Canada: Securing Funding With NFTs, The New Kids On The Blockchain

By December 4, 2021NFT
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Non-fungible tokens ("NFTs") have revolutionized how artists sell their art; now, artists are hoping that NFTs can revolutionize how they fund their art. Recently, the sale of collectible NFTs has funded the production of two television projects: Stoner Cats and The Gimmicks. Stoner Cats raised around $8 million in NFT sales on the premise that only those that purchase Stoner CatNFTs will be able to watch the show. The Gimmicks, on the other hand, has promised that NFT holders will be able to determine how the show's story progresses from episode to episode. While this new way of funding is exciting for artists and fans alike, it is important to consider the securities law implications that may arise.

What is an NFT?

First, we'll start with the basics. An NFT is an intangible digital token that represents an item. That token is composed of unique data stored on a ledger using blockchain technology. Being "non-fungible" means that each token is one-of-a-kind. For instance, cryptocurrencies like Bitcoin are considered "fungible" tokens because they function like money; a loonie is the same as every other loonie and can be substituted for similar tokens of equal value, such as 20 nickels1. NFTs are unique in that they are not replicable or interchangeable in such a way. Simply put, NFTs are digital collectibles.

NFTs and ownership

When someone buys an NFT of a work of art, they purchase a token that represents ownership of the art - not necessarily a portion of or an interest in the art itself. The common misconception surrounding ownership is that buyers own the real-life version of the asset. The reality is that owning an NFT is like buying a limited-edition print of a painting: the buyer does not typically own the copyright to it, nor does the buyer have the right to reproduce the painting for resale or other commercial purposes. They do, however, own that unique individual copy and that certificate of authenticity to match. Similarly, in the case of the television funding mentioned above, the NFT buyers do not own a portion of the show or its potential profits; rather, they own a collectible NFT that comes with certain tertiary benefits. (For more on NFTs and the entertainment industry, tune in to the upcoming American Bar Association (ABA) discussion - Lost in Tokenization: Legal Implications of Non-Fungible Tokens on Finance, Art, Property, and Culture).

Securities law considerations

Alongside issues surrounding IP rights, NFT ownership raises important considerations for Canadian securities laws. The offer of ownership of or income streams from a venture in association with NFTs connected to entertainment products might trigger requirements for dealer registration or rights to license. It is therefore important for artists, agents, or anyone in the business of creating or selling NFTs to first answer the question of whether or not the NFT that they are selling might be a security.

While many cryptocurrency offerings do involve the sales of securities, the Canadian Securities Administrators ("CSA") has advised that a unique token valued for its entertainment or collectible purposes is not typically a security.

To help understand some Canadian securities law implications for selling tokens, the CSA offers helpful guidance in Staff Notice 46-308. The guidance is based on the investment contract test (referred to more commonly in Canada as the Pacific Coin test or in the United States as the Howey test), a token will be classified as a security where it involves (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profit (iv) to come significantly from the efforts of others. 2

For many entertainment-related NFTs, the purchaser determines the value of the token based on their own personal preferences in relation to the unique characteristics of that token as a collectible item. Accordingly, market forces, rather than the continued development of a business by the issuer or the promise of future profits from that enterprise, determines the token's future market value. If a token's unique characteristics, and not the effort of others, determine its value, then it is likely that there is no common enterprise and therefore, it would not satisfy the test mentioned above.

In the case of television shows or other artistic endeavours raising funds through the sale of NFTs with ancillary benefits or value, here are some common "red flags" that indicate that the sales might be considered investments contracts or otherwise securities rather than mere tokens. First, watch out for where the NFT owners appear to receive benefits beyond merely owning a collectible, such as exclusive access to watch the show or having some creative control. Second, where the tokens are being sold to raise capital, this will be a strong indicator of a security and could mean that the purchasers are not merely purchasing the tokens in appreciation of their actual unique characteristics. And finally, where it may be said that the value of the NFT is closely tied to the success or failure of the show or project itself, this could potentially indicate a common enterprise. For example, if a television show funded through NFTs grants exclusive access to NFT holders, then the price of those NFTs will increase alongside the public's desire to watch the exclusive show, especially if that show receives favourable ratings or award nominations.

If the NFTs were found to be securities, their distribution could be subject to prospectus requirements, resale restrictions and dealer registration requirements. Jurisdictional considerations would also need to be kept in mind for NFTs that are offered internationally. The CSA notes that a Canadian securities regulatory authority may have jurisdiction over trades to investors residing outside of Canada where there is a real and substantial connection between the transaction and Canada. Given these Canadian securities law concerns, it is important for artists and producers to consult their legal counsel before moving forward with minting and selling NFTs, especially as a means to fund their projects.

Footnotes

1. Susan Abramovitch et al., NFTs: Why a picture is worth a thousand Bitcoins. Webinar (May 31, 2021).

2. Securities Law Implications for Offerings of Tokens, CSA Staff Notice 46-308 (June 11, 2018), https://www.osc.ca/sites/default/files/pdfs/irps/csa_20180611_46-308_implications-for-offerings-of-tokens.pdf.

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