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Legal aspects of Non-Fungible Tokens

Non-fungible tokens (NFTs) made world headlines in March 2021 when a digital artwork NFT was auctioned for nearly 70 million USD. NFTs represent a market that is growing fast: in the second quarter of 2021, NFT transactions already were worth 2.4 billion USD. So, what are Non-Fungible Tokens, and what are some of the legal issues when dealing with them?

The Wikipedia defines a non-fungible token as “a unique and non-interchangeable unit of data stored on a digital ledger (blockchain). NFTs can be used to represent easily-reproducible items such as photos, videos, audio, and other types of digital files as unique items (analogous to a certificate of authenticity) and use blockchain technology to establish a verified and public proof of ownership. Copies of the original file are not restricted to the owner of the NFT and can be copied and shared like any file. The lack of interchangeability (fungibility) distinguishes NFTs from blockchain cryptocurrencies, such as Bitcoin.”

So, key items to remember are that an NFT is a digital asset. It is a piece of software code that is entirely unique, yet transferable. That software code usually is a form of smart contract, and it is stored in a blockchain. NFTs typically have to do with digital media.

Let us use an analogy. Imagine a very famous photograph, taken back in the days before digital photography, where photos were still taken on celluloid film. Next, imagine that the original first print of the photograph or the original negative is being auctioned by the original photographer or somebody who acts on their behalf. You get an authentic piece of art, even authenticated by the artist. You can hang it in your house, or you can sell it. But that does not mean you get the copyrights on that piece of art. The original photographer still keeps the rights to reproduce, license, etc.

NFTs are something similar, but specifically created for digital media rather than physical media. The problem with digital media is that they can be infinitely copied and distributed without any loss of quality. NFTs were created as a way to make sure the original artists can benefit from their artwork. When you buy an NFT, you get an authenticated replica of a digital medium that is unique. It is a smart contract that contains certain terms and condition, e.g., to make sure that the original artists, e.g., gets a royalty when the NFT is sold. The smart contract is executed automatically each time there is a transaction that is registered in the blockchain, e.g., when an NFT is sold to a new owner. In other words, an NFT is a non-replicable digital certificate of ownership of a copy of a digital creative work.

It is worth repeating that while the NFT gives you ownership of a copy of a digital artwork, it does not transfer any intellectual property on the original digital artwork to the owner of the NFT, other than the license to own a copy of it. So, why do people by them? Because they are collector’s items that are authenticated and unique, that cannot be modified or amended, yet are transferable. As such, they can also be used as investments.

NFTs are fairly new, and legislation worldwide still has to catch up with the phenomenon. There are several legal issues that have to be considered.

Are NFTs legal? The answer to this question will vary from country to country. But, generally speaking, if there are no laws in place, they should be considered legal. Some countries have already enacted some legislation. Other are likely to follow, which may change what about NFTs is legal and what is not. But there are several caveats, discussed below.

Proof of ownership happens through the Blockchain. The combination of a public key and a private key allows the NFT to be decrypted and provide the necessary information.

Data hosting and storage: the NFT functions as a certificate of ownership of copy of a digital artwork that is stored somewhere, and typically the code of the NFT links to the stored copy. Problems can arise if the storage ends or the link to the storage changes because it is not possible to update a blockchain entry. So, the smart contract code has to explicitly allow transactions to modify the location of the digital artwork.

Smart Contracts: NFTs are smart contracts. The caveat here is that smart contracts usually only work on a specific platform. What about sales on a different platform?

Royalties: since an NFT is a smart contract, it is possible to include code that a fee is automatically paid to the original artist each time the NFT is sold. But, as mentioned above, what about sales on a different platform than the one where the smart contract originated?

Data Protection Laws: Exercising the personal rights to be erased or to modify or correct personal information appear to be incompatible with the immutable nature of the blockchain. In other words, NFTs that contain personal information may violate data protection laws. It may be wise to include non-executable code in the smart contract that clarifies that the people involved have agreed to have their personal information included as it is.

Intellectual Property Laws: as mentioned above, the buyer of an NFT by default does not acquire the intellectual property rights that are associated with the digital artwork. The buyer may not be fully aware of this or its implications. They may, e.g., not be aware that they are not allowed to make copies of the digital artwork or to use it in a publication, which may then constitute a potential intellectual property infringement liability.

Money Laundering: NFTs can be sold for exorbitant amounts of money. Add to that, that they may be sold using cryptocurrencies. There are valid concerns that the transactions of NFTs are being used to circumvent money laundering legislation.

Estate & succession: NFTs are typically linked to specific individuals. What happens to the NFT when the owner of the NFT dies? The immutable nature of the blockchain will not allow to recognize the heirs as new owners.

Unregistered securities: NFTs can be used as investments and there already are NFT marketplaces that allow several traders to take part simultaneously in the acquisition of NFTs. In other words, the new owners all get a share of the NFT. Some argue that in these circumstances, NFTs could be regarded as unregistered securities.

Taxation: the market for NFTs is worldwide. The artist may be in one country, the transaction may happen in another country, while the buyer may reside in yet another one. Transactions of NFTs may therefore be subject to double taxation.

The market of NFTs is expanding faster than anybody predicted. NFTs offer great opportunities, both for the creators of digital artwork, as well as for collectors and investors. But clearly, there still are multiple legal issues that need to be addressed.

 

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