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Digital Artists Launch Pre-Enforcement Challenge against the SEC
What Happened?
Last Monday, Jonathan Mann and Professor Brian L. Frye filed a complaint against the Securities and Exchange Commission (SEC) preemptively challenging the agency’s jurisdiction over NFTs. Jonathan Mann is a well-known and record-breaking artist, known on social media as @songadaymann, creating, as the name suggests, a song a day. Brian L. Frye is a securities law professor at the University of Kentucky and is known for creating the work known as the “SEC No-Action Letter Request.” Following the recent SEC enforcement actions brought against NFT projects, such as Stoner Cats and Impact Theory, the plaintiffs seek declaratory judgment that their respective NFT projects are not securities offerings within the jurisdiction of the SEC.
The complaint attacks the SEC’s overbroad application of the Howey test because it improperly expands the definition of an investment contract under Howey to include a broad range of artistic activities and products, including “all digital art represented by NFTs regardless of the context in which they are offered and sold.” Plaintiffs also criticize the SEC’s “ecosystem” theory, arguing that every seller of art builds an “ecosystem” around their artistry — e.g., by doing performances at venues, book tours, merchandise sales, or any other acts in benefit of their brand — and doing so is “typically integral to artists’ livelihoods.”
Using Taylor Swift as an example, the plaintiffs argue that the SEC’s lack of guidance and fuzzy “ecosystem” theory could be applied to Swift’s offerings of merchandise, music, concert tickets, among other aspects of the brand and “ecosystem” Swift has created. For instance, buyers of Swift concert tickets may reasonably expect profit from secondary market sales, the value of which increases due to Swift's managerial and entrepreneurial efforts through concert management and advertisement. Moreover, ticket purchasers could be seen as having their fortunes intertwined, as the value of tickets of the same category rise and fall with Swift’s actions. As plaintiffs explain, the case for concert tickets qualifying as securities is cognizable under the SEC’s theory.
What does this mean?
Without clear guidance surrounding SEC jurisdiction, NFT artists are left without reasonable rules of the road and have to fear potential enforcement actions by the SEC. It does appear that the SEC has a particular problem with digital art and assets, a point highlighted by Chair Gensler’s comment about Pokémon cards before the House Financial Services Committee in 2023. This complaint seeks to provide clarity — at least for the projects Mann and Frye seek to issue.
As to the specifics of the arguments made here, analogs between collectibles are not new to SEC litigation. Beanie Babies made their debut in the action between Coinbase and the SEC and was met with skepticism both from the court and the SEC. However, the expansion and application of the SEC’s “ecosystem” theory does provide new grounds for the court to analyze. As far as next steps, the industry will wait on the SEC’s response to the complaint.
Litigation Continues on SEC’s Dealer Rule
What happened?
Last week, the Blockchain Association (BA) and the Crypto Freedom Alliance of Texas (CFAT) filed a combined reply brief in support of their motion for summary judgment and opposition to the Securities and Exchange Commission's (SEC) cross-motion for summary judgment in their ongoing challenge to the SEC’s recently finalized Dealer Rule. BA and CFAT originally filed their lawsuit in April 2024, arguing that the SEC’s Dealer Rule strays dramatically from the long-standing and well-settled meaning of the term originally established in the Securities Exchange Act of 1934.
As we’ve previously explained, the Securities Exchange Act defines a “dealer” as any person engaged in the regular business of buying or selling securities for that person’s own account through a broker or otherwise. The Exchange Act also creates a clear distinction that dealers are those persons who engage in this activity as a part of their regular business. This provision is commonly referred to as the “trader exception,” which excludes persons engaging in trades not as a primary business.
The SEC’s amended definition of “dealer” shifts the test from looking at regular business to one that hinges on whether participating in trades has the effect of providing liquidity to other market participants. The new rule comes with two tests to determine if someone is a dealer: whether a participant regularly expresses trading interest at or near the best available prices for a security on both sides of the market, or whether a participant earns revenue mainly from capturing the spread on securities prices or incentives offered by trading venues for providing liquidity.
The plaintiffs argue in their combined reply brief that the SEC fails to overcome two fundamental problems with the amended Dealer Rule. First, they argue that the rule’s redefinition of "dealer" conflicts with how Congress defined the term in the Exchange Act. Second, they argue that the SEC applied its new definition to the digital asset industry without adequately explaining why it is appropriate, given the unique nature of digital asset markets. As stated in the plaintiffs’ brief, Prometheus Radio Project v. FCC established that the Commission must “reasonably explain” the need for the change. The plaintiffs assert that the Commission’s explanations fall short of the required standard as it relies on post hoc rationalizations deemed unreasonable by the Supreme Court in Motor Vehicle Mfrs. Ass’n of U.S., Inc. v. State Farm Mut. Auto. Ins. Co. Additionally, the plaintiffs argue that the Commission failed to adequately respond to comments from the digital asset industry. Therefore, the plaintiffs contend that the Dealer Rule violates the Administrative Procedure Act (APA) because it is arbitrary and capricious, as it fails to meet the statutory requirements for reasoned decision-making and adequate explanations.
What does this mean?
The SEC’s Dealer Rule is dangerous for DeFi participants. As we argued in our comment letter to the SEC back in 2022, the proposed definition for “dealer” exceeds the statutory authority granted by the Exchange Act. Furthermore, the lack of clarity and precision in the new definition will lead to legal uncertainty and arbitrary enforcement. We appreciate the continued efforts of CFAT and BA to strike down this overreaching and impractical rulemaking.
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