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A recent guilty plea in U.S. v. Wahi in the U.S. District Court for the Southern District of New York, a crypto insider trading case, sets up an interesting situation where the defendants — who have already pled guilty to wire fraud — are challenging the SEC’s parallel civil charges…

In its first enforcement action of the year involving ICOs, the U.S. Securities and Exchange Commission (SEC) charged two companies and their founder for violations of antifraud and registration provisions of the federal securities laws in connection with an initial coin offering (ICO).  On January 6, 2022, the SEC announced charges against Australian citizen Craig Sproule and two companies he founded, Crowd Machine, Inc. and Metavine, Inc. (collectively, the Defendants), for making materially false and misleading statements in connection with an unregistered offer and sale of digital asset securities in an ICO.  (SEC v. Crowd Machine, Inc., No. 22-00076 (N.D. Cal. filed Jan. 6, 2022)).

These charges add to the SEC’s growing list of enforcement actions that target unregistered offerings of digital assets.  ICO activity peaked in 2017, when hundreds of issuances raised an estimated $5 billion from investors.  Since that time, scrutiny from the SEC has cooled this practice. However, the SEC remains vigilant in taking action against unregistered ICOs, based on its view that digital tokens are likely to be securities. In remarks last year, SEC Chairman Gary Gensler voiced agreement with former SEC Chairman Jay Clayton’s position on ICOs: “To the extent that digital assets like [initial coin offerings, or ICOs] are securities — and I believe every ICO I have seen is a security — we have jurisdiction, and our federal securities laws apply.”

Except for the extensive coverage surrounding Coinbase’s IPO last week and the volatility in the price of cryptocurrencies, much of the air in the crypto space in the last few months has been taken up by the meteoric rise of non-fungible tokens (NFTs). At this point, we will assume that readers have at least a basic familiarity with NFTs. If not, we suggest a review of this SNL skit, as it is actually a pretty good summary.

It seems like new articles appear on a daily basis addressing some aspect of the legal issues associated with the NFT phenomenon. Interestingly, however, there have been few articles and little attention paid to what ultimately might be the most interesting development in this space, that is, the rise of fractional NFTs (F-NFTs).

F-NFTs Stir Up New Issues

Given that many NFTs are selling for significant amounts of money (in both fiat and digital currencies), the idea of fractionalization is taking shape to allow smaller investors to pool resources to purchase fractional interests of a NFT.  Additionally, there is great interest in the opportunity to buy fractional interests of large NFT collections. For example, it was recently reported that a collection of fifty CryptoPunks, which are early, now valuable NFT pixel art collectibles, were fractionalized into millions of tokens. The interest in fractionalization is not surprising given the high sale price of some NFTs and the widespread adoption of crowdfunding in many areas in e-commerce and investing.

Beyond mere entry into the market, purchasers can hold onto an F-NFT in the hope of seeing investment gains or realizing dividends, or else sell the F-NFT (from a technical perspective, referred to as a “shard”) to another investor. Several entities have emerged to facilitate the sale of F-NFTs to unlock liquidity in the market and create and trade fractions of NFTs.  For example, the NFT trading platform Niftex states that it allows owners to break NFTs into shards for purchase at a fixed price, with the fractions able to be subsequently traded in the market. The site also states that it allows shard owners some local governance rights on the platform with respect to a particular fraction set and provides an investor with a certain percentage of shards who wishes to own the entire digital asset with a method to bid on the remaining shards.

As most anything can be reduced to an NFT, it’s interesting to think of the possibilities of fractionalization. Now that the buying and trading of cryptocurrency has become mainstream, with major fintech platforms having begun to allow users to buy, sell or hold crypto and more and more decentralized finance (or DeFi) and decentralized applications (DApps) being developed to offer new digital solutions for various financial transactions, the continued fractionalization of NFTs is almost inevitable.

But is it legal?

The Securities and Exchange Commission (“SEC”) recently issued highly anticipated guidance to assist market participants in determining whether a digital asset is offered and sold as a security.

On April 3, 2019, the SEC’s Strategic Hub for Innovation and Financial Technology published an analytical framework for evaluating whether the offer…

U.S. District Judge Raymond Dearie of the Eastern District of New York has ruled that initial coin offerings (ICOs) may be subject to securities law. The ruling came in the court’s denial of defendant Maksim Zaslavkiy’s motion to dismiss an indictment that alleges that he committed securities fraud for selling tokens that he claimed represented shares in a real estate venture and a separate diamond business. Zaslavskiy’s motion to dismiss argued that the investment schemes and their related ICOs did not involve securities and are beyond the reach of federal securities laws and that the securities laws, specifically the Exchange Act and SEC Rule 10b-5, are unconstitutionally vague as applied to this case.