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(March 19, 2021) – Catherine Zhu and Louis Lehot of Foley & Lardner LLP discuss the increasing popularity of nonfungible tokens and legal considerations in launching an NFT marketplace.
While the initial coin offering (“ICO”) craze of 2017-2018 fizzled out in the face of government enforcement actions, a new resurgence in the global market for bitcoin and a new category of non-fungible tokens (“NFTs”) are fueling a recent boom in digital assets. This post will attempt to sketch out a legal guide to NFT's and legal tips for launching an NFT marketplace.
NFT is an acronym for “non-fungible token.” Using blockchain technology, an NFT can be “minted” to document digital ownership of an underlying physical or digital asset and constitutes a unique certificate of authenticity.
The blockchain provides the protection and transferability enabled by distributed ledger technology. Representing anything from tweets to real estate – NFTs are ultimately digital collectibles. NFT's are different from other blockchain-based assets like Bitcoin, Ether, and stablecoins that are identical, interchangeable, and ultimately fungible. This is because NFT's represent non-fungible, divisible, and transferable pieces of ownership in distinct assets.
While many NFT's are issued on the Ethereum blockchain, new NFT-focused protocols are being launched independently of more extensive networks. NFT marketplaces are mushrooming to process purchases and sales of these assets and to enable peer-to-peer transactions.
Lately, we have seen a spike in the popularity of NFTs as mainstream interest increases. In fact, in just 48 hours last month, internet celebrity Logan Paul made over $5 million selling NFTs, while musician Post Malone invited fans to play beer pong with him if they bought an NFT. And recently, Christie's became the very first major auction house to offer a fully digital work.
A few days ago, it sold1 a Beeple piece, “Everyday: The First 5000 Days,” for a record-breaking $69 million, making the creator of the work one of the top 3 most valuable living artists. Finally, the 10x increase in the price of Bitcoin over the past year has aficionados of the digital currency looking for new ways to diversify their holdings.
This article will cover some common legal considerations when launching an NFT marketplace, including documentation you need, intellectual property and other legal considerations, as well as overarching legal implications of this new technology.
When creating an NFT marketplace, it's vital to ensure that you appropriately allocate intellectual property rights between the creators/artists, purchasers/collectors, and any other involved parties effectively and fairly. Without an effective allocation of intellectual property rights in place, you run the risk of undermining the legitimacy of your entire marketplace.
Owning an NFT will not automatically grant you ownership of the original work. The ownership of the original work is copyright ownership that vests in the creator of the original work.
When an NFT is minted and subsequently sold, the purchaser or collector will receive (as part of owning the NFT) a set of intellectual property rights from the creator.
At the same time, your company will also need to utilize the original work for the marketplace and promotional activities, such as digital galleries, promotions and events, potential compilations, and other displays of the original work.
You will need to ensure sufficient allocation of intellectual property rights from the creator to the company for any such business purposes.
When considering the appropriate intellectual property rights allocation from the creator to collectors, the company, and any other involved parties, it's essential to set a fair percentage of intellectual property rights.
If you are overly aggressive in transferring rights from the creator, this may turn away artists and other creators from participating in your marketplace. In contrast, if you do not allocate sufficient IP rights to collectors, the company, etc., these involved parties will not have the right to carry out their role or function in the marketplace.
When operating a NFT marketplace, you will face some unique content challenges due to the predominance of user content and transactions, the need for authenticity, and the current limitations of the underlying blockchain technology.
Since marketplace items essentially comprise those minted by creators, content moderation should be top of mind for most NFT platforms. A user could upload illegal, offensive, or other damaging content.
While you can impose legal restrictions prohibiting this (such as in your terms of service and code of conduct), it would be even more effective to have technical measures in place to detect and takedown prohibited content. Otherwise, a proliferation of prohibited content can turn away users as well as attract regulatory scrutiny.
Content moderation is likely to become an even more significant liability for businesses in the future. Section 230 of the Communications Decency Act provides online platforms with a degree of legal immunity for user-generated content.
However, given the failure of platforms such as Facebook to self-moderate misinformation, lawmakers on both sides of the aisle are pushing for a repeal or modification of Section 230, which could erode immunity for businesses concerning user-generated content.
As collectibles, NFTs are supposed to represent a unique certificate of ownership over digital assets. Purchasers of an NFT will expect the NFT to be “authentic.” However, there are ways in which NFTs can be “counterfeit” or non-unique.
For example, a creator may mint different NFT's for the same digital asset by making indistinguishable duplicates, such as with varying types of file (mp3 vs. mp4, png vs. jpeg, etc.). As another example, a user may also copy, modify, or create a derivative of an original digital asset and mint it as a supposedly authentic NFT. In these cases, the purchaser could quickly pay for what they believe to be an authentic NFT, only to end up with a counterfeit.
NFT marketplaces should, at a minimum, prohibit any behavior that would lead to unauthorized commercialization of counterfeiting of underlying works.
However, suppose counterfeit NFTs were to proliferate on your marketplace despite the legal prohibitions. In that case, that could undermine user trust, weaken your community, and cause users to migrate to other marketplaces.
As such, NFT platforms should also take a proactive role in implementing technical measures to prevent counterfeiting and preserve items' authenticity in their marketplace.
Following the internationally coordinated crackdown on the ICO craze that culminated in Telegram's payment platform's shutdown and return of $1.3 billion in ICO proceeds, issuers of NFT's and NFT marketplaces would be wise to avoid falling into the same potholes as their ICO predecessors.
Wishful thinking will not prevail over securities regulators, particularly if retail investors lose all or a material part of their investment.
While each NFT should be analyzed for compliance based on its specific characteristics and the methods it monetizes, NFTs that underly collectibles (such as individual pieces of artwork) arguably should not be deemed to be securities.
Instead, these NFTs are essentially finished products whose value is determined at a sale made directly to a buyer. Moreover, for NFTs representing a specific underlying asset or collectible, there is typically no expectation or need for a third party to extend managerial efforts that will enhance the value of the NFT, the sine qua non of an “investment contract” outlined by the Supreme Court (commonly referred to as the Howey test).
This logic has been previously supported by the United States Securities and Exchange Commission (the federal regulator of American securities markets).
In 2019, the SEC published a digital securities “framework” document, where it said that “[p]rice appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered 'profit' under the Howey test.” Therefore, so the reasoning goes that an NFT can rise and fall in value does not make it a security.
However, promoters of NFTs would be wise not to take this to the bank. Technological developments driving demand for NFTs could lead to a whole new world of derivative digital property rights that fail other Howey test prongs. Tokenization of insurance coverage and the after-market provide a notable example – artists selling rights to future proceeds on a secondary market form another.
For any issuer of an NFT, analysis must establish that your NFT is not a security nor making a market in a security that would require registration or an exemption from registration under US securities laws. Similarly, NFT marketplaces need to ensure that they are not required to register as a securities exchange or alternative trading system and broker-dealer.
Issuers of NFTs must take care not to market their NFTs for potential appreciation, profit, or dividends. The mere marketing of an NFT could transform it from a non-security into a security. Also, issuers should avoid (and NFT marketplaces should prohibit and prevent their users from):
There are also other legal implications to consider regarding NFT marketplaces, including consumer protection and taxes.
When it comes to consumer protection, many consumers may not be deemed sufficiently informed about what they're buying when purchasing an NFT. We may start to see consumer rights laws being expanded to apply to NFT purchases and digital assets generally (such as the UK Consumer Rights Act).
NFTs may also trigger questions about who is conducting know-your-customer and anti-money laundering procedures, whether any specific party is recording the sale of an NFT, and what sort of rights buyers have.
NFT's, like any other digital asset, are viewed as “property” by the Internal Revenue Service, or IRS, and persons making a market or purchasing and selling them must report sales taxes, profits, and losses.
Given the current surge in public demand for NFTs, people who speculatively purchase an NFT may sue the marketplace or the creator of the NFT if it then drops in value. Traditional securities law, sanctions law, and commodities law may need to be reapplied.
Regulators may want to know if there is pricing transparency and also look into any secondary market. From the tax standpoint, who's collecting sales tax in NFT primary and secondary sales? NFT marketplaces may also have to deal with different jurisdictions' tax regimes.
With the current proliferation of NFTs and NFT marketplaces, it's clear that NFTs have the disruptive potential to allow artists and creators to monetize their work and create new revenue streams we previously could not imagine.
Brands have also started experimenting with NFTs, using the tokens to unlock new digital products, distribution models, and monetization strategies. A couple of years ago, Nike2 patented the concept of CryptoKicks – shoes as NFTs – combining the concept of NFTs with the ability to customize sneakers. Microsoft3 created a game to celebrate female scientists and incentivize players with NFTs that unlock secret games inside Minecraft.
At the same time, others view the current NFT craze as a bubble, with some investors buying NFTs as a speculative investment in hopes of flipping the tokens at a much higher price to make a quick profit.
However, given the potential application of NFTs and underlying blockchain technology to a variety of real-world transactions, such as real estate, art and collectibles, retail, finance, and others, it's likely we are only at the very start of the possibilities for what NFTs can be used for in the future.
With more and more interest and adoption, we expect to see the current NFT surge to pave the way to more fundamental value as time progresses.
Footnotes
1. http://bit.ly/3eZvILU
2. http://bit.ly/38YbQVD
3. http://bit.ly/3ltmCZc
Originally Published by Thomson Reuters – Westlaw Today.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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