power has been expanded to allow access to information pertaining not only to a foreign bank’s correspondent account in the US but also to any account at a foreign bank that has a US correspondent account, including records that are located outside the United States. It would not be a great leap for the Government to view the traditional and virtual currency trading platforms as no different for purposes of law enforcement.

With the likely issuance of regulations impacting the cryptocurrency market and digital art NFTs, who will bear the consequences of the new enforcement regime? The digital artist? The issuers of the digital art? The buyers and traders of the digital art? Potentially all, if the source of the cryptocurrency used to purchase the digital art is demonstrated to be illicit funds. In that case, violators will end up not only with empty pokes but also potentially much worse.