Non Fungible Tokens: US legal issues to be considered

Article 07 June 2021 Experience: Technology

M. Ridgway Barker co-authored this article with Joseph Bambara, CIPP/US.

As we move forward into 2021, beyond the rise of cryptocurrency and decentralized finance, non-fungible tokens (NFTs) have also gained in popularity. Digital creators are utilizing NFTs to monetize digital creative works. The utility of NFTs is based on blockchain technology. Blockchains, as we all know by now, are permanent, immutable digital ledgers used to record transactions. Smart contracts are open-source code recording transactions executed on the blockchain. Smart contracts are stored in decentralized platforms such as GitHub providing transparency. They directly control the transfer of digital currencies or assets between parties under certain terms and conditions. Assets that are transferrable between two parties in the blockchain ecosystem are commonly referred to as “tokens”. The Ethereum blockchain platform has standards that enable the issuance of tokens, i.e., tokens can be assigned specific uses and properties. Within Ethereum, the ERC-20 token standard is used for fungible tokens and the ERC-721 token standard is used for non-fungible tokens. The tokens exchanged in the transaction have properties demonstrating the provenance of a digital asset. Bitcoin or other cryptocurrency tokens using the Ethereum ERC-20 standard are identical and are readily exchangeable for equal value (i.e., they are fungible). An NFT is non-fungible. In other words, an NFT represents a one-of-a-kind asset. NFT’s when minted contain a unique identification code and metadata that distinguishes one NFT from any other. An NFT is also a digital certificate of ownership for any designated digital asset. The majority of NFT’s reside on Ethereum. NFTs “smart contracts” use these attributes to enforce limitations on the use of the NFT by a purchaser, provide for automatic royalty payments from resale transactions, and prove ownership. It is worth noting that there are other token standards such as the ERC-1190 that provide additional functionality for more complex NFTs. They have been proposed and are waiting to be approved by Ethereum’s governing committee.

Before the recent surge in the use of NFTs, creators faced limitations on the revenue that they could generate from their works. Copies could be made an infinite number of times and distributed throughout the internet with no loss of quality. However, NFTs and the ERC-721 token standard facilitate the generation of unique and finite tokenized versions of digital creative works ensuring that the digital creative work cannot be counterfeited. For example, NFT creators can set both the sales price and the maximum number of replicas of the digital creative work that can be sold. This allows the NFT creator to perpetuate the scarcity of their asset like a lithograph that grows in value because of its exclusivity and the limited number of prints. NFTs can also spare creators from losses related to piracy since NFTs cannot be replicated. NFTs also provide for the improved ease of transferring digital creative assets over traditional sales models since NFTs can be sold on any NFT market or peer-to-peer, without the need for an intermediary. While the excitement relating to NFTs is growing exponentially and on a global level, the legal treatment of NFTs continues to evolve and is unsettled. Here we will examine some of the issues and their status.

How is NFT hosting and storage accomplished? The creation of an NFT can be broken into two parts. First, there is the blockchain which handles the minting and accounting of the NFT. The second is the NFT’s data storage. Blockchains are not the right place for storing large amounts of data because it is extremely expensive to replicate large amounts of data across thousands of computers. The NFT contains information, i.e., a link to where the digital asset is located. However, if the digital asset is deleted or the server hosting it fails or otherwise goes offline, the link will break and the NFT that remains will be worthless because it would no longer be associated with the digital asset. Since the NFT is unique and cannot be replaced, the NFT purchaser might be left without recourse. Based on the use of the specific NFT, this can result in business interruptions, regulatory record-keeping violations, and loss of data. A remedy is available today using decentralized storage. The InterPlanetary File System (IPFS) is a protocol and a peer-to-peer technique and trusted data store for sharing large files and removing the possibility of censorship or unilateral deletion. The combination of distributed computing and content-based addressing makes IPFS both highly performant and reliably persistent. The smart play is to use IPFS and place the immutable IPFS hashes into a blockchain transaction to timestamp and secure NFT content without having to put the data on the chain itself.

How are NFT Royalty Payments handled? As mentioned, the majority of NFTs reside on the Ethereum blockchain (other platforms include Wax and Flow) When creating an NFT on a particular platform, the creator designates the amount of royalty they should receive with each secondary sale. A creator can configure the smart contract that administers the NFT, but the existing ERC-721 standard has some limitations. It does not provide for platform interoperability for paying a royalty. In most existing implementations, that royalty payment will only happen when the work is sold on that same platform. That since royalty payment implementations are not typically compatible with the other platforms across the entire NFT ecosystem. As NFT development matures it will need to address this interoperability across platforms.

What are NFT owners Intellectual Property Rights? The NFT’s usefulness when it comes to IP rights is limited. Ownership of an NFT does not translate into ownership of an original work. In other words, buying an NFT does not mean that one is buying the underlying IP rights in a given content. A copyright owner has exclusive rights in reproducing and preparing derivative works. See, Section 106 of the US Copyright Act. They also have exclusive rights in distributing the copyrighted work. Buying an NFT does not mean that the copyright to that artwork transfers to the buyer. From the perspective of copyright, an NFT is a digital receipt showing that the holder owns a version of a work. The NFT marketplace Dapper Labs established an NFT license to resolve IP rights. This was important as it informed users that with NFT, they do not buy the copyright. Users are buying only a form of licensed content. An NFT license is suggested as a contract that buyers and sellers can use as they deem appropriate. An area where NFTs currently generate significant impact is in the world of art. Virtual images with their unique codes can be sold to buyers. Aside from ownership, the digital art linked to an NFT minted online can be traded in different marketplaces. Here, NFTs have a major impact. As mentioned, NFTs provide a form of authenticity to digital art. As a unique token, it can be used to tag specific works of art. NFTs create an online canvas where a digital artist can share a new genre of performative artworks. It is the nature of the NFT as a unique token that provides this sense of authenticity to digital art. This is valuable these days when forged art is proliferating online.

What is NFT Fractionalization? Given that some NFTs are selling for significant amounts of money, the fractionalization of the asset (f-NFT) would allow smaller investors to purchase interests of an NFT. New entities have emerged to facilitate the sale of f-NFTs. The NFT trading platform Niftex allows owners to break NFTs into shards, a piece or fragment of an NFT, for purchase at a fixed price, with the fractions able to be subsequently traded in the market. The site also allows shard owners governance rights on the platform. With fintech platforms, decentralized finance (DeFi), and decentralized applications on the rise (see, https://www.withersworldwide.com/en-gb/insight/defi-decentralized-finance-is-on-the-rise), the continued fractionalization of NFTs is inevitable. The development of f-NTFs brings to bear the concern that they may be securities. Such efforts to build up the market and value surrounding f-NFTs will raise flags with financial regulators. Efforts to create fractural interests will raise questions about whether f-NFT’s look like an investment product that regulators could classify as a security under the Howey test. As SEC Commissioner Hester Peirce stated during the recent Security Token Summit 2021, if someone wants to place numerous NFTs into one basket and sell F-NFTs or take one NFT and sell shards, then “you better be careful you’re not creating something that’s an investment product, that is a security.” Under the Supreme Court’s Howey test, the standard definition of what is an investment contract, and thus, a regulated security, is where an individual invests money in a common enterprise and reasonably expects profits to be derived from the entrepreneurial or managerial efforts of others. The evaluation of whether NFTs and f-NFTs fit in this context is an issue that may be resistant to easy answers, as it is a case-by-base determination given the economic realities of each transaction. The SEC’s views will evolve, and uncertainty about whether NFTs or f-NFTs are securities is likely to persist without more specific guidance from the SEC or the courts.

In conclusion, NFT’s are here to stay. In fact, considering that the current transfer of real estate ownership is labor-intensive and expensive, it is likely that NFTs will be applied to solve these transfers. By “tokenizing” property rights, it will facilitate their sale and maintenance. Imagine that one could buy real estate as an NFT, and instantly borrow against the NFT using DeFi products with a great interest rate. Why would one ever go through the months of due diligence for a traditional bank loan? Ultimately, laws and regulatory action will need to address these issues allowing fungible and non-fungible digital assets (NFT’s ) to provide censorship resistance, worldwide participation, and the elimination of trusted third parties within the decentralized ecosystem. As it matures, the underlying blockchain infrastructure applied to NFT’s will provide performant, inexpensive transactions/settlement, immutability of contracts, and execution of smart contracts to handle ownership, authenticity, certification, governance, royalty payments, and a host of other ecosystem functionality. The decentralized ecosystem transparency will support and provide price and market efficiency. Decentralization will grow via the network effect, as the rise of innovation, performance and resulting participation will elevate a vibrant global ecosystem of applications.

Our Withers attorneys can assist and educate clients from a legal and technical standpoint to incorporate these emerging technology trends safely and efficiently to help your businesses stay ahead of the competition. Please contact your regular Withers attorney or the author of this piece with any questions.