Bursting The Bubble of NFTs (Legally Speaking)
Collective emotional reaction to the pandemic or new big digital market segment?
Would you pay a hefty sum to own a video, photograph or digital artwork that everyone can view online and even download for free and legally?
Would you pay to see a tweet that you can download (and retweet) for free??
Think about a book signed by the author, which has additional value compared to an identical unsigned copy, and you might think about it more than once.
What are NFTs and why have they attracted market interest?
Non-fungible tokens (NFTs) are certificates of ownership stored on a blockchain backed by blockchain technology (primarily Ethereum and Bitcoin) that are typically associated with a digital asset, such as visual art, videos, music or collectibles. Each NFT is unique or "non-fungible" and cannot be erased or counterfeited (although another NFT could be created by copying and repainting the same underlying artwork). This differentiates them from other virtual assets, such as cryptocurrencies, and even from any fiat currency such as the U.S. dollar.
The particularity of NFTs is due to their limited or scarce nature. Although digital works, by their very nature, can be copied, recreated and replicated infinitely, although NFTs do not change that, they are capable of generating a unique digital record that authenticates ownership of a particular version of a digital work (usually one that the creator himself holds as the true version). Anyone can view Beeple's "Everydays: The First 5,000 Days" and multiple copies of the work exist, but only one person can claim ownership of the version authenticated by the artist himself.
NFTs disrupt the traditional art marketplace
NFTs create new revenue possibilities for artists, who have been experiencing increasing constraints, from illegal reproduction, counterfeiting or piracy, high fees, a saturated chain of intermediaries or the need for physical interaction, etc.
- The ERC-721 token standard ensures that digital creative work cannot be counterfeited or pirated.
- NFT creators can set both the selling price and the maximum number of replicas of the digital creative work that can be sold.
- NFTs can be sold on any NFT marketplace or peer-to-peer, without the need for an intermediary.
This phenomenon has obviously created a number of novel legal issues and implications
Legal issues surrounding NFTs
The creation, distribution, ownership and trade of CLTs are new phenomena that raise a plethora of legal issues, many of which are ambiguous or unresolved.
i.) Copyright and intellectual property:
When you buy an NFT you are not buying the digital work itself. You are simply purchasing a collection of code or metadata, which links to the "true" version of that work. This metadata is written to the blockchain and contains information about where the original work is located and to whom that particular version of the work belongs. This does not prevent anyone else from downloading and viewing the digital artwork.
Therefore, the copyright of the digital artwork is not acquired. The rights of NFT holders are generally simply to own, sell, lend or transfer the NFT itself depending on the particular terms of the digital marketplace in which the sale and purchase takes place.
In this area the most complex issues arise when someone creates and sells an NFT of an existing work over which he or she has no ownership rights, either in the work itself or in the copyright in the work.
Under copyright law, once copyright has expired and a work has entered the public domain (e.g., in the UK, 70 years after the artist's death) there is nothing to prevent anyone from making a copy of the work and then marketing that copy (through NFT or otherwise).
But where a work that is not in the public domain, copying it, even by NFT, could give rise to copyright infringement, especially if the process of creating and selling the NFT involves making a digital copy of the underlying work.
Then there are the moral rights of an artist, both the right to have his or her work attributed and the right to object to its denigrating and offensive treatment. Even in the conventional art market, there is very little case law in these areas, so how these cases might play out in the digital world is currently a matter of mere speculation.
These rights are typically country-dependent, whereas NFTs can change hands without jurisdictional limit through digital marketplaces. Add in the anonymity behind blockchain technology, and it is typically more complex for those involved in an NFT transaction, and especially the buyer, to enforce any form of intellectual property or contractual rights in the event of an eventual infringement.
In this regard, it is imperative to conduct rigorous due diligence. Specifically:
- Verify whether the seller is actually the creator of the work, holds title to it and has obtained permission from any third party whose IP is present in the digital work
- Check the terms and conditions of any platform to ensure the characteristics of the digital asset for sale.
- Check that both the artist and the site hosting the digital asset are reputable.
- Check whether the digital artwork itself, which is attached to the NFTs, may be hosted on the servers of a third-party website, and is not secured on the blockchain. This because if the website were to go down for any reason, the NFT would end up attached to nothing and, as a result, would likely lose its value and become redundant
ii.) Smart Contracts:
Smart contracts govern NFT sales. These are digital contracts where the terms of the agreement are written in code and embedded within the purchase tokens. SMART contracts are typically programmed to operate automatically when a set of predefined conditions are met. For example, the SMART contract code might automatically make royalty payments to the creator upon resale of the NFT. The code itself is permanently minted into a token on the blockchain, so it cannot be replaced, deleted or modified. The programmed nature of SMART contracts reduces the level of distrust required between contracting parties, as the contractual terms will be automatically executed upon a triggering event, such as the making of a payment.
The operation of smart contracts should ensure that there are no legal disputes over the terms and execution of the contract. However, there is virtually no case law, legislation or regulation addressing SMART contracts. This raises doubts as to whether SMART contracts are actually legally binding. Additionally, SMART contracts will generally work in conjunction with the text-based terms and conditions of the particular digital marketplace, so these will need to be considered as well.
iii.) Money laundering regulations:
Given the exorbitant sums being spent in the NFT market, and the widespread use of cryptocurrency, concerns have arisen as to whether these transactions are being used to circumvent the increasingly stringent anti-money laundering regulations being implemented around the world. It is of note, coincidence or not, that the popularity of NFTs has coincided with the application to the conventional art market of anti-money laundering regulations for the first time (at least in Europe).
The EU's Fifth Anti-Money Laundering Directive (5AMLD) subjects all "art market participants" (i.e. anyone involved in the sale or purchase of works of art worth more than €10,000) to a plethora of new obligations. The most prominent is the obligation to conduct Customer Due Diligence (CDD) to verify a buyer's identity and source of funds prior to any transaction.
Interestingly, it is far from clear whether NFTs fall within the scope of the regulation. While the EU expanded its AML regulatory framework to include "virtual currency exchanges" and "custodial wallet providers" through its implementation of the AMLD5 in 2018, it did not define specific regulations for NFTs, most likely because NFTs, while well known to cryptocurrency enthusiasts, were not being widely used.
However, on September 24, 2020, the European Commission adopted a digital finance package that includes a legislative proposal for the regulation of cryptoassets, the Cryptoasset Markets Regulation (the "MiCA Proposal").The MiCA Proposal includes regulations that would apply to NFTs in certain cases and defines for the first time in the EU a cryptoasset as a "digital representation of value or rights that can be transferred and stored electronically, using distributed ledger technology or similar technology."
The MiCA proposal aims to comprehensively regulate cryptoassets that were not yet covered by EU financial legislation. The MiCa Proposal generally refers to three main categories of tokens (asset referenced tokens, e-money tokens and other cryptoassets), with different requirements for each in terms of licensing and issuer operations. Under Title II of the MiCa Proposal, NFTs would likely fall into the "general" category of "Other cryptoassets."
Under the MiCa Proposal, issuers of other cryptoassets - i.e., cryptoassets that are not asset referenced tokens or e-money tokens - have no specific licensing obligations, but are required to be a legal entity (which may be established outside the EU) and to meet certain governance and business conduct requirements.
The latter category would be subject to regulations regarding admission to trading on a trading venue and authorization of related service providers, as well as market abuse rules for related firms. However, the MiCA Proposal exempts issuers of "cryptoassets [that] are unique and not fungible with other cryptoassets" from the requirement to publish a white paper for public offerings. This exemption would likely extend to NFTs. Notably, this exemption is the only place in the MiCA proposal where cryptoassets that are "unique and non-fungible" are specifically mentioned.
iv.) Hosting and data storage:
An NFT and the digital asset it represents are typically stored separately. The NFT is stored on the blockchain and contains information about the location of the digital asset. The NFT is connected to the digital asset through a link. However, if the digital asset is deleted or the server hosting the digital asset fails or goes offline, the link will be broken and the remaining NFT will be worthless because it will no longer be associated with the digital asset and there will be no way to back up the NFT. Since the NFT is unique and cannot be replaced, the purchaser of the NFT could be left without these resources. Depending on the use of the specific NFT, this can result in business interruptions, regulatory record violations and data loss.
Today there is a remedy using decentralized storage. The Interplanetary File System (IPFS) is a peer-to-peer protocol and technique and a trusted data store for sharing large files and eliminating the possibility of censorship or unilateral deletion. The combination of distributed computing and content-based addressing makes IPFS high performance and reliable persistence. The smart play is to use IPFS and place the immutable IPFS hashes in a blockchain transaction to time stamp and secure the NFT content without having to put the data on the chain itself.
v.) Data protection regulations:
In general, data protection laws give individuals various rights over their personal data, including those of deletion or rectification, but the immutable nature of the blockchain may pose an obstacle to the enforcement of these rights. Therefore, NFTs containing personal information could violate data protection laws.
vi.) Fractionalization of NFTs:
Since some NFTs sell for significant amounts of money, fractionalizing the asset (f-NFT) would allow smaller investors to buy shares of an NFT. New entities have emerged to facilitate the sale of f-NFTs. The f-NFT trading platform, Niftex, allows owners to split f-NFTs into fragments, a piece or fragment of an f-NFT, for purchase at a fixed price, and the fractions can subsequently be traded in the market. The site also allows fragment owners governance rights on the platform. With fintech platforms, decentralized finance (DeFi) and decentralized applications on the rise, the continued fractionalization of NFTs is inevitable. The development of f-NTFs raises concerns that they may be securities. These efforts to create the market and value surrounding f-NTFs will raise flags with financial regulators. Efforts to create fractal interests will raise questions about whether f-NTFs resemble an investment product that regulators might classify as a security under the Howey test.As SEC Commissioner Hester Peirce stated during the recent 2021 Security Token Summit, if someone wants to put numerous NFTs in a basket and sell F-NFTs or take an NFT and sell fragments, then "they'd better be careful that they're not creating something that is an investment product, that is a security."
Most 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 to receive with each secondary sale. A creator can configure the smart contract that manages NFTs, but the existing ERC-721 token standard has some limitations.
First, it does not provide for platform interoperability for a royalty payment. In most existing implementations, that royalty payment will only occur when the work is sold on that same platform. That, since royalty payment implementations are typically not compatible with the other platforms across the NFT ecosystem. As NFT development matures, it will need to address this cross-platform interoperability.
Second, some legislation, such as the US, does not recognize resale rights relating to creative works, so the law does not provide any remedy for unpaid resale royalties in the US, which is the case in approximately 70 other jurisdictions, including the UK and the EU.
viii.) Estate and succession planning:
Death and judicial incapacitation.
One issue affecting investors that younger investors, such as Generation Z may not be considering, is how the applicable legal framework treats digital collectibles upon the death of the owner. This is an increasingly important issue given the number of estates that now have a digital footprint. This has highlighted the need for comprehensive estate planning when dealing with assets such as NFTs.
One of the key issues is access to NFTs after death, as (like cryptoassets) they can only be accessed by a unique personal key and password. Given the real risk that these potentially money-making assets could be lost forever (and there are an alarming number of known examples of private keys and passwords to digital assets being forgotten or misplaced), investors should, at the very least, take some simple steps to mitigate these risks.
These include, among others, making personal representatives (and professional advisors) aware of these assets, developing an inventory detailing the assets and how to access them (protected and regularly updated), and developing a will that includes instructions on how to access the NFTs. This will help create a more robust "digital legacy" plan.
The rise of NFTs and cryptoassets has inevitably accelerated the development of technology in this area, so that not only is it possible to back up these digital legacy schemes using cloud data storage providers, but there are now sophisticated products in the industry that are created specifically for these assets. In relation to cryptoassets, for example, "multisig wallets" allow users to assign a third party a "backup key" in case of emergency. This technology is designed to allow the owner's personal representatives to recover the funds upon his death on behalf of his beneficiaries. In this regard, it is imperative to have appropriate cybersecurity protections in place.
The same is extensible to situations other than death, such as judicial incapacitation.
Trusts are often used as an estate planning mechanism to avoid the need for assets to go through probate. While at first glance this may seem attractive to investors (also for confidentiality reasons), trustees should carefully consider their investment approach and fiduciary duties when it comes to holding digital collectibles such as NFTs. Given the speculative and volatile nature of these assets, trustees should be aware of the limits of their investment powers, including their diversification powers, etc. Where trusts are used to hold these assets, consideration should also be given to including additional provisions relating to NFTs (i.e. relating to liability, management or delegation).
Another area where legislation has not yet caught up with the increased popularity of NFTs is taxation. There is a dearth of legislation and guidance dealing specifically with NFTs, both in Europe and globally. In the UK, HMRC's recently updated "Cryptoassets Handbook"deals mainly with cryptocurrencies. NFTs belong to a slightly different category of digital assets and the handbook states that NFTs are separately identifiable and therefore not "pooled" for capital gains tax (CGT) purposes. It seems clear that CGT may apply to gains or losses on the disposal of NFTs and that they certainly fall within the scope of UK Inheritance Tax and other taxes, although the precise tax position is far from clear.
A particularly difficult issue is determining where NFTs are situated for tax purposes. This is a key issue for foreign domiciled owners whose overseas assets may fall outside the scope of taxation in some EU country. The consensus view is that cryptocurrencies are taxed where the beneficial owner resides and it is possible that they will take the same approach with NFTs, especially where the underlying artwork is in digital form, although the law is unclear on this point.
How Can Gowper Help You?
NFTs have a great deal of potential to make a significant difference in the art market. However, it remains to be seen whether NFTs will establish themselves as a legitimate art form or whether they represent a bubble that may burst. In any case, the commercialization and ownership of digital art and NFTs will continue to raise complex legal issues. Regulators and governments will need to move quickly to keep up.
Our attorneys can assist and educate clients from a legal and technical standpoint to incorporate these emerging technology trends safely and efficiently to help their businesses stay ahead of the competition. Please contact our attorneys or the author of this article if you have any questions.
This article was published on September 21, 2021 and has not been updated since then. It is a summary of legal considerations as of that date and is not intended to constitute legal advice.
 See Art. 13 of the MiCA Proposal.
The NFT on the cover is titled Epic Charms Ethereum #6 and is created and owned by Chriscu_nft. According to Chriscu_nft, "Epic Charms Ethereum is intended for good luck. 20 second loop that will bring all the good luck to your digital wallet and your life in particular. Each one has a characteristic or value that makes it unique and special." The author has expressly authorized Gowper to publish the work.
NFT is available for sale here.
More from the author here.