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10 December 2021

Dear frens,

A beautiful thing about NFTs from a legal perspective is that they are definitely not securities. They raise all kinds of interesting issues about copyright claims and even the potential application of gambling laws, but because they are one-of-a-kind items, their offering and sales can hardly be said to be securities. You can make and sell NFTs as much as you’d like, and trade them on whatever platform, with the peace of mind that the securities laws (at least) are not implicated.

That is, unless you securitize them.

The crypto community is not known to leave well enough alone, so I’ve been pretty bemused to see how much “fractionalization” of NFTs is being done. I just want to raise the potential securities law issue so that folks who are doing this, or are thinking of it, can be aware of it because I’m sure regulators are watching.

One of the pioneers of fractionalizing NFTs is PleasrDAO, which describes itself as “an art collective that buys and stewards culturally significant NFTs.” They famously bought the Doge NFT and then proceeded to issue 16,969,696,969 $DOG ERC-20 tokens that represent ownership stakes in the NFT. (It’s probably a little more complicated than that, but that is how it’s generally presented and shouldn’t affect this analysis.) They then sold 20% of the total supply in an auction to the public, allocated 25% of the supply toward a fund for “community programs and continued development,” and kept 55% for themselves. If the Doge NFT is sold to an external party, the FAQs say that “fractional owners are able to trade all their ownership tokens in for the ETH that was deposited by the [external party] on a pro rata basis.”

There are a couple of ways regulators could say this is a security. First, they could say the $DOG tokens simply represent equity in the enterprise and equities are securities. Alternatively they could say that the scheme is an investment contract. Most would agree that there is an investment of money in a common enterprise with an expectation of profit. The question then is whether those profits are “derived from the efforts of others,” typically the promoter. In this case I can imagine regulators saying the fact that PleasrDAO kept 55% of the token supply for itself (80% if they count the “community fund”), as well as all the marketing and community infrastructure PleasrDAO provides, means there’s reliance on their efforts. This is not unlike the case the SEC is making against Ripple.

I don’t know if such a charge would be successful, and there are any number of defenses one can imagine, but that’s probably what the complaint would look like.

The reason I started looking into “fractionalization” is that this week I saw a lot of chatter around PleasrDAO’s latest project: an effort to buy an NFT of art by convicted Silk Road creator Ross Ulbricht being auctioned to benefit his legal defense and other causes. What I found so amazing was that Pleasr created a DAO — FreeRossDAO — not just to fractionalize the NFT if they acquired it, but also to raise funds to bid in the auction, very much like ConstitutionDAO.

In a previous missive I explained why I didn’t think ConstitutionDAO could be said to be offering securities. The main reason is that at the time there were no expectation of profits. Participants understood their contributions as donations and it was made clear that issued tokens did not confer any ownership stake, just the ability to vote in advisory polls about the disposition of the Constitution in the event they won.

FreeRossDAO seems to be trying to follow the same recipe. Their marketing talks in terms of “contributions” and “donations”. However, while it also doesn’t talk in terms of fractional ownership, it does say things like

Once the bid to acquire the Genesis Collection succeeds, contributors will receive $ROSS tokens in return for their contributions pro-rata, serving as both fractional pieces of the Genesis Collection as well as FreeRossDAO’s governance token. Holders of $ROSS can vote on proposals and contribute to the direction of FreeRossDAO. (Emphasis mine.)

And

If FreeRossDAO wins the auction, the NFT will be fractionalized into $ROSS and distributed pro-rata, weighted by contribution. $ROSS will represent governance rights within FreeRossDAO and a fractional part of the “GENESIS COLLECTION” NFT. (Emphasis mine.)

I have no idea what this means. Unlike the Doge NFT, I haven’t found FAQs about whether the NFT can be sold to external parties and what happens to the DAOs assets if there was to be a sale. I’ve heard some involved say that they will use Fractional, the same platform used to fractionalize $DOG. I also asked on the FreeRossDAO Discord and was told that they’ll “probably set a high reserve price on Fractionalize [sic] but yeah in theory it could get bought out, in which case holders would get a share of the sale price proportional to their holdings.” Although they won the auction, they haven’t done this yet as far as I can tell.

Also interesting is that, PleasrDAO promised investors that it would take steps to ensure that the DAO won the auction. In particular, they said

PleasrDAO has seeded the FreeRossDAO multisig with 240 ETH (~$1mm) symbolizing Ross’s sentence. PleasrDAO will donate an additional 240 ETH each time the total amount raised hits a multiple of 2,400 ETH. PleasrDAO will continue contributing if FreeRossDAO gets outbid until PleasrDAO hits its secret max donation.

That is, PleasrDAO committed to continue adding funds to the FreeRossDAO treasury if the bidding at auction went higher than the amount that had been raised (up to a secret amount). This was clearly designed to avoid the fate of ConstitutionDAO whose max bid was known to all other bidders.

Again, I note the word “donation” in the quoted paragraph above. I’m not sure if the means that PleasrDAO was donating free and clear all its contributions to FreeRossDAO, or whether they will get fractional shares pro rata, and I’m not sure how to look it up right now, but that would certainly factor into the securities law analysis a regulator might do.

In any event, FreeRossDAO won the auction yesterday and it’s going to be interesting to see what next steps they take. What worries me is that a regulator looking at all this might see not just a fractional ownership security, but also a fundraiser for a venture fund à la theDAO.

I’m putting all this out here because clearly this tech is letting the community do incredible things and I want folks to know what legal risks there are so they can stay safe. Staying safe means either avoiding doing things that are securities offerings, or offering securities in compliance with law and regulation. What does that look like? It’s not easy, but it’s doable.

Fractional shares of unique, high-price items like fine art, wine, and even race horses are nothing new. Masterworks has been doing this for some time with art. From what I can tell, the way they do it is they first create a Delaware LLC, then that LLC acquires a work, and then Masterworks sells shares in the LLC to investors. In doing so, they register the offering with the SEC. Here is Masterworks’s registration for their first offering: Andy Warhol’s iconic work, “1 Colored Marilyn”.

I know, it’s not easy, but please don’t shoot the messenger. If it was up to me there would be lots more exceptions to the securities laws.

OK that’s all I have this week. Please hit reply and let me know if you have any comments.

A couple of housekeeping items:

I’ve been prevailed upon to put these missives up on the web, but I’m doing so only after two weeks, so the only way to read the latest issue continues to be to subscribe. To that end, please forward this to friends you think might find it interesting.

Finally, a new episode of my book review podcast with Stably is out. We discuss The Uncontrollability of the World by Hartmut Rosa, which was great if depressing. Check it out.

Have a great weekend!

JB