With emerging technologies, the phenomenon of non-fungible tokens (NFTs) has swept across the several sectors at a fast pace and with force.
NFTs have left an indelible mark on the art, entertainment, commerce and finance sectors. This article focuses on the legal and regulatory environment for NFTs in the Israeli financial market, delving into the classification of NFTs as securities and financial assets and examining the legal consequences associated with initiating an NFT venture in Israel.
Finally, the article will assess whether NFTs are only a passing phenomenon or are here to stay.
NFTs as securities
The first question is whether NFTs fall within the scope of Israeli securities law. Classification of securities is applied on a case-by-case basis, adapting to a certain extent the well-known US Howey test, which also applies to the Israeli context.
NFTs could potentially be categorised as security tokens and classified as securities, especially given that they sometimes include representations or commitments from the issuer implying that purchasers can anticipate returns derived from the efforts of others.
Consequently, the offering and sale of these NFTs would be subject to stringent regulatory oversight. However, it should be noted that, to date, there has not been any apparent enforcement action in Israel against an NFT project claiming that it is in breach of Israeli securities law.
An initial legal analysis of NFTs in Israel presents several sound arguments as to why NFTs do not fall under securities law:
- Unique identity – at its core, each NFT should stand alone. Unlike traditional securities, no two NFTs should be alike, even if the digital creation process associated with the NFT is similar. This distinctiveness renders them non-interchangeable and thus non-fungible.
- Associated rights – Israeli securities law defines a “security” as an instrument that confers rights of membership, participation or a claim. NFTs in and of themselves are not intended to confer membership or participation rights, nor do they provide a right to claim against the issuing company.
- Subjective value – NFTs that embody art, music or registration of ownership are not meant to function as a medium of exchange. Their value lies primarily in the subjective assessment of the buyer. This value can stem from the right to use the digital creation as an owner or the ability to demonstrate ownership through blockchain technology.
- Expectation of profits – economically, possessing an NFT does not generate an expectation of profits from the efforts of others, as per the US Howey test. Unlike securities, the value in an NFT should be derived from the product itself and should not require additional contributions from the seller.
- Marketability and digital currencies – the fact that an NFT’s value may appreciate due to ease of marketability or its transferability does not categorise it as a security. Trading of NFTs is akin to trade in art, antiques, stamps, sports and cards, among other things. Although the motive might be profit, the transaction value hinges on the product itself and not on the creator’s future business activities.
However, despite these solid arguments and despite the fact that NFTs may not have the inherent features of securities, they may be turned into a form of security if they are used as financial products to generate expectation for profits by their issuers or sellers.
- promises for appreciation in value;
- emphasis on the capabilities of the team to push the project forward;
- application of a monitory policy to drive up value;
- creation of a market for the NFTs; and
- other methods that operate based on the value of the NFT and not the actual right or utility associated with it.
While there are no apparent cases related to NFTs in Israel, in a recent draft legislation put forward by the Israeli Securities Authority (ISA) for public consultation, the ISA proposed adding a definition of “digital asset” and “digital financial asset” to Israeli law.
This is usually done through various representations made by the initiators or backers of NFTs, such as:
These would be classified as financial instruments and would be subject to securities law. However, the draft amendment excludes non-fungible assets from the definition of “digital financial asset”.
Non-fungible assets are characterised as unique assets (ie, the same or similar units cannot be bought or sold). While this is still a draft proposal, it certainly provides an indication regarding the ISA’s view of NFTs and their classification under Israeli law.
NFTs as financial assets
While it is important to understand whether NFTs fall within the scope of the Israeli Securities Law, the offering and sale of NFTs may also fall under the Supervision of Financial Products (Regulated Financial Services) Law (RFS).
Businesses subject to the RFS are required to obtain a license from the Israeli Capital Market Authority. The applicability of this law depends on whether the sale of NFTs on a company’s platform in exchange for other digital currencies (eg, USDC) constitutes the provision of a service in a financial asset, as defined in the RFS.
Financial assets under the RFS can include various forms of assets, including virtual currency. Virtual currency is not defined in the RFS, but a definition can be inferred from an order detailing the anti-money laundering obligations of financial service providers.
In that order, virtual currency is defined as a “digital unit which can be digitally traded, transferred and used for payment or investment”. While there is little doubt that NFTs are digital units that can be traded and transferred, the issue is whether they are used for payment or investment.
Unlike many other cryptocurrencies, NFTs represent an ownership right in a digital asset (and rights attached thereto) and are not necessarily a tool for accumulating value. Their primary purpose is not to amass value, as they lack any face value and are effectively worthless without the associated digital creation.
Some would argue further that, while purchasers may acquire NFTs for trading and potentially for the purpose of making profit, the acquisition of NFTs is not solely driven by investment motives.
This is similar to the acquisition of items like sports cards, where the buyer’s intent may encompass both the investment and the inherent value of ownership. There is, therefore, some doubt as to whether NFTs would be classified as “financial assets”.
Even if NFTs were to be classified as financial asset under the RFS, the next step would be to determine whether a project that sells NFTs fulfils can be classified as a “financial service” under the RFS.
A distinction should be made here between a company that runs an NFT platform that facilitates the transfer, exchange or conversion of financial assets, and a company that only sells its own NFT creations.
While the first clearly includes the aspect of providing services to others and would therefore likely be deemed a financial services provider, the latter is more similar to a transaction between a retailer and consumer where there is no aspect akin to a financial service.
In that case, an NFT project selling its self-made NFT may not be obligated to comply with the various requirements of the RFS, such as maintaining an anti-money laundering policy, conducting know-your-customer (KYC) checks, and complying with reporting requirements the way other regulated financial services must do.
However, it should be noted that, while there may be no formal obligation to obtain a license, it would still be advisable for such a process to conduct KYC checks on its customers.
Stringent Israeli banking policies with regards to cryptocurrencies and various tax considerations, including value added tax, would probably lead to the conclusion that knowing who the customer is, even when it is a customer purchasing an NFT online, could be helpful when the company wants to pay its proceeds into a bank account or pay its taxes.
Comment
As Israel grapples with the legal intricacies of NFTs, the market moves at its own pace. From dozens of NFT projects in 2022, 2023 has only seen a few thus far.
The notion of making a quick profit has given way to the understanding that there must be more regulation involved.
Many projects that rode the wave successfully and managed to gather large communities of followers are now struggling to maintain these communities and are investing effort, time and resources into making sure their followers are satisfied, all with limited success.
That said, beyond the hype, NFTs may serve a concrete role in the banking and financial services. However, achieving this requires going back to the foundations of NFTs, such as the registration of unique ownership.
In the near future, there may be an emergence of projects (eg, land ownership registration rights, patent registration and distribution of music royalties) that are likely to spark the need to address these crucial aspects. These types of projects can utilise the inherent attributes of NFTs to solve real-world problems of ownership, transferability, efficiency and authenticity.
There are already encouraging signs of such projects in Israel, pointing to a more mature and probably more sustainable approach in the future. If the momentum is kept afloat, the future of NFT projects in Israel should undoubtedly be met by more regulatory clarity, which will enable them to thrive.
This publication was first published by Lexology.
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