Exponential Growth of Non-Fungible Tokens Trailed by Legal Issues

NFT


As the global economy becomes increasingly digital, innovators and existing market participants are finding new ways to tokenize assets and expand their uses. The exponential growth of non-fungible tokens (NFTs) has spurred interest in tokenizing many types of assets. An NFT is a digital certificate of ownership or rights to a unique asset, the ownership of which is recorded on a blockchain. NFTs have been commonly used to represent digital art, photos, videos, audio files, collectibles, gaming items, tickets, and other digital assets. However, they can be used to represent virtually any digital or physical asset and entitlement (eg tickets, subscriptions, exclusive access, etc.).

Whether you are a gaming company contemplating tokenized virtual goods, an artist looking to tokenize digital art, or a brand owner looking to jump into the digital craze or other types of NFTs, there are potential legal issues to be aware of. Tokenization may involve various US laws, including those related to licensing, securities, anti-money laundering, sanctions, intellectual property, gambling, and others. Below is an overview of some of the potential legal issues with NFTs.

Examples of legal problems with NFT

  • Ownership/License Rights: Ownership and license rights are threshold issues with NFTs. Typically, the buyer owns the token, but can only receive a license to the asset represented by the token (for example, if it is a form of digital media). Typically, the creator of the asset will retain the copyright to the asset. Various license terms may apply, ranging from personal and non-commercial rights to broad marketing rights. Whatever your desired business model, the rights granted to the buyer must be clearly and precisely communicated in both marketing communications and license terms. Inaccurate marketing that, for example, suggests that a buyer “owns” an asset for which they only have a limited license can lead to various legal claims and other problems. The license terms should outline rights and clearly specify what a buyer can and cannot do with their purchase. It is also important to ensure that there is an affirmative acceptance in order to have a valid contract.

  • Intellectual property rights clearance: If you are minting an NFT for a digital asset that includes content (for example, artwork, music, or video clips) or trademarks that you do not own or have a valid license to use, you may be liable for infringe third party intellectual property. If you do not have the necessary rights to the intellectual property that is used in your NFT, you also do not have the right to grant the purchaser of your token. If you misrepresent the rights that are transferred in connection with the sale of your NFT, you may be subject to additional claims. Exchanges or platforms that sell or display digital assets that incorporate third-party copyrights or trademarks, even without knowing it, may also face intellectual property lawsuits.

  • Securities Law – Most NFTs that represent only a single asset and have a single owner are likely not securities. However, under some circumstances, they can. An NFT may be subject to U.S. securities law if it has security-like characteristics or meets the Howey test: specifically when there is an investment of money or other consideration in a joint venture with a reasonable expectation of profit to be derived from the efforts of others. A case-by-case Howey analysis is crucial in determining whether a particular NFT is a security. However, depending on the facts, NFTs may involve securities laws where:

    • NFTs represent pre-sales of digital assets intended for use on a platform that is not yet built and the proceeds from the sale are used to build the platform;

    • There is a “pooling” or “fractionalization” of digital assets (eg, art where artists pool assets and share income and/or where multiple NFTs represent fractional ownership of an asset by multiple investors);

    • NFTs represent a license to a digital asset (eg a song) and a portion of the revenue from the asset (eg a percentage of sales).

  • Anti-money laundering: In some cases, NFTs (particularly high value ones) can be used to facilitate money laundering. The United States Department of the Treasury published a study on the facilitation of money laundering and the financing of terrorism through the art trade. Among other considerations, the study analyzed the risks of financial crimes in relation to digital art and NFTs. The study found that the high-value art market has certain inherent qualities that make it potentially vulnerable to a variety of financial crimes.

  • OFAC/Sanctions: Sales of NFTs must also comply with sanctions restrictions. These include transactions with Specially Designated Nationals and Blocked Persons (SDNs) involving works valued at more than $100,000. Recently, the Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned a Latvian-based exchange, Chatex, its associated support network, and two ransomware operators for facilitating financial transactions for ransomware actors. In total, OFAC designated Chatex and 57 cryptocurrency addresses (associated with digital wallets) as SDNs. This is the first time that NFTs have been publicly affected as “blocked property”, as one of the designated cryptocurrency addresses owns non-fungible tokens (NFTs). Because US persons are essentially prohibited from transacting with the persons and entities associated with the designated cryptocurrency addresses, transactions with those NFTs are also prohibited for US persons.

  • Gambling: To the extent that players pay for the opportunity to win an NFT, and the NFT is freely tradable on a secondary market, it may be considered a “thing of value” and potentially involve problem gambling. An example of where NFTs can be used in this way is with blockchain games. The increased use of chance-based mechanics in games (eg, loot boxes, social casino games) has led to increased scrutiny of gambling laws and more class action lawsuits. Many traditional game publishers have prevailed in gambling lawsuits brought against them because their terms of service grant only a license to use in-game currency and in-game items and prohibit their sale, transfer, or exchange. In these cases, the courts have generally determined that these in-game currencies and items are not of value for gaming purposes. This basis may not apply to NFTs where gaming companies promote true ownership and the ability to sell cryptocurrencies and NFTs through secondary markets. This is one of the reasons why many blockchain-based games use less random-based mechanics and more user-generated content or game-to-win business models.

  • NFT Insider Trading Policy: Companies that create NFTs and marketplaces that sell NFTs are required to adopt an NFT insider trading policy. There have been recent high-profile incidents of employees and executives in NFT companies and markets engaging in activities that may be considered unfair or illegal. These incidents create unwanted press for these entities. NFT insider trading policies often prohibit the purchase of NFTs based on material non-public information. They also prohibit various types of trading in company NFTs that are designed to improperly manipulate the perceived price or trading volume of such NFTs.

conclusion

With proper advice from a lawyer, the vast majority of NFTs created by reputable companies can easily comply with relevant laws and avoid these and other legal issues. It is important to work with an attorney who understands the legal issues that can arise with NFTs and who can identify and advise you on relevant legal issues based on the specific facts of your NFT. The attorney can also draft a license for your NFT based on your business choices and draft a custom NFT insider trading policy for NFTs related to your business.

Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XII, Number 104