Welcome to the world of fractionalized art ownership. Located at the intersection of NFTs, finance tech bros, and easily digestible modern and contemporary art, here you can fulfill your dreams of owning blue-chip artworks while simultaneously hedging your investments in your college friend’s overhyped tech startup. Well, sort of... Fractionalized art ownership is a new kind of alternative investing that has recently emerged in the past few years with the overall goal of democratizing the traditionally secretive art market. It comes in the form of digital platforms like Masterworks.io and utilizes blockchain technology to tokenize ownership of artworks which can then be divided among many different owners through NFTs. So while you can own a blue-chip artwork, it’s only a portion of it, meaning you won’t be able to hang it up and show it off to your art school friends. The idea of Masterworks.io and other platforms offering fractionalized art ownership, is that by dividing ownership of an artwork into digital shares, people who traditionally wouldn’t be able to invest in art due to the art market’s high barriers to entry, now have a chance at dipping their toes in the multi-billion dollar art market by benefitting from price increases in blue-chip artworks. Now with fractionalized art ownership, you no longer have to have an extra million dollars laying around to invest in a single artwork. So how does all this work? How is it legal? And where can you get started investing? The rest of this paper answers these questions by exploring relevant securities regulations surrounding the legality of fractionalized art ownership platforms.

Generally speaking, fractionalized art ownership operates in a way that’s analogous to owning a share of a public company’s stock, so trading digital shares of artworks is equal to trading securities that have been defined as investment instruments in the form of debt or equity. This means that investors in these digital shares of artworks who use American platforms such as Masterworks.io are protected by the laws and legislation governing security transactions. There are two regulations fundamental to these laws, the Securities Act of 1933 and the Securities and Exchange Act of 1934, which formally established the Securities and Exchange Commission. The 1934 act regulates transparency in the securities market and ensures a fair environment for investors by requiring all companies being publicly traded on the stock exchange to follow guidelines around registration, disclosure, and audit requirements. The 1933 act highlights full and fair disclosure from the seller by requiring sufficient information from them so that potential investors can make informed and confident investing decisions. This act allows for the SEC to audit companies who submit registration statements, taking into account a scope of various factors such as the method of the offering, a description of the securities offered, financial statements certified by independent accountants, and information about the management of the issuer and key personnel. Additionally, the 1933 act clearly defines a “security” as an “investment contract” and says that transactions qualified as “investment contracts” must meet the requirements of the 1933 act, but what exactly determines whether or not a transaction falls under an “investment contract?” Well, according to the SEC, the answer falls more on how the contract is set up rather than what’s being sold and bought. Let’s examine this act in relation to the 1946 Supreme Court Case SEC v. W.J. Howey Co. to understand the parameters for investment contracts and to illustrate how fractionalized art shares fall within this definition.

Howey was a Floridian company who financed the development of future citrus groves by selling a portion of the land they owned for a uniform price per acre to prospective investors in the form of real estate contracts. The contracts they offered were set up in such a way that the investors who bought the land agreed to lease back the land to the company with the understanding that the investors themselves didn’t have the knowledge and resources necessary to grow citrus trees. In 1946 the SEC sued Howey for not registering with the SEC, and the case eventually made it to the Supreme Court, where the Court sided with the SEC, establishing a new standard for determining whether or not a transaction is classified as an investment contract. This new methodology known as The Howey Test says that a transaction is an investment contract if an investor invests money “in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party” (Securities and Exchange Commission v. Howey Co., 328 U.S. 293 (1946)). The test can be broken down into three essential elements fundamental to all investment contracts: 1. an investment of money, 2. the investment of money is in a common enterprise, and 3. there’s an expectation of profits that are to be derived solely from the efforts of others (not the investors themselves). So even though factionalized art sales don’t come in the traditional form of a stock or bond, they are still classified as investment contracts because they involve investments of money in a common enterprise, the artwork in this case, with the expectation of profits. In other words, they pass The Howey Test and can be qualified as security transactions meaning that platforms like Masterworks.io have to comply with the requirements of registering with the SEC and providing sufficient information about the present market value of the artwork being sold, the provenance of the work, background about the artist, and information about potential market returns.

Masterworks.io is one of the popular online platforms offering fractionalized art ownership services for as low as $20. It was established in 2017 with the focus on blue-chip artists, artists who have a record of proven market value such as Warhol, Basquiat, and Haring, rather than emerging talent. They started off by purchasing Warhol’s 1 Colored Marilyn for $1,815,000 in November 2017 at an auction and later in 2018 they filed an offering document with the SEC to sell joint ownership of the piece to about 1,300 investors. On behalf of the co-owners, Masterworks manages and stores the artwork privately for a 1.5% per year management fee. If co-owners want the painting to be sold before the agreed amount of time set by Masterworks, they have to reach an agreement through majority wins voting, and no shareholder can own no more than 10% of any given work. Each time an artwork sells, Masterworks keeps 20% of the profit. While the painting is sitting in storage and increasing in value, the co-owners also have the opportunity to trade their shares on a trading platform. This entire process is done using blockchain technology where a virtual representation of the artwork is created on a blockchain and its ownership is then split up among different people using NFTs. These NFTs equate to digital shares of the artwork and can be bought with cryptocurrencies. Since the blockchain’s record is permanent, verifiable, and public, you can always trace the ownership of the NFT to validate it, as well as see all the relevant information about the work such as provenance, storage method, location, insurance, condition, and independent valuation.

With securities laws in place to protect investors, fractionalized art ownership platforms redefine the old notion of fine art as a risky investment and offer more opportunities for people outside of the fine art world to invest in art. But there’s still a lot of quirks to be worked out before it becomes a sound investment opportunity for everyone. Most of the platforms are created by people with no background in art, which creates a lot of room for oversight problems.

The use of blockchain technology, NFTs, and cryptocurrencies poses additional problems in volatility. And since the fractionalized art ownership market hasn’t been around for that long, there’s not enough data to accurately estimate how much your potential returns could be. It could be anywhere from making enough returns to actually buy the piece you only had a small fraction of ownership in, to losing it all.