In all three cases, the NFTs had a utility value meaning they could also be used for a specific purpose on the platform of the issuer or appreciated as art. Having both a utility value and characteristics of financial investments, make these hybrid tokens. But the line between utility and investment is not that clear, and it’s edges are in the eyes of the regulator as it applies the Howey test.

Flyfish Dining Club

Flyfish Club introduced a novel approach to exclusive dining by offering NFTs as the only way to gain access to its restaurant and bar. These NFTs, stored on the blockchain, grant owners the right to membership, which include the ability to dine at the restaurant once it opens. While food and drink would still need to be purchased separately, holders of a more expensive Omakase NFT would also receive access to a private room for a premium dining experience. Not only could the NFTs be resold or leased to others, but Flyfish earned $2.7 million in royalties from these secondary market transactions.

The company initially created about 3,000 NFTs and sold over half, with prices set at $8,400 for standard NFTs and $14,300 for the Omakase versions, raising $14.8 million in the process. The remaining NFTs were held back for future sales. The broader vision of Flyfish Club was to build more than just a restaurant. The vision was to create an expansive network of social experiences, including multiple clubs and unique events, making the NFTs central to both membership and a larger, lifestyle-driven concept.

The SEC views Flyfish as selling more than access to a dining experience also. They see it as offering an investment opportunity. The SEC determined that Flyfish led investors to believe they could profit from the appreciation of NFT values in the secondary market or by leasing them out as a form of passive income. These characteristics are reminiscent of investment contracts. Also, the NFTs traded actively on secondary markets, with Flyfish collecting a 10% royalty on each transaction until February 2023.

As a result, the SEC concluded that the Flyfish NFTs met the definition of securities under the Howey Test. The SEC found that investors purchased NFTs with the expectation of profiting from Flyfish’s entrepreneurial and managerial efforts in building and operating the restaurant. That the NFTs have a value beyond gaining membership and access to a private social dining club. Thus, the SEC determined that the sale of Flyfish NFTs constituted an unregistered securities offering, violating Sections 5(a) and 5(c) of the Securities Act of 1933.

However, this enforcement action was not unanimous. Commissioners Hester Peirce and Mark Uyeda dissented, raising concerns about the application of the Howey test and its application in this case. Both Commissioners argued that the Flyfish NFTs were primarily marketed for their utility - exclusive access to the club - rather than as traditional investments. They expressed concern that expanding the definition of what constitutes a security in cases involving membership models, like Flyfish, could stifle innovation in the rapidly growing NFT space.

Critically, the dissent also highlighted the broader issue of subjectivity in applying the Howey Test. Commissioner Peirce and Commissioner Uyeda questioned the need for enforcement, especially since the NFTs had already been actively traded and many buyers clearly understood the unique benefits tied to club access. They likened the SEC's regulatory approach to NFT’s namesake dining experience, stating,

"For curmudgeonly commissioners like us, crypto enforcement feels a bit like a trip to a restaurant for a meal, Omakase style. Omakase translates to, ‘I’ll leave it up to you.’ This directive is wonderful in the hands of a renowned chef, but disastrous in the hands of a crypto-obsessed Commission... Today’s settled enforcement action with Flyfish Club for its sale of non-fungible tokens (“NFTs”) is just the latest dish that undermines trust in Chef SEC."

https://www.sec.gov/newsroom/speeches-statements/peirce-uyeda-statement-flyfish-091624

Flyfish highlights one of the inherent criticisms of the Howey Test- its subjectivity. The decision to classify Flyfish’s NFTs as securities rests on an interpretation of investor expectations and the nature of the asset. While the SEC viewed Flyfish’s NFTs as investment vehicles, the dissent argued that the primary value lay in the utility of membership access. This subjectivity raises important questions about whether a test from 1946 remains suitable for assessing digital assets in today’s market. By applying the Howey Test in such a broad manner, the SEC risks capturing innovative business models -like Flyfish’s -that were not designed with traditional securities regulations in mind.

Flyfish has agreed to cease and desist from future violations and to implement a series of compliance measures, including destroying all NFTs in its possession, publishing notice of the settlement, and paying a civil penalty of $750,000.

The dissent reminds us that the regulatory application of securities laws to emerging technologies like NFTs is still evolving, and the line between utility and investment is not clear. As we continue to navigate these regulatory waters, staying informed and compliant while advocating for regulatory clarity remains key to supporting innovation without overreach.

Subjectivity of the Howey Test in Hybrid NFTs

The subjectivity of the Howey Test becomes more pronounced when applied to hybrid NFTs, which are those tokens that have both utility value and investment characteristics. In these cases, where NFTs can be used for something tangible like exclusive club access, but also traded for profit, deciding which aspect defines the transaction is a matter of interpretation. This raises a critical question of who decides whether the buyer was motivated by the utility the NFT offers or by its potential to appreciate?

It is the SEC making this determination, but this process inherently involves subjective judgment. If the NFT is marketed with an emphasis on resale value or “passive income,” the SEC is more likely to classify it as a security. However, if the focus is primarily on the practical use of the NFT—like accessing exclusive dining experiences—the argument could be made that the NFT is primarily a product, not an investment. But as in the Flyfish case, the NFTs are both.

The dual nature of hybrid NFTs complicates the analysis because buyers themselves may have mixed motivations. While some may purchase purely for utility, others could view the NFT as a financial opportunity. The difficulty in gauging intent adds another layer of subjectivity to the process.

The Flyfish case highlights the need for clearer regulatory frameworks that can address this duality without stifling innovation. The safest course in terms of regulatory risk would be to avoid issuing hybrid tokens, but this is a little akin to the tail wagging the dog. The application of a test developed in 1946 to the NFT space, where utility and investment overlap, creates significant challenges for both businesses and regulators. Companies must tread carefully when designing and marketing hybrid NFTs and understand they may be entering a regulatory gray area.

The Flyfish Club case serves as a reminder that while innovation drives progress, navigating regulatory complexities with care and foresight remains crucial for businesses looking to thrive in the digital asset space.

De Silva Law Offices regularly provides guidance to clients on the legal treatment of all types of NFTs under U.S. law, considering their unique characteristics, sales, and distributions. We are well-versed in securities and blockchain regulations and can assist you in navigating this nuanced legal landscape, ensuring your business stays compliant and informed. The value of compliance in this space cannot be overstated.  For questions or guidance, contact us.