SEC settlement with Stoner Cats may signal agency’s intent to assert its authority over unregistered securities in the NFT space

The SEC has announced it has brought and set­tled charges against Ston­er Cats 2 LLC (SC2), the com­pa­ny behind Ethereum-based NFT project Ston­er Cats – a gen­er­a­tive col­lec­tion of 10,420 illus­trat­ed cat themed NFTs that SC2 mint­ed in July 2021 to fund its pro­duc­tion of the epony­mous ani­mat­ed web series. The project raised rough­ly $8 mil­lion and pro­duced six episodes, fea­tur­ing A‑list celebri­ty tal­ent, that can only be viewed by own­ing a Ston­er Cats NFT.

In its Sep­tem­ber 13 cease-and-desist order, SEC alleged that the ini­tial sale of Ston­er Cats NFTs was an unreg­is­tered offer­ing of “cryp­to asset secu­ri­ties” in vio­la­tion of Sec­tions 5(a) and 5© of the Secu­ri­ties Act of 1933. To reach that con­clu­sion, SEC applied the Supreme Court’s Howey test, deter­min­ing that Ston­er Cats NFTs con­sti­tut­ed “invest­ment con­tracts.” In sim­ple terms, an “invest­ment con­tract” under Howey requires an invest­ment of mon­ey in a com­mon enter­prise, where buy­ers have a rea­son­able expec­ta­tion of prof­it derived from the efforts of others.

Though SEC has often applied Howey to vir­tu­al cur­ren­cies and token sales, this is only the sec­ond time the agency has applied it to NFTs. An ear­li­er case last month charged a Los Ange­les-based com­pa­ny, Impact The­o­ry, with Sec­tion 5 vio­la­tions for its unreg­is­tered sale of NFTs called Founders Keys. Com­pared to that case, the enforce­ment action against Ston­er Cats tar­gets a far more gener­ic pat­tern of con­duct that may sig­nal SEC’s intent to aggres­sive­ly assert its reg­u­la­to­ry author­i­ty in the NFT space.

The alle­ga­tions

In par­tic­u­lar, the order alleges that SC2 told buy­ers their NFT pur­chase would fund devel­op­ment of the ani­mat­ed series through the efforts and indus­try con­nec­tions of SC2’s founders. NFT hold­ers were fur­ther promised exclu­sive access to the series and any future Ston­er Cats-based con­tent, an exclu­sive com­mu­ni­ty of Ston­er Cats NFT hold­ers, and a decen­tral­ized autonomous orga­ni­za­tion (DAO) that could pro­vide cre­ative input on any future ani­mat­ed projects.

Ahead of the NFT sale, SC2 launched a social media mar­ket­ing cam­paign pro­mot­ing these ben­e­fits and adver­tis­ing the ster­ling indus­try cre­den­tials of the SC2 team in charge of pro­duc­ing the series. SEC asserts these rep­re­sen­ta­tions “led investors to expect prof­its from [SC2’s] entre­pre­neur­ial and man­age­r­i­al efforts because a suc­cess­ful web series could cause the resale val­ue of the Ston­er Cats NFTs to rise in the sec­ondary mar­ket.” The fac­tu­al sup­port for this asser­tion, how­ev­er, is rel­a­tive­ly light in the order.

For exam­ple, SEC faults Ston­er Cats for analo­giz­ing its NFTs to trans­ferrable tick­ets. SC2 alleged­ly told hold­ers that if they do not care for the web series, they “can take that tick­et and sell it.” Accord­ing to the order, SC2 stat­ed, “[T]he more suc­cess­ful the show, the more suc­cess­ful your NFT” will be. To be sure, SEC has not pre­vi­ous­ly treat­ed event tick­et sales as unreg­is­tered offerings.

SEC also cites three of the SC2’s tweets from August and Sep­tem­ber 2021. These includ­ed a meme encour­ag­ing fol­low­ers to buy Ston­er Cats NFTs while the price of ETH was down, a tweet high­light­ing three record sales of rare Ston­er Cats NFTs, and a tweet iden­ti­fy­ing the floor price and total trad­ing vol­ume of the collection. 

The order also men­tions sev­er­al gener­ic facts about the Ston­er Cats col­lec­tion that are stan­dard fea­tures of NFT projects. For instance, the order states that each Ston­er Cats NFT was unique, that ini­tial buy­ers could not choose which ran­dom­ized NFT they got, that most NFT hold­ers bought more than one NFT, and that the NFTs were cod­ed with a 2.5 per­cent roy­al­ty that went to SC2 upon sec­ondary sales. SEC fur­ther points out that SC2 took steps to “ver­i­fy” the Ston­er Cats col­lec­tion on a third-par­ty sec­ondary mar­ket­place which assured that SC2 would receive its 2.5 per­cent roy­al­ty. Tak­en togeth­er, these acts offer lit­tle to dis­tin­guish Ston­er Cats from myr­i­ad oth­er NFT projects.

A dis­sent

Address­ing this point, Com­mis­sion­ers Hes­ter Pierce and Mark Uye­da reg­is­tered a tren­chant dis­sent. They wrote that SEC’s Howey analy­sis “lacks any mean­ing­ful lim­it­ing prin­ci­ple” and called for SEC to “lay out some clear guide­lines for artists and oth­er cre­ators who want to exper­i­ment with NFTs as a way to sup­port their cre­ative efforts and build their fan com­mu­ni­ties.” They fur­ther likened Ston­er Cats to “fan crowd­fund­ing” which they called “a com­mon phe­nom­e­non in the world of artists, cre­ators, and enter­tain­ers.” And, build­ing on the order’s “tick­et” anal­o­gy, the dis­sent­ing com­mis­sion­ers com­pared Ston­er Cats NFTs to the “I.O.U. cer­tifi­cates” that Star Wars fans could redeem for scarce Star Wars toys in the 1970s, and which were clear­ly not unreg­is­tered secu­ri­ties. Though the dis­sent acknowl­edges that some NFT cre­ators should be sub­ject to the secu­ri­ties laws, it con­demned the order for con­tribut­ing “to the legal ambi­gu­i­ty fac­ing artists, writ­ers, musi­cians, film­mak­ers, and oth­ers seek­ing to build a loy­al, engaged following.”

Notably, by the time of SEC’s order, SC2 had com­plet­ed its ini­tial run of six episodes and uploaded them to a decen­tral­ized stor­age plat­form called Arweave; SC2 claims it can­not con­trol or take down the web series from this plat­form and that NFT hold­ers will have access to the series there “in per­pe­tu­ity.” But this attempt to pro­gres­sive­ly decen­tral­ize Ston­er Cats was appar­ent­ly not enough to dis­tance SC2 from its fall 2021 activities.

Broad­en­ing the range of activ­i­ties sub­ject to SEC scrutiny

Ulti­mate­ly, the order broad­ens the range of activ­i­ties that may sub­ject NFT projects to SEC scrutiny.

Under the order, SC2 con­sent­ed to pay a $1 mil­lion penal­ty ear­marked for a Fair Fund—a fund to dis­trib­ute penal­ties to alleged­ly-injured investors. Though the agency did not appar­ent­ly seek dis­gorge­ment of the Ston­er Cats mint funds, SC2 is required to destroy all NFTs in its pos­ses­sion. SC2 also agreed to pub­lish notice of the order on its web­site and social media with­in 10 days and sup­ply a list of wal­let address­es for all Ston­er Cats NFT holders.

Key take­aways

• SEC’s order against Ston­er Cats may indi­cate a shift towards more aggres­sive enforce­ment against NFT projects.
• SEC’s order offers lit­tle to dis­tin­guish Ston­er Cats from oth­er projects that use NFT sales and roy­al­ties to crowd­fund media cre­ation or experiences.
• Ston­er Cats’ attempt to pro­gres­sive­ly decen­tral­ize through cre­ation of a DAO and stor­age of the com­plet­ed web series on a decen­tral­ized net­work could not dis­tance the founders from their ear­ly pro­mo­tion­al activities. 
• In dis­sent, Com­mis­sion­ers Pierce and Uye­da called for greater clar­i­ty for cre­ators look­ing to sup­port their art through NFTs.

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