SEC Hammers LA Crypto Firm for Selling NFTs as Securities

SEC Hammers LA Crypto Firm for Selling NFTs as Securities

 Published: August 30th, 2023

The SEC has levied a six million dollar (USD) fine against LA-based Impact Theory, after the agency alleged that the firm’s NFTs were unregistered securities. A company press release said the firm has also been ordered to destroy its Founder's Keys NFT collection as part of a settlement.

At time of writing the collection had been removed from Opensea. On Monday, 28th August the NFTs were fetching a floor price of 0.038 ETH, or roughly USD 63. The collection’s total volume before takedown amounted to USD 5.3 million.

Impact Theory is a venture co-founded by Tom Bilyeu, a social media influencer. Both the allegations and settlement were announced by the SEC on 28th August. According to the regulator, Impact Theory launched and sold three tiers of NFT under the Founder’s Keys brand, Heroic, Legendary, and Relentless.

The SEC said Impact Theory actively promoted its NFTs as a direct investment opportunity to attract financing for the company. Purchasing a Founder’s Key would yield returns if the firm did well and drew parallels with the growth trajectory of established multinational entertainment brands such as Disney.

The watchdog now says that promise turned the NFTs into ‘security investment contracts,’ which by extension placed them under SEC jurisdiction. By not registering the NFTs as securities when it sold them, the company broke the law. Impact Theory raised circa USD 30 million from a group of investors, including some based in America.

In reply to the SEC's findings, Impact Theory has agreed to abide by a cease-and-desist order. The order mandates that the firm fell afoul of America’s Securities Act of 1933, though the company neither admits nor disputes the charges. The total fine against the company totals USD 6.1 million.

From warnings to punishments

On the east coast, American crypto firms operating in New York State were warned in May that they needed to manage their customers' digital assets with greater care.

In the wake of the FTX scandal, the New York Department of Financial Services (NYDFS) published an open letter to the industry outlining how investor assets should be kept separate from company funds. The letter also included guidelines for custodians, and explained the necessary disclosures that firms need to make when keeping custody of digital assets for clients is part of their business model.

NYDFS took the action as federal prosecutors apply more scrutiny to collapsed crypto trading exchange FTX and its controversial founder Sam Bankman-Fried. Bankman-Fried, or ‘SBF’ as he is known colloquially, is accused of misusing billions of dollars in customer assets and funneling them from the exchange to fund dodgy trades at his recently shuttered hedge fund.

‘As stewards of customer assets, crypto companies that act as custodians need to have rigorous processes in place that follow those relied on by traditional financial services firms,’ the NYDFS letter said.

The role of asset custodians in finance is to ‘hold on’ to customer assets for safe keeping. They could be funds, bonds, equities, or cryptocurrencies. In all cases custody has to be executed in a secure and transparent manner.

The new NYDFS guidelines are even more specific and provide detailed guidance on how digital assets should be handled.

Crucially, the agency said custodians must keep customers’ digital assets separate from any assets that belong to the custodian itself. In crypto terms this could mean recording the assets both on-chain and on the custodian’s own books but maintaining appropriate records to avoid double counting.

The agency also said that assets under a custodian’s control should only be held for the purpose of safekeeping. Specifically, there should not be a debtor-creditor relationship between custodian and customer when possession of a digital asset is transferred.

Custodians in New York are also required to give customers written disclosures that clarify what the custodial arrangement means and how the custodian operates. Disclosures should explain how the custodian ‘segregates and accounts for and digital currency held in custody,’ and clarify the customer's ‘retained property interest in it.’

Ramping up the regulatory clampdown

Back in July the Financial Stability Board (FSB), a G20 entity charged with monitoring financial activity in the world’s top-20 economies, announced a coming proposal that will lay out new 'robust regulation and supervision’ for cryptocurrencies.

A report scheduled for October will be shared with G20 finance ministers with a proposed set of new rules to govern and supervise crypto assets, including so-called stablecoins.

An FSB press release said that digital currencies are evolving rapidly in a tumultuous environment marked by extreme volatility. 'Despite these worries, cryptocurrencies are becoming increasingly integrated into the traditional financial system, exposing investors to new risks.’

The FSB is worried, it says, about the potential for one market failure to negatively impact participants in the wider crypto ecosystem. ‘Investors can suffer huge losses while risks are transmitted to other parts of the system and market confidence is damaged.’

Crypto market watchers saw this as a veiled reference to Terra’s dramatic failure in early May of 2022. The collapse of the Terra ecosystem triggered a liquidity crisis and sent several well-known crypto finance firms and hedge funds into bankruptcy.

Though the organization monitors the financial services industry closely, the October crypto proposal will mark a new chapter for the FSB. Up until now it has played a background advisory role, and any recommendations to G20 ministers and bankers have been made outside the public sphere.

The push for tougher rules kicks off

In May, pro-crypto Portugal became the latest country to reboot its financial services rules and clamp down on crypto activity. The shift from pro-crypto to crypto-curious is significant, since Portugal had become a haven for blockchain and crypto innovation.

All that changed when the country's finance ministry did an about-face and announced that all crypto assets in the country would be subject to capital gains taxes.

Previously the government took a hands-off approach to cryptocurrency transactions, treating them as cash exchanges and effectively excluding them from capital gains taxes by definition.

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