A Legal Analysis of NFTs

The summer is here, and so far this year has been a bumpy ride for the crypto sphere.

As a part of our 8-part series covering different crypto phenomena, we wanted to bring light to one of the most popular trends in cryptocurrencies – non-fungible tokens, or NFTs. In this article we go through the basics of NFTs and take a peek on their current and future market view.

What are NFTs?

The legal nature of NFTs is not intrinsically complex, but there are certain aspects in NFTs that are good to understand before diving into the details in order to get a grasp of what NFTs are and how they differ from traditional cryptos.

Simply put, NFTs are a completely unique virtual asset – like a picture or a video depicting digital art – that is stored on a blockchain and built on a certain blockchain standard, usually on Ethereum using the ERC-721 or ERC-1155 standard. At the turn of the year, the transaction costs of Ethereum were rather high, and more and more NFT collections were launched on the Solana blockchain.

NFTs can present practically anything, which means that using NFT technology it is possible to tokenize a car or a building and then saving them on-chain to prove ownership, after which the tokenized item can be transferred from one blockchain wallet to another.

Being a unique digital asset, NFTs cannot be traded in the same manner as regular cryptos; NFTs are unique whereas regular cryptos are identical, making regular cryptos easy to be used as a method of payment. With that in mind, the price fluctuation of NFTs can be strong and unpredictable, since their value is solely based on the subjective estimation of the community. Take tokenized art for example: an orange drawn by a known artist is more valuable as an NFT than a nearly identical piece drawn by the average Joe. A reference can also be made to physical collectible cards and their price estimation mechanism – they gain their value simply through the fact that enough people deem owning the card a great thing. After this the final price of the card is defined with supply and demand, using the same principles to both physical or digital rarity items.

Now that we have scratched the surface on NFTs, we can move on to certain crucial legal aspects currently surrounding NFTs.

The issuance of NFTs

The issuance of NFTs starts by creating the NFTs where, for example, a piece of art is tokenized and morphed into an NFT over a certain token standard to be saved on a blockchain. Here is where the NFT issuer usually turns to a third party service provider who has the technological capability to create – or ‘mint’ – the NFTs. In these situations the creator and the minter agree on a minting agreement containing all the responsibilities of the provider and the rights of the parties to the NFTs after minting and other ordinary details from IPRs to non-disclosure.

Anyone can issue NFTs and thousands of people are doing so every day. It should be kept in mind, however, that if the issued NFTs would be considered cryptocurrency according to applicable legislation, it could result in a registration/license obligation (e.g. in Finland an issuer of cryptocurrency has an obligation to register itself to the Finnish Financial Supervisory Authority).

Contract law and NFTs

When NFTs are minted, sold or purchased, it is important to agree on the arrangements in a contract, whereby contract law becomes an integral part of an NFT’s life cycle.

From a lawyer’s perspective, contract law in NFTs is nothing out of the ordinary, though it is paramount that the legal expert drafting contracts understands what the object of the contract is – otherwise it is impossible to draft a suitable contract for the situation.

For example:

• In regard to tokenized art, it is crucial to agree about the restrictions of intellectual property rights and whether the minter gains the right to sell the NFTs on the secondary market in exchange for a royalty paid to the issuer.
• It is also important for the NFT buyer to understand what they are really buying. NFTs may contain certain built-in smart contract properties, for example reselling royalties – therefore a thorough research of the NFT planned to be purchased is vital. Without a sufficient understanding of the rights attached to owning an NFT makes it impossible to understand its true value or later use cases. The buyer may plan to divide the bought NFT to smaller fractions for reselling purposes only to find out it is impossible to do so after the purchase. The rules concerning reselling can vary by country, so both the issuer and the buyer must understand the rules and restrictions that stem from the applicable law and different marketplaces.

General ancillary obligations and notions

As already mentioned above, the parties operating in the NFT field must understand the possibility that tokens in question might be subject to additional obligations, such as registration obligation. It is also good to keep in mind both domestic and foreign legal systems and their (possibly) differing interpretations of the taxation of NFTs. Different jurisdictions have alternating views on what kind of a property an NFT should be considered as. Finnish issuers should remember that the created NFT must actually be a clearly separate and unique non-fungible token compared to traditional cryptocurrencies so that the obligations set to cryptocurrency providers are not imposed on the NFT creator, for example in the form of a registration obligation.

Regarding privacy and data protection, NFTs rarely contain any personal data and therefore generally fall outside the scope of the General Data Protection Regulation (GDPR). Data protection on the other hand, has a significant role in NFTs, and it is crucial to carefully consider beforehand the token standard to be used and how the NFT transactions are secured. Data protection has relevance to both the buyer and the issuer – an NFT acquired from a poorly secured marketplace can prove to be a scam and a poorly selected minter can lead to a failed NFT issuance.

Intellectual property rights

Recognizing the boundaries of IPRs is a key part of the value of NFTs. Even though a certain person can be identified as the owner of a particular token, it does not mean that they would automatically be the owner of the IPRs of that token. A person interested in purchasing a certain NFT must understand and recognize the copyrights and other IPRs attached to the NFT. Usually, the issuer wants to cover their position by reserving all copyrights and by giving the NFT to the buyer’s personal use. It is also typical that the issuer has built a function to the NFT through a smart contract that grants the buyer a license to use the token for a certain purpose – to keep it on display in their personal NFT-gallery to be admired by others.

It is fairly common as well that an NFT having a strong brand has been coded to generate royalty revenue to the issuer upon sale – it is used as a way to include brand value directly to the NFT’s other properties. If the buyer does not comply with the terms of ownership, it is possible that the marketplace denies/suspends the rights to the token from the owner – not forgetting the possibility that the issuer institutes a litigation process against the owner and claim damages for a copyright violation. Inversely, the NFT buyer can present own claims in case thee think they have suffered damage in such a case. Thanks to blockchain technology, the interpretation of the matter is hardly ever a matter of evidence but instead of the interpretation of contractual nuances. Therefore, it is paramount that the issuer of an NFT understands what they are issuing, and the buyer understands what they are buying.

Conclusion

Due to the rapid advancement of technology, NFTs are still in a legal gray area and the regulation trend in Europe and the rest of the world is still unclear. The European Council released a proposal for a regulation of the European Parliament and of the Council on Markets in Crypto-assets (MiCA) on September 2020 and the draft proposals on the new money laundering regulation and directive.This legislation will substantially change the legal landscape in the EU for issuers of cryptocurrencies.

If the final version of MiCA will not regulate on a regulatory margin (or if it is not utilized nationally) for issuers, compliance with money laundering legislation or obtaining a license to conduct business other than issuing reference tokens or electronic money tokens will not be required in the future.

To conclude, the parties active within the field of NFTs, should not now or in the future think that innovative technology is a way to avoid regulation. Operators within the field should remember to conduct a thorough due diligence process before launching new business models to avoid possible legal repercussions and to avoid wasting resources.

As Finland’s leading law firm in Web3, we are more than happy to assist you with all NFT related questions starting from legal due diligence of the NFT all the way to the actual business operations.

Our Associate Trainee Patrik Anthoni took part in writing this article.

20.06.2022 MAX