This blog post is a follow-up to my blog post Substance Over Form: A Short Note on the SEC’s First NFT Settlement regarding the Impact Theory project. I assume you have read that before you read this.
Impact Theory was an obvious example of an entrepreneur instantiating a security as an NFT. Stoner Cats is a borderline case, and below we’re going to briefly explain why.
Stoner Cats is a cartoon, starring Ashton Kutcher and Mila Kunis, about a bunch of house cats who like to smoke marijuana. They go on zany adventures and toke doobies. It is intended to be watched while high on ganja. Since nobody has executed on this vision well in the 10 years since Aqua Teen Hunger Force, the greatest television show ever made, went off the air, it is understandably something a lot of people got excited about.
This is exactly the sort of project which deserves its own NFT.
The SEC claims:
The purpose of the Stoner Cats NFT offering was to fund the production of an animated web series called Stoner Cats. SC2 told investors it would develop the Stoner Cats web series based upon the managerial and entrepreneurial efforts of SC2 and its agents. SC2 promised investors in the Stoner Cats NFTs exclusive access to the web series and an online community, as well as access to unspecified, future entertainment content.
To be clear, people were buying digital collectibles and, per the SEC’s view, they were buying them so they could get access to future content and access to the finished content.
SC2 offered and sold the Stoner Cats NFTs as an investment into SC2’s efforts to create this content. SC2’s public communications tied the success of the show to the value of the NFTs and thus led investors reasonably to expect to profit from the managerial and entrepreneurial efforts of SC2.
Stoner Cats did this by selling merch from the series in NFT form:
Each Stoner Cats NFT was associated with a unique still image of one of the characters in the Stoner Cats web series, with different expressions, apparel, accessories, and backgrounds, resulting in a multitude of NFTs. Purchasers could not choose their NFT in the offering, but instead received a random allocation. Over 62% of the purchasers in the offering bought more than one Stoner Cats NFT. In addition, at least 20% of the Stoner Cats NFTs purchased in the offering were resold in the secondary market before the first episode of the Stoner Cats series aired, two days after the offering, and the majority of the NFTs purchased in the offering were resold in the secondary market before the release of the second episode on November 15, 2021.
They also promised to develop content in the future, as one would expect artists to do in a friggin television series.
On its website, SC2 promised that if 100% of the NFTs were sold (which happened), it would facilitate the creation of a decentralized autonomous organization (“DAO”) comprised of Stoner Cats NFT holders and that it would commit to working with the DAO to “develop at least one new animation project a year for the next three years.” The website promised that NFT holders would have access to this additional content.
Apparently SC2 also gave itself – not the buyer – a 2.5% secondary sale royalty fee. In the usual analysis this wouldn’t, either by itself or in combination with other factors, make the NFT a security in the hands of anyone. Royalties are regularly payable on secondary art sales to the author of the art. Selling the royalty stream might create a security, but the existence of the royalty stream should not.
So here’s what gets me about this. Buying film stills from a movie is a thing that happens. Below is a montage together with three cells from a theater which played the movie Pink Floyd: The Wall. The SEC appears to be saying that if you sell these stills before you produce a web series – say, by selling stills from the pilot – you’re now selling securities.
Buying merch and collectible stuff from existing TV series is also a thing. See e.g. Netflix selling NFTs for its Love, Death + Robots series. The regulator doesn’t seem to have a problem with that, either, at least not yet.
The SEC points out that “the show was largely incomplete at the time of the offering… [t]he final episode was not released for another fifteen months[.] SC2 sought to persuade investors that the show and the NFTs would be successful as a result of SC2’s entrepreneurial and managerial efforts.” Ok. Let’s accept this logic for a second and ask some further questions of the SEC.
If you sell the NFTs after you’re done making the series, as evidenced by the huge market for film stills which the SEC has never once intervened in, I suppose according to the SEC you’re not selling securities? But what if you’re Netflix selling them in the middle of a popular series, apparently they’re not selling securities either? But if you’re a startup selling them after the pilot, you are selling securities?
When is a show “complete” and NFT sales of stills are therefore permitted? After the pilot? After the first season? Second season? First run? Spinoff? Sequel? When, exactly, is an artist allowed to sell an NFT representing a good which is already routinely sold as a collectible all over the Internet without it becoming a security?
It’s all very confusing. The short answer, the logical answer, the answer most consistent with economic reality, is that this was a bad call by the SEC and they picked a weak startup to make an example of. Impact Theory was an obvious example of an entrepreneur trying to dress up an investment contract as an NFT. Stoner Cats appears to be an example of the SEC trying to dress up a collectible as an investment contract.
That said, this is truly a borderline case. The SEC’s logic follows that in a California law case, Silver Hills Country Club v. Sobieski, 55 Cal 2d 811 (1961), in which presold memberships to a country club were deemed investment contracts by that state’s regulator using a test known as the “risk capital test.” But it bears mentioning that the SEC is a federal agency and the risk capital test is not a test which is applicable anywhere outside of the State of California, so it should not be influencing their enforcement decisions. Even if it were, the fact that the NFTs correspond directly to a real-world collectible for which there are real world markets makes the statement of facts in the SEC’s settlement – which the SEC was free to write by itself without any input from anyone else – not a slam dunk.
Is the addition of minor fringe benefits like access to a website and a promise to draw more comics really enough to take a garden-variety collectible and turn it into a full blown investment contract of the type which Congress intended to restrain with the 1933 Act? The SEC seems to think so.
Against whom and when to enforce is of course a regulator’s prerogative, and maybe the facts and circumstances of Stoner Cats really made this a project worth enforcing against, but I don’t see it. The only certain outcome from this enforcement action is that NFT projects will have to do extensive and expensive legal analyses and pre-publication reviews to try to avoid Stoner Cats’ fate in marketing these collectibles, and because the SEC overreached here they’ll never be able to get absolute certainty from their lawyers that they’re on the right side of the line. This will stifle creative business and prevent creators from using crypto collectibles instead of more traditional types of merch. Given what we know about the policy objectives of Democrats in Congress, maybe that’s the point.
For our policymakers in Washington, though, who oversee that agency, I ask you this. In the last 12 months has the SEC really had nothing better to do – for example, rulemaking to bring our crypto regs into the 21st century, or pursuing obvious frauds – than pick on a bunch of cartoonists selling trading cards of stoned cats?