TechNotes - Top 10 issues for NFTs

Introduction

Over a year ago, an NFT of Beeple's "Everydays: the First 5000 Days" sold at Christie's for $69.3m USD, becoming the sixth most expensive piece of artwork sold by a living artist. This price exceeds the price paid for original artworks from Pablo Picasso, Damien Hirst and many others. Similarly in March 2021, an NFT for Twitter’s boss’ first tweet was sold for $2.9m USD (although the highest bid it achieved a year later was just $6,800). The buyers did not receive any physical painting, sculpture or asset. Instead, they received an NFT that authenticates their ownership. The use of NFTs is diverse and raises interesting legal questions. In this note we touch on the top 10 legal issues raised by NFTs.

1. What is a non-fungible token? An NFT is a piece of data that is hosted on the blockchain. Its non-fungible nature means that each token is unique and cannot be replaced with another (unlike a banknote). NFTs are usually linked to a particular asset. Once linked, NFTs are used as a modern certificate of authenticity. They certify that a person "owns" the asset to which the NFT is attached. Anyone can look on the blockchain and verify who owns the asset. NFTs are tradable and the records of the transactions are recorded on the blockchain. These records cannot be altered. Assets can include digital assets such as digital art, photos, music, or property in virtual worlds. However, there is no reason why an NFT cannot also be used to certify the authenticity or ownership of physical assets. In March 2022, on a freezing injunction application, the English High Court found that there was a realistically arguable case that NFTs should be treated as property under English law (but HHJ Pelling QC indicated that he expected there to be fuller argument on this issue at some stage).

2. Copyright issues: In the same way that purchasing an original painting does not mean that the buyer acquires the copyright in it, the owner of an NFT does not necessarily own the copyright in the work. The purchaser typically acquires only a right to display and use the underlying asset. NFTs could include smart contract terms that provide that each time the NFT is sold the original artist/subject receives a percentage of sales. For example, Emily Ratajkowski sold an NFT linked to a photo of herself, where she receives a portion of all future sales (here). Although Emily Ratajkowski does not own the copyright in the original photo, she will continue to profit from the new work she created in the future. However, those creating NFTs from others’ copyright works will likely infringe copyright if they do so without the copyright owners’ permission and they should be mindful of these risks.

3. Impact on brands: Big brands are already considering the use of their trade marks in the metaverse and Web3. Although some existing trade mark registrations may be used to prevent the unauthorised use of identical or similar marks in immersive and interactive online worlds, companies such as Heineken, L’Oreal and Nike are filing new trade mark applications for “downloadable virtual goods” and NFTs to mitigate against any uncertainities. Further Hermès and Nike have already commenced lawsuits in the US to prevent the unauthorised use of their marks for digital assets. In May 2022, a US District Judge held that Hermès’ case against designer Mason Rothchild, for selling images of its Birkin bags as MetaBirkins NFTs, could proceed. These cases will shed some light on how traditional trade mark law principles will apply to use in virtual worlds.

4. Environmental Concerns and Regulation: The underlying blockchain technology can be energy intensive. In order to verify transactions and add them to the blockchain, most blockchains will either use "proof of work" or "proof of stake" authentication. In proof of work authentication, to verify transactions, miners compete to solve complex mathematical puzzles. It is estimated that the wordwide verification of all of these "proof of work" blockchains is using similar amounts of energy to many whole countries. "Miners" (those who solve these complicated puzzles), are also in an arms race to use the latest and greatest processors. This leads to older hardware being discarded and becoming e-waste. The European Environmental Agency has already written about these issues and called for "careful monitoring" and "more reliable data on current and future blockchain energy consumption". New blockchain regulation may proliferate in order to minimise its environmental impact. This may cause further adoption of "proof of stake" validation, where a randomly selected miner will validate transactions (rather than a race between all miners).

5. Tax and securities laws: While it has been established that crypto assets are legal property; it is still not clear if crypto assets like NFTs are choses in action or another type of property. This will have wide ranging impacts, including in tax treatment. Further issues arise around seizure (HMRC has already seized NFTs in a £1.4m fraud case), VAT and the opaqueness of HMRC’s treatment of NFTs. In addition, where NFTs represent certain fractionalised rights, for example, the fractionalisation of income, profit or returns from a music, video, or artwork, these fractionalised NFTs (which may become investment opportunities for others) may start to resemble traditional regulated products such as securities or units in collective schemes and engage securities laws.

6. NFTs and the real world: While most of the discourse relates to virtual items, NFTs can be linked to real-world assets. Nike owns a patent for the use of NFTs to certify that a pair of its trainers are authentic. In the future, NFTs could be used to streamline the ownership and transfer of land or intangible property (such as intellectual property rights). NFTs have already been linked to intangible assets in the form of front-row seats to concerts. However, in order to work effectively, this will require major overhauls of current registries such as the land registry, trade marks journal, patents register etc.

7. Enforcement: Courts have been quick to intervene and grant relief to prevent valuable NFTs from being traded by bad actors. In May 2022, the English High Court granted a freezing injunction without notice against persons unknown, to prevent NFTs from being dissipated after they had been removed from the applicant’s wallet without her consent. The Singapore High Court also granted a worldwide injunction to an individual who owned a Bored Ape NFT (which had been used as collateral for an Ethereum loan) to freeze the sale and transfer of the NFT by an “unknown metaverse personality” called “chefpierre”. In China, the Hangzhou Internet Court has placed the onus on platforms trading NFTs to put in place adequate IP review mechanisms and check the ownership of digital works sold on their platform, otherwise the platform will be liable for copyright infringement. NFTs may also be used to serve court orders - a New York State judge permitted cryptocurrency exchange LCX to serve an order freezing stolen assets, on an anonymous defendant, via a “service token”. LCX’s lawyers were permitted to send a digital token with a hyperlink to the court’s order to a wallet address.

8. Insider Trading and Reputation: One of the largest NFT platforms, OpenSea, was embroiled in controversy when it was revealed that one of its senior employees was profiting from insider trading of NFTs. The public nature of the blockchain ensured that the employee was identified quickly (users spotted that someone was purchasing multiple NFTs before they were featured on the OpenSea home page, and then selling them for a profit). There have been moves to introduce more regulation (both in the US and EU), which should help to minimise insider trading and establish NFTs’ reputation. However, the hesitancy of some of those involved in distributed ledger technology to accept regulation could fuel a perception that it is not reputable.

9. Fraud and money laundering: The anonymised nature of blockchain technology can mean that users may be susceptible to fraud. Last year, a user bought an NFT purportedly linked to a piece by Banksy and featured on Banksy's official website for £244,000. It transpired the NFT was fake and Banksy's site had been hacked. However, the untraceable nature of blockchain technologies is often overstated. In February 2022, two individuals were arrested in the US for an alleged conspiracy to launder cryptocurrency that was stolen during a 2016 hack of a cryptoasset exchange. The cryptoassets seized by the US DOJ were valued at approximately $3.6bn, the department's largest financial seizure ever. Despite the individuals initiating a series of complicated transactions to try and launder the bitcoin, the authorities were still able to trace the ultimate owners of the stolen cryptoassets.

10. Advertisement of NFTs: In November 2021, the UK Advertising Standards Authority (ASA) stated that ads for NFTs were a “red alert priority issue”. They were concerned about the lack of appropriate warnings in ads, the trivialisation of investments in cryptocurrency, that ads were taking advantage of consumers’ inexperience or incredulity and were more generally irresponsible. In March 2022, the ASA and Committee for Advertising Practice (CAP) published further guidance for the advertisement of cryptocurrencies and an Enforcement Notice highlighting that their compliance teams would commence targeted enforcement action against non-compliant ads from 2 May 2022. Although that Notice does not strictly cover ads for NFTs, the ASA and CAP have indicated that future enforcement action is planned for NFTs and the latest Notice for crypto many indicate the likely direction of regulation.

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