In their 2024 book Over Ruled, Justice Neil Gorsuch and Janie Nitze document the dramatic expansion of federal laws. This expansion stems not just from enactments by Congress and decisions of courts, but also from the numerous federal agencies through their arsenal of rules and regulations, informal public guidance and enforcement actions. Federal statutes used to fit in one volume, but now surpass 54 volumes and 60,000 pages. Federal agency rules ran 16 pages in 1936, but now surpass 200 volumes and 188,000 pages. No one knows for sure how many agency regulations have criminal penalties, but one estimate is that the total surpasses 300,000. And, more worrisome, federal agencies sometimes “don’t just write and enforce legally binding rules,” but also “act as prosecutor and judge, too.”
This proliferation of laws and regulations may reflect the complexities of modern society. But, as the book details, it has led to tragic consequences with federal laws being over-enforced against individuals, even in ways beyond the law’s intended scope. Especially when laws are over-enforced based on tenuous if not incorrect interpretations, the rule of law is undermined. As Justice Gorsuch and Nitze show, the rule of law “requires that laws that are publicly declared, knowable to ordinary people, and stable.”
Unfortunately, that’s not the case with the Securities and Exchange Commission’s opaque treatment of non-fungible tokens (NFTs). Instead, the regulator’s approach adds another sad chapter to the problem of over-enforcement of laws, which paradoxically undermines the rule of law.
In 2021, a new market for digital artworks blossomed. NFTs provided artists with an innovative new way to sell their art and collect resale royalties, which provide artists a modicum of financial sustainability. As artists flocked to the burgeoning NFT market, with sales volume hitting $27 billion, the SEC remained silent. Artists had no public guidance on whether the SEC would treat NFTs as securities. Top law firms were unsure.
Read more: Brian Frye – Art Is Not a Security
But, in 2023, when the NFT market was in a downturn, the SEC added another risk to the ones artists faced: possible SEC prosecution. The SEC announced the settlements of enforcement actions against two NFT projects, which were developing a cartoon cat series and avatar-based game, respectively. The SEC alleged the NFTs were investment contracts and unregistered securities. Although the settlements do not establish legal precedents and the entities admitted no wrongdoing, the SEC required the two projects to destroy their NFTs. Neither project survived. Other businesses, such as GameStop, killed their NFT projects due to “regulatory uncertainty.”
Then, in late-August, the SEC showed it’s not done. OpenSea, one of the largest NFT marketplaces, revealed the SEC sent a Wells notice indicating a potential action against the company for allowing the sales of NFTs that were allegedly unregistered securities. Although a Wells notice doesn’t necessarily end in prosecution, it often does.
NFT artists and businesses were upset. On social media, some even discussed going to jail. While that fear may be unfounded, the panic is not. The SEC’s strategy of bringing selective enforcement actions against NFT projects and businesses, without promulgating any rules or public guidance related to NFTs, threatens the entire NFT market. The uncertainty will chill artists from creating NFTs and kill business ventures involving NFTs.
Regulatory uncertainty isn’t the biggest problem with the SEC’s approach. Instead, as I explain in a forthcoming U.C. Davis Law Review article, the SEC’s approach is likely unconstitutional. Requiring securities registration of artwork NFTs before they can be offered to the public is a prior restraint in violation of the First Amendment rights of the artists. Prior restraints on speech, including pre-publication licensing and registration, “are the most serious and the least tolerable infringement on First Amendment rights,” as the Supreme Court admonished. Prior restraints may mask censorship and chill speech. Even the delay of publication is problematic under the First Amendment. Speech delayed is speech denied.
Artists shouldn’t have to hire securities lawyers — or risk prosecution by the SEC — before selling NFTs. Such a regime of prior restraint harms society. As the Supreme Court explained in the election context: “Many persons, rather than undertake the considerable burden (and sometimes risk) of vindicating their rights through case-by-case litigation, will choose simply to abstain from protected speech — harming not only themselves but society as a whole, which is deprived of an uninhibited marketplace of ideas.”
The solution to this constitutional problem is simple: the SEC and courts should return to the original public meaning of the Securities Act of 1933 — what the statute actually says; that’s what the Supreme Court recently did in interpreting the National Firearms Act of 1934. In 1933, the original public meaning of “investment contract” referred to a specific type of investment: investors’ payment of money for a contractual right to a share in the profits made by the offeror. When the Supreme Court interpreted “investment contract” in 1946, in SEC v. W.J. Howey Co., it expressly endorsed this ordinary meaning of the term a state supreme court had identified in 1920. Every Supreme Court decision finding an investment contract, including Howey, involved such a contractual right, or “the promise of profits.”
Of course, an investment doesn’t have to be titled as an “investment contract” to be one. Because the Securities Act applies to mere offerings, it’s not essential that a contract existed. But, to fall within “investment contract,” the offering must involve a contractual right to a share in the profits made by the offeror. Without it, the offering involves an investment, but not a contractual one.
It is not for the SEC or courts to read the word “contract” out of the Securities Act. It serves an important purpose in distinguishing investment contracts from other investments, such as the purchase of artworks and collectibles. Investors permitted by Hermès to buy Birkin bags can reasonably expect to make a profit from Hermès’s assiduous efforts to maintain their rarity and value. But investors’ expectation of profits doesn’t turn Birkin bags into investment contracts. Nor does it with NFTs. Buying collectibles, whether Birkin bags or artwork NFTs, is different in kind from investing in investment contracts: the former lacks the contractual right to profits that the latter has.
If the word “contract” in the Securities Act continues to be ignored, it will soon be time for the Supreme Court to step in. The rule of law requires no less.
Note: The views expressed in this column are those of the author and do not necessarily reflect those of CoinDesk, Inc. or its owners and affiliates.
