Cover Story - NFTs and The Law

NFTs and The Law - When The Dust Settles

By Giuliano G. Castellano & Stefano Beghi

NFT means “non-fungible token”, but many associate this short acronym with much more. For some, NFT is shorthand for describing the latest hype and yet another get-rich-quick scheme; for others, it is an indispensable feature of a new, emerging digital world, the “metaverse”. Admittedly, the current popularity of NFTs may suggest an ‘irrational exuberance’, pushing many to jump onto the new bandwagon. However, the potential of NFTs, beyond the hype, is yet to be determined. When the dust settles, several novels and useful applications of this technology are likely to emerge, impacting a variety of industries. In the meantime, an objective look requires us to steer away from polarized opinions in order to understand what NFTs are as well as the key legal and regulatory issues affecting this new phenomenon.

WHAT’S AN NFT?

In essence, NFTs are digital certificates consisting of non-interchangeable units of data stored on a blockchain, that is a digitally distributed ledger. Here, records (or “blocks”) are linked together using cryptographic chains; each block contains a reference (or “cryptographic hash”) to the previous block, a timestamp, and other transaction data. Even though the underlying technology is the same supporting cryptocurrencies such as Bitcoin, NFTs, unlike a cryptocurrency, are not mutually interchangeable (or “fungible”).

Each NFT, even when part of a series or collection, is unique and distinguishable from others. The process of creating an NFT (referred to as “minting”) consists of turning a specific digital item – such as a picture, a document, or a sound file – into a record on the blockchain that will typically have a link to the item itself. Once in the blockchain, any attempt to duplicate, change or tamper with the record on the blockchain representing the digital item is virtually impossible. Hence, while the digital item can be duplicated (or screenshotted), its record on the blockchain is unique and immutable regardless of how many times the NFT changes hands.

In essence, NFTs perform two main functions from which they derive their value. First, they provide a mechanism for ascertaining the “provenance” of a digital item, since it is always possible to determine the origins of an NFT as well as all its subsequent transfers. For this reason, NFTs are also referred to as “decentralized digital certificates”. Second, NFTs introduce an element of scarcity in a digital world, where assets are typically not scarce as infinite copies identical to the original can be easily created. NFTs are minted to contain elements of rarity so to enhances their value and collectability. In this context, NFTs are also referred to as “digital collectibles”.

The digital assets ecosystem, in general, and NFT space, in particular, are constantly evolving. While the most extreme sales make the headlines (for the better or worse), behind the scenes there is a myriad of NFTs. Some are copycats of famous NFTs or counterfeits of well-known trademarks, some might have a disproportionate value that is artificially created with wash-trading practices, while others are simply tech fantasies with no real business prospects. Yet a few NFTs are emerging, advancing interesting applications that connect the digital and the physical world in new ways. In any respect, the success or failure of a given NFT is rarely about the digital token per se, and more often than not it is about the project behind it and the economic purpose justifying the sale and purchase of these digital assets.

ARE NFTS REGULATED?

As with any new activity involving the investment of money and the prospect of a profit, it is important to understand whether, in any given jurisdiction, it qualifies as a regulated activity. With NFTs, the answer is: it depends.

The simplest NFTs are either certificates, like a bar code, or collectibles, like baseball cards, except in digital form. This type of NFT does not currently trigger specific bans on cryptocurrencies and are not regarded as regulated activities, such as securities or other forms of investments. They are purchased for their enjoyment or to be part of a certain community of afficionados. They might be also used to access to some experiences, such as art shows, concerts, or other activities.

However, not all NFTs are made equal. Recent trend to use NFTs as a medium of exchange or currency, either in a game or in the real world, are likely qualify as cryptocurrencies. In most countries, regulators are still racing to decide whether or not to regulate them. In Hong Kong, the Securities and Futures Commission (SFC) and Hong Kong Monetary Authority (HKMA) are currently working on guidelines to regulate the use of NFTs as a cryptocurrency.

The situation is more complicated for NFTs that are created for the purpose of investing in physical assets. In this case, multiple holders are allowed to own a fraction of an original (physical) asset, such as a piece of art, a vintage whisky collection or a resort hotel. As the parties enter in such a transaction with the objective to participate in financial returns from the underlying asset through a fractionized ownership scheme (or “fractional NFT”), regulatory regime for financial services is likely to apply. For instance, in Hong Kong, the SFC – similarly to the stance taken by U.S. regulators and others – indicated that fractional NFTs qualify as securities. Hence, any promotion, trading, or transfer of NFT should be regulated to protect investors and to maintain the integrity of the local market.

Over time, we should expect to see significant changes in the NFT regulatory landscape. Some of the existing rules will continue to apply, as it is the case for securities and capital markets laws. In a similar vein, outright frauds and other cybercrime (such as hacking of NFT wallets) can be dealt with existing criminal laws. Traditional accounting and reporting rules as well as anti-money laundering rules are likely to extend to any NFT deal. These rules generally apply to platforms, such as marketplaces, but they can extend to digital wallets and other intermediaries, requiring the implementation of so-called “know your customer” (KYC) protocols to profile and trace transactions. It is conceivable that NFT-based projects will need to comply with different anti-money laundering rules, depending on whether they qualify as cryptocurrencies, securities, art deals, or simply if they qualify as “virtual assets”, a new category introduced in 2019 by the Financial Action Task Force (FATF).

However, new rules might be introduced. There are sufficient indicia to indicate that wash-trading (where the value of an NFT is increased artificially through a series of fake sales) is a fairly common malpractice in the market and that some of the trading might hide illicit activities, thus funnelling money laundering. Such abuses might require the introduction of new

regulatory policies and penalties to protect the public. More broadly the current volatility in the cryptocurrency space is likely to trigger new regulatory changes, which are likely to affect the NFT space, if not directly, at least, indirectly. In fact, most NFTs are currently purchased through the use of cryptocurrencies.

WHAT IS OWNED?

At a minimum, every NFT holder holds a digital certificate, that is a unique record on the blockchain connected to a digital item. In the absence of any specific contractual agreement, the holder of an NFT owns a piece of code with no right to own or use any real-world asset. This is why NFTs are defined and valued intrinsically as collectibles or certificates offering a representation of something, rather than evidencing (let alone create!) actual ownership.

If the creator of an NFT intends for holders to enjoy additional rights such as ownership or other rights linked to a physical asset, these will be stipulated separately in line with the legal requirements established in any given jurisdiction to create or transfer such rights.

The problem is even more salient for anyone who buys NFTs not from the creator but from another buyer. As the obligation between the creator and the first buyer is typically of personal nature, a separate agreement might be needed between the creator and any subsequent buyer to have legally enforceable contract. This is normally not an issue, if subsequent buyers acquire the NFT as a collectible, for its intrinsic value.

THE IP DILEMMA

Another critical aspect concerns the intellectual property (IP) rights related to NFT representing any form artworks or other creative elements. Creators and buyers will need to ensure that they have the rights to use and commercialize all creative elements represented by the NFT. Moreover, the owner of such rights should ensure that they are assigned to the holders of NFT, who, in turn, will be able to enjoy the NFT without infringing any rights. For instance, the use of popular movies or comic-book characters in conjunction with an NFT may be problematic if not explicitly authorized by the IP owner. Legal actions have been already triggered in the U.S. and in Europe, leaving creators, curators, and buyers in the midst of a battle that depletes the underlying NFT of any value.

Finally, whenever an NFT is transferred, specific terms and conditions apply. In this context, the rights of enjoyment or use of any artwork related to the NFT should be clearly established in the terms accompanying the purchase.

All in all, prospective buyers need to evaluate carefully a series of elements. In addition to typical considerations concerning the rarity factor of the NFT and its functionality, it is key to assess: the specifics of the project beyond any NFT launch (who are people behind it? How IP rights are managed? what are the ultimate goals of the project?), the purpose of the transactions (is it a collectible, a digital certificate, an investment, or a mean of payment?) and the contractual fine print (what rights the buyers has? what is transferred? are you first buyer?)

WHAT IS THE FUTURE FOR NFTS?

A digital certification that traces transactions, creates digital scarcity, and provides certifiable evidence of originality is a true innovation. An illuminating Opinion Piece published in the Guangming Daily, in October 2021, noted that, for NFT projects to succeed it is essential to “remain humble and cautious, and resolutely reject all kinds of speculation and hype related to NFT”. 1 This is to say that NFT projects, whether in the arts or in other realms, should focus on developing applications that benefit society and users, rather than just another opportunity for price speculations.

For this purpose, creators of NFTs and anyone contemplating an investment in one should be guided by two key principles. First, the focus should be on the project rather than on minting NFTs per se. NFTs offer a novel and interesting opportunity to tap into the quickly evolving digital ecosystem and create bridges with the physical world. Even though the legal and regulatory landscape may change to address particular risks, the conditions to develop legitimate projects already exist now, in 2022. The seeds for the development of profitable, sustainable, and legitimate applications are sowed today.

Second, each project should be structured to take full advantage of available market opportunities within the boundaries of law. Legal rules and regulatory regimes are not in place to discourage innovation but to provide legitimacy to market players that are prepared to operate within such boundaries and afford basic protections. NFTs offer an unprecedented range of touch points between creativity and value both in the physical and in the digital world.

Artists can digitally link NFT to their physical pieces and decide which ownership and/or use rights are bundled with the NFT when it is sold. When a collector decides to purchase such an NFT, they may hold a digitally authenticated NFT and the artwork itself. This simplifies the sales process, provides liquidity to the creator and subsequent owners, and has the potential to increase the exposure of the artwork and the artist. While the NFT might change hands many times, the physical artwork can remain on display to the public or sit in a storage vault. For this arrangement to occur, technology is not enough. Depending on the jurisdiction, different contractual structures must be in place.

The same principles can be applied to NFTs of other genres. For instance, musicians can leverage on their community by issuing NFTs that generate royalties, which can be used to reward initial investors or support their activities. In a similar vein, the entertainment industry can issue tickets for events tin the form of NFTs. The process can revolutionize the industry, since tickets can be kept as collectibles after the event or as a membership token for free or discounted access to future events, threading together a community of fans. Similarly, bars, restaurants and clubs can offer loyalty programs whereby customers are issued NFTs based on their patronage can be traded and priced more transparently than any existing secondary markets.

Finally, on the cutting edge of what is possible with NFTs, closed ecosystems can be created to cater the need of specific industries or businesses. For examples, it might be possible to develop a new form of (digital) documents of titles to transfer goods and service, globally, regionally, or domestically. Hong Kong, owing to his status of international hub, is certainly in a privilege position to explore these applications.

The range of opportunities and business niches that NFTs can fill is limited only by our imagination… and law. Irrespective of the project, a proper legal assessment is needed. A legal due diligence is likely not only to complement but also to steer technological ambitions as well as business and marketing plans in this new space.

See Guangming Daily, NFT 发展要低调务实 谨防炒作和捧杀 [The Development of NFT Should be Low-key and Pragmatic, Beware of Hype and Praise] (13 October 2021), available at https://finance.gmw.cn/2021-10/13/content_35229322.htm