SEC’s Wells notice to OpenSea tags NFTs as unregistered ‘securities’

OpenSea says America’s securities regulator has warned the company that it could face an enforcement action for selling unregistered securities on its non-fungible token (NFT) marketplace.

On August 28, OpenSea published a blog post titled “Taking a stand for a better internet” in which it revealed that it had received a Wells notice from the Securities and Exchange Commission (SEC) indicating that the regulator “is considering bringing a lawsuit against OpenSea.”

A Wells notice is issued to entities subject to SEC probes and indicates the likelihood that the agency found sufficient evidence of rule-breaking to file a legal complaint. Recent months have seen similar notices sent to decentralized finance (DeFi) platform Uniswap, the ‘crypto’ division of online brokerage Robinhood and the Ethereum-focused blockchain software firm Consensys.

OpenSea CEO Devin Finzer tweeted that the SEC was “threatening to sue us because they believe NFTs on our platform are securities.” Finzer claimed to be “shocked the SEC would make such a sweeping move against creators and artists.” However, it’s not NFT creators facing the SEC’s wrath here but the platform that takes a cut from matching creators looking to sell and buyers looking to flip NFTs for profit.

The SEC has previously targeted commercial NFT issuers, reaching seven-figure settlements last year with Impact Theory and Stoner Cats after charging both with conducting illegal unregistered offerings of ‘crypto asset securities.’

That quoted phrase was recently rubbished by a U.S. federal judge in the SEC’s case against Kraken for operating as an unregistered securities broker. However, the judge said this was “a semantic error” that didn’t undercut the SEC’s case against the digital asset exchange. The judge added that while digital assets were “a relatively novel financial instrument, the principles driving the SEC’s attempt to assert regulatory authority over it are not new.”

Finzer issued the standard ‘crypto’ talking points about the SEC trying to “stifle innovation” and found fault with the SEC trying to “regulate digital art in the same way we regulate collateralized debt obligations… Every creator, big or small, should be able to innovate without fear.”

Finzer claimed it would be “a terrible outcome if creators stopped making digital art because of regulatory saber-rattling.” OpenSea declared that it was “pledging $5M to cover legal fees for NFT artists and developers that receive a Wells notice.”

Two creators selling NFTs on OpenSea—Brian Frye and Jonathan ‘Song a Day’ Mann—filed a pre-emptive suit against the SEC on July 29, seeking “a declaratory judgment that their proposed NFT projects do not violate U.S. securities laws—i.e., that they would not be engaging in the offer and sale of securities by merely publicly offering and selling their art as NFTs, attaching royalties to the NFTs, and/or marketing the NFTs and their personal artistic endeavors to the public.”

Long time coming

The timing of the OpenSea artists’ suit seems impeccable unless it wasn’t. The Verge released a profile of OpenSea the same day the company announced its Wells notice, revealing not only knowledge of the imminent SEC dustup but also “a previously unreported ‘matter’ with the Federal Trade Commission.”

Reporter Ben Weiss said the SEC had been sending OpenSea third-party subpoenas regarding other entities since 2022. An OpenSea spokesperson said the company was committed to “complying with applicable laws and regulations” as part of its standard practice to “cooperate with regulators and law enforcement.”

However, internally, OpenSea’s legal counsel created a ‘vocabulary guide’ that instructed staff to avoid saying “buy, sell, or pay on OpenSea.” Instead, staff were told to use the phrases “purchase on the blockchain,” “purchase using MoonPay” or “buy using OpenSea.” The verbiage was required because “it impacts our tax and legal obligations.”

For obvious reasons, staff were also told to avoid the terms “exchange,” “broker,” “marketplace,” “profit,” “shares,” “stocks,” “trading,” “trade,” and “traders.” 

Weiss had less insight into the ‘FTC matter,’ other than the fact that OpenSea had received document requests and that its most recent submission to the FTC was a year ago. A professor with knowledge of the ‘crypto’ sector told Weiss the FTC’s interest in OpenSea may be unrelated to the SEC probe.

Oh, and Weiss shed light on OpenSea’s August 2023 decision to stop enforcing royalty payments to creators on secondary sales of their art. That decision was made to staunch the flow of speculative traders to rival NFT marketplaces that didn’t impose these fees. “Multiple former employees” told Weiss that OpenSea had “decided to cater to speculators.”

One creator told Weiss, “[i]nstead of doubling down and supporting the creators who put them in the position to be the best marketplace in the market, they instead turned their backs on all of us.”

Kinda hard to square those quotes with Finzer’s ‘think of the children’ pleas accusing the SEC of not being fair to creators and artists.

What goes up…

OpenSea’s decision to focus on speculative traders came following a dramatic reversal of business fortune. OpenSea had been a rising star until around mid-2022, when a wave of ‘crypto’ bankruptcies and collapses began in earnest, exposing the fraud that underpins most get-rich-quick schemes.

The ensuing ‘crypto winter’ appears to have given many ‘investors’ time to think about what exactly they’d been buying, along with the absence of the exponential returns they’d been led to expect, leading to much of the air going out of the NFT balloon.

Stagnation was inevitable due to the ubiquity of bad computer-generated ‘art’ consisting of only slight variations of the same image (think the much-derided ‘monkey JPEGs’ that became synonymous with NFTs). Mirroring the traditional trajectory of utility-free memecoins, NFTs that were supposed to ‘moon’ in value instead took a swan dive off a fiscal cliff as sanity returned.

NFT’s monthly sales volume cratered from a peak of over $6 billion in January 2022 to around $400 million today. OpenSea’s quarterly revenue peaked at around $265 million in Q1 2022 but fell to just $19 million by Q1 2023. By Q2 2023, one OpenSea investor had cut the firm’s valuation from $13.3 billion to just $1.4 billion.

By July 2022, OpenSea was laying off one-fifth of its staff, with Finzer citing “an unprecedented combination of crypto winter and broad macroeconomic instability.” In November 2023, OpenSea laid off half of its remaining staff as the NFT market remained stagnant, and OpenSea continued to shed market share to rivals like Blur.io.

Bro down

Reaction from the ‘crypto’ world to OpenSea’s announcement has largely consisted of the manufactured outrage that routinely follows every SEC attempt to rein in the sale of unregistered securities.

Brian Armstrong, CEO of the Coinbase (NASDAQ: COIN) digital asset exchange, tweeted his ‘congrats’ to OpenSea and offered a hearty “welcome to the club!” Armstrong, whose firm has been locked in a legal fight on the unregistered securities issue with the SEC for over a year now, claimed to be “long wells notice companies.”

Armstrong neglected to add that Coinbase Ventures was an early investor in OpenSea. As was Mark Cuban, who also rode to OpenSea’s defense on Wednesday with a tweet saying SEC chairman “Gary [G]ensler screws up again.”

Jesse Powell, the reliably apocalyptic Kraken co-founder, called the brouhaha “obviously absurd on its face” and accused the SEC of trying to “distract, waste resources, spread [fear, uncertainty and doubt] and slow us down.” Powell wondered, “Why is it always American companies” in the SEC’s crosshairs, accusing Gensler & Co. of “treasonous acts of sabotage.” (The penalty for treason is death, remember.)

Some conspiracy theorists claimed it was “not a coincidence” that the OpenSea news came shortly after Donald Trump released his fourth NFT collection aka ‘Trump digital trading cards.’ Others claimed that the timing indicated that “Trump killed NFTs.” Based on these views, we suspect NFTs are actually killing ‘Crypto Twitter’ brain cells.

DraftKings sacked for a loss

In other ‘are NFTs securities’ news, online sports betting operator DraftKings announced on July 30 that it was shutting its NFT Marketplace “effective immediately, due to recent legal developments.” The company said this decision “was not taken lightly and we believe it is the right course of action.”

Earlier in July, a U.S. federal court judge ruled that a class action suit brought against DraftKings by a customer who purchased NFTs from the site could proceed. The judge found that the plaintiff had “plausibly alleged that DraftKings NFTs in the context of the Marketplace are securities” as defined by the Howey test. Thus, it appeared that DraftKings was operating an unregistered securities exchange.

DraftKings began selling NFTs in August 2021 and began minting ‘gamified’ NFTs on the Polygon chain in February 2022. DraftKings promoted the NFTs via social media and other channels and limited users’ ability to sell their NFTs off-Marketplace. DraftKings also took a 10% cut of secondary market NFT sales.

Ticking the Howey box for involvement in a ‘common enterprise,’ the judge concluded “if DraftKings shut down the Marketplace or interest in the Marketplace evaporated, the value of the NFTs would plausibly drop to zero.”

As for Howey’s ‘reasonable expectation of profits solely from the efforts of others,’ the judge noted that DraftKings issued updates on the Marketplace’s “biggest risers and fallers,” as well as telling buyers they would “keep the open market profit of your cards.” The judge also noted chatrooms in which users discussed how best to profit by trading DraftKings’ NFTs.

The fact that users “did not, and possibly could not, withdraw their NFTs from DraftKings’ system and place them in their own wallets” ensured the ‘efforts of others’ clause got the judge’s approval.

Fast-forward to August 26, when the NFL Players Association (NFLPA) sued DraftKings over the abrupt termination of the NFT Marketplace contract the two parties signed in 2021. The NFLPA insists that DraftKings remains on the hook for the $65 million it claims to still be owed under the terms of the contract.

DraftKings is relying on a clause in the contract “which allows DraftKings to terminate if a government, regulatory or adjudicatory body ‘determines’ that the ‘Licensed Products’ constitute ‘securities.'” DraftKings cited the above federal court ruling as justifying the triggering of this clause.

The NFLPA pointed out that this ruling dealt solely with DraftKings’ motion to dismiss, so nothing has yet been ‘determined’ by any authority. The NFLPA claims DraftKings reneged on the deal because “the once white-hot market for NFTs has cooled down.” Regardless, “DraftKings’ inability to profitably commercialize the intellectual property it licensed does not excuse performance.”

This makes DraftKings the one NFT marketplace that’s actually aspiring to be found guilty of selling unregistered securities. It’s a start.

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