The buzz surrounding non-fungible tokens (NFTs) reached a fever pitch with the US$69 million sale of an NFT by digital artist Beeple in March 2021. While artwork has remained the predominant use of NFTs – and generated a good deal of media hype along the way − companies across a variety of industries are coming up with new and innovative use cases for NFTs – and turning to our multidisciplinary global team for guidance in the uncharted territory surrounding these digital assets.
First: What Is an NFT?
NFTs are unique tokens based on blockchain technology. Unlike cryptocurrency tokens such as bitcoin, which are fungible, NFTs are digitally unique – no two NFTs are alike. The unique nature of NFTs, as well as the security and other advantageous features of blockchain technology, provide a number of unique benefits, including:
- Verification of ownership and authenticity
- Driving of value of digital assets through scarcity
- Built-in smart contracts for re-sale royalties for artists and other NFT creators
- Decentralization of digital asset ownership, management and transfers (in other words, independence from large platforms)
Lifecycle of an NFT
In order to advise your business on the legal issues and third-party relationships that arise out of NFT deals, it is vital to understand the lifecycle of NFTs:
- The underlying work is created (or, it may be pre-existing)
- The NFT is “minted” on the blockchain
- The underlying work is hosted on a secure site or NFT marketplace, or is available as a virtual item on a third-party platform (gaming, social, etc.)
- The NFT may be sold on or through a public or private marketplace, third-party platform or in a peer-to-peer transaction
- The NFT may be resold
An important distinction to keep in mind is that the underlying work that is represented or referenced by the NFT exists off the blockchain and completely separate from the NFT. The underlying work may be commissioned or created by the owner like a traditional artwork might be, or it might be a pre-existing work/asset of the owner. Once created, the underlying work is hosted or is usable or viewable to the owner in a marketplace or gallery, on a secure hosting site that the NFT “calls to” or on a third-party platform (e.g., social or gaming).
The underlying work can be as simple as a JPEG image, a GIF, or a sound file, (e.g., MP4), but use cases are expanding and becoming increasingly sophisticated. Some noteworthy examples include a conversant, AI-powered female avatar; Snapchat filters and other virtual items for use in AR environments and games; virtual horses (that can be raced, betted on and bred); sports and event tickets; and even physical goods, such as luxury apparel sneakers and personal protective masks.
Who Is Involved? Addressing Third-party Risks in NFT Deals
Depending on the specifics of an NFT offering, “drop”, or deal, a number of services and third parties will be involved in the process. The owner will likely have a direct business and contractual relationship to the extent any of the below parties are involved and must address the legal issues arising out of such relationships. Though not exhaustive, a checklist of stakeholders might include the following, and certain parties may serve multiple roles, depending on the nature of the arrangement:
- Creator of the underlying work, virtual item or event ticket
- Creator/Minter of the NFT
- Host of underlying work (e.g., hosting service)
- Marketplace (public or private) and third-party platforms (gaming, social, AR)
- Primary (and secondary) purchasers of the NFT
- Agency (e.g., to aid in the promotional/marketing aspects if the NFT is promotional in nature)
- Blockchain wallet (to effectuate the transfer)
- KYC/AML provider (to address Know Your Customer/anti-money laundering obligations and risks; some blockchain wallets provide this)
- Carbon offset organization (to address carbon offset due to the energy expended, which is often a part of NFT deals for PR and other purposes)
Additional Legal Issues to Consider
Third-party intellectual property rights – As with the creation of any digital assets, the owner should have a clearance process with respect to patent, trademark, copyright and other IP rights to ensure that it has the right to utilize the underlying work in the manner contemplated by an NFT deal. Organizations investing in novel use cases should consider landscape searches and freedom-to-operate opinions, particularly when it relates to physical goods, a space where companies appear to be seeking patent protection. NFT marketplaces and organizations hosting works or virtual items in a gallery, website or platform should also take advantage of available safe harbor programs (e.g., DMCA in the US and the E-Commerce Directive and its local implementing provisions in the UK) and implement compliant procedures pursuant to the same.
Securities and other regulation – There is uncertainty as to whether an NFT in certain use cases would be considered a security under US securities laws. Given the blockchain-based nature of NFTs and the corresponding regulation of cryptocurrency, the potential speculation associated with certain NFT assets, and allowance for future royalties to be built into smart contracts, there are aspects of NFTs and their offerings that may subject them to securities regulations in the US and abroad. Businesses engaging in the offering and sale of NFTs should pay attention to updates and guidance from regulators on this issue.