SEC Issues Wells Notice to Blockchain Gaming Venture: Insights from Sheppard Mullin Richter & Hampton LLP

The U.S. Securities and Exchange Commission (SEC) has made a notable move in its regulatory examination of blockchain gaming initiatives by issuing a Wells notice to CyberKongz, a leading NFT gaming platform. This event highlights the rising friction between blockchain creators and federal authorities regarding the intersection of NFTs, utility tokens, and securities regulations. Refer to this link for our analysis of some prior SEC NFT enforcement actions.

SEC Focuses on NFTs and Utility Tokens

On December 16, CyberKongz disclosed in a post on X (previously known as Twitter) that the SEC’s Division of Enforcement had approached the project with an alarming communication: blockchain games that include an ERC-20 token alongside NFTs are required to register the token as a security.

A Wells notice serves as a formal alert indicating the SEC’s plans to contemplate enforcement actions founded on its findings. Recipients generally have 30 days to reply to the notice, after which the SEC might opt to pursue formal charges. CyberKongz cautioned that this action could have extensive repercussions for the blockchain gaming sector, especially for ventures that combine NFTs with utility tokens.

Overview of CyberKongz and its Banana Token

CyberKongz originated as a distinctive and randomly generated collection of 1000, 34×34 pixelated NFT gorillas, now referred to as the Genesis Collection. CyberKongz were pioneers in introducing and popularizing various innovative NFT features, including unique tokenomics for their utility token $BANANA, which facilitated breeding and the creation of Babies. Each Genesis Kong yields 10 $BANANA daily until March 18th, 2031. The overall amount of $BANANA generated for the entire collection over the 10-year agreement is 36,500,000 $BANANA. Anyone holding two Genesis Kongz in their wallet and burning 600 $BANANA is entitled to receive an incubator for breeding a baby. Each baby is distinct and possesses randomized items with varying rarities. The project also incorporates numerous other imaginative elements.

According to its website: “CyberKongz is motivated by community, utility, and naturally the primary life source of any ape, $BANANA! $BANANA operates as the utility token that powers the CyberKongz ecosystem. It is NOT intended as an investment and holds NO economic worth.”

However, the SEC does not prioritize such disclaimers. Instead, it emphasizes the entirety of the facts and circumstances as well as the economic realities surrounding any tokens.

CyberKongz Responds Defensively

In their reply, CyberKongz conveyed its intention to contest the SEC’s view. The project also criticized the SEC for what it termed a “complete lack of comprehension of blockchain technologies,” pointing to “unjust accusations and inaccuracies” that have characterized the agency’s dealings with the blockchain sphere. CyberKongz reiterated the necessity of defending against the SEC’s perspective for the benefit of the broader blockchain gaming ecosystem.

Looking Ahead: What’s at Risk?

The CyberKongz Wells notice illustrates the hurdles faced by blockchain initiatives as they maneuver through the SEC’s shifting enforcement strategies. Should the SEC’s stance be validated, it could establish a precedent mandating NFT gaming platforms that integrate utility tokens to register those tokens as securities.

The SEC is not the sole federal authority monitoring blockchain gaming. The Consumer Financial Protection Bureau released a report regarding Banking in Video Games and Virtual Worlds, cautioning of heightened scrutiny and enforcement regarding financial services in games resembling conventional banking and payment systems. Refer to this link for our critique of the report.

As the dispute between CyberKongz and the SEC progresses, the case is likely to attract considerable interest from the blockchain community, regulators, and legal analysts alike. For the time being, CyberKongz is preparing to safeguard its project and principles in what may become a critical case for the blockchain gaming industry.

Blockchain gaming firms with uncertainties regarding whether NFTs they have issued or plan to issue may implicate securities regulations should consult a knowledgeable attorney, informed by the specific details of their offerings. In certain situations, particular actions can be taken to reduce the enforcement risk.