Since this area in the digital space is quite new there are various implications NFTs pose in the legal and regulatory realm causing different issues. The following points out some related concerns and considerations.
While the NFT marketplace is mostly situated within the United States, blockchain technology is not bound to specific jurisdictions. Thus, with regards to international transactions, applicable laws must be assessed on a case by case basis.
It should be noted that some jurisdictions already have regulatory regimes in place. The European Commission (EC), for instance, published a proposal on the Markets in Crypto-assets regulation (MiCA) for EU crypto-assets and their service providers. MiCA defines “crypto asset” as “a digital representation of value or rights, which may be transferred and stored electronically, using distributed ledger or similar technology.”
MiCA will introduce an authorization regime for issuers of asset-referenced tokens, and for crypto-asset service providers, harmonizing the crypto-asset ecosystem across national legislations. That means, MiCA will supersede any national crypto-asset regulatory frameworks that are applicable in various EU Member States where those frameworks are not based on existing EU financial services legislation.
- Generally, digital tokens are subject to the jurisdiction in which they are created.
Ownership & Intellectual Property Rights
A buyer purchases the ownership of the digital asset in the form of a unique digital token, the NFT, which exists on the blockchain. Traditional intellectual property right laws still apply, in the asset (physical work of authorship) and the token (digital work of authorship). Both co-exist independently.
- The Creator remains the owner of the underlying IP who retains the exclusive rights to copy, modify, distribute, publicly perform as well as publicly display the art (Section 106 of the US Copyright Act).
An NFT may be jointly owned by multiple collaborators and can include copyrighted elements by others which need to be licensed before any use. For instance, if an NFT includes a song, the musical composition owner must provide for the sync license. The same concept applies if a sound recording is used as the sound recording owner must permit its use.
Keep in mind that the creator or “author” of a work is not necessarily the copyright owner. That applies when the employee creates copyrightable work or an independent contractor under a “works made for hire” agreement.
- The NFT buyer doesn’t purchase the artist’s underlying work and IP but the property rights to the work ending up owning the token, a piece of identification code and metadata that can’t be replicated, and the right to use the copyrighted art associated with the NFT for personal use.
An NFT must be compliant to applicable IP laws, meaning that a purchaser of the NFT won’t have any right to the original work, for instance the right to create a derivative work or sell merchandise of the underlying content.
Due to the fact that NFTs are so new, IP rights associated with a transfer may be unclear unless a contract sets the specific terms. Any artist, online marketplace/vendor should therefore state the rights associated with a sale or resale in a written agreement or the terms of service.
NFTs aren’t necessarily originals. On the contrary, many are digital “reprints”. The same work of art can be subject to hundreds of different NFTs on several blockchains, there is no legal right of exclusivity.
- The NFT creator can perpetuate the scarcity of their token by setting the sales price and the maximum number of replicas of the digital asset.
Moral Rights (Droit Moral)
Whereas the EU attaches broad moral rights subject to the Berne Convention, in the US, those are limited to visual “fine art” under the Visual Artist Rights Act (VARA). Also, VARA merely provides for rights of attribution (right to claim authorship) and integrity (right to prevent mutilation or destruction). California’s equivalent is the California Art Preservation Act (California Civil Code §987). VARA protects works of “recognized stature”. It is unclear whether NFTs fulfill that standard.
Trademarks and Publicity Rights
It is still unclear how those legal regimes will be applied – VARA rights of attribution and integrity will play a role – but artists will likely seek protection of all of them.
Profit Participations – Royalties
- Smart contracts written into the code of NFTs allow for the distribution of funds for the payment of royalties to the creator each time the work is resold.
Some automated resale royalty payments may only incur if the NFT is resold through the same platform.
Profit participation from secondary sales depends on the contractual agreement between the parties (artist, manager, label, etc). US law does not recognize resale rights relating to creative works, so the law provides no recourse for unpaid resale royalties in the US (whereas the UK and EU laws do).
Data Hosting and Storage
An NFT and the digital asset it represents are usually stored separately.
- The NFT is stored on the blockchain and contains information on where the digital asset is located. The NFT is connected to the digital asset via a link.
So, if the digital asset is deleted or the hosting server fails, the link will break and the NFT becomes worthless as it is no longer associated with the digital asset. This is a major pitfall to any NFT that identifies a file at a specific domain. Traditional URLs could be lost simply by the owner forgetting to pay the hosting bill. In such cases the buyer has no control over a potential disappearance of the NFT. Since an NFT cannot be replaced, the NFT purchaser might be left without recourse.
This goes to show that a written contract is extremely important to ensure the buyer has enforceable rights against the seller of the asset. Often though, smart contracts won’t include the literal contract detailing the rights and how they can be used but instead they are built into the marketplace’s terms of service.
Section 230 of the Communications Decency Act of 1996 protects certain online service providers from liability for hosting content that someone else created. Section 230(c)(1) states that “No provider or user of an interactive computer service shall be treated as the publisher or speaker of any information provided by another information content provider.” However, courts have developed different interpretations of the scope of the Section regarding federal intellectual property claims and carved out state intellectual property claims such as a plaintiff’s right of publicity [e.g. Perfect 10 v. CCBill, 488 F.3d 1102 (9th Cir. 2007)].
In addition, liability may arise for a platform if it doesn’t fulfill the requirements under the Digital Millennium Copyright Act.
Given the fact that the SEC shows increased interest in cryptocurrencies scrutinizing initial coin offerings (ICOs) and token offerings, it is important to be aware that certain actions may fall under financial regulation.
Under the Supreme Court’s Howey test [SEC v. Howey Co., 328 U.S. 293 (1946)], an investment contract, and therefore, a transaction that is qualified as regulated security, is where (1) an individual invests money (2) in a common enterprise and (3) reasonably expects profits to be derived (4) from the (entrepreneurial or managerial) efforts of third parties.
Generally, NFTs of art or collectibles are final products that already exist and are valued at the time of the sale. For the tokens to maintain or appreciate in value is typically not tied to any managerial efforts. The SEC 2019 Framework clarifies: “Price 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.”
BUT: There are varieties of digital property rights emerging that can constitute NFTs as securities, especially when they are marketed as an investment that allows holders to receive appreciation, profit or dividends. One potential example of an investment contract could be a so-called “fractional” NFT (fNFT), where an investor shares a partial interest in an NFT with others.
If considered a security, then common securities law would apply e.g., registration or exemption of the offering under the Securities Act of 1933; registration of the sellers of those instruments as broker-dealers under the Securities Exchange Act of 1934 (“Exchange Act”); registration of the marketplaces on which the instruments are sold as securities exchanges under the Exchange Act, etc.
Uncertainty will remain until there is guidance from the SEC or the courts.
- While most NFTs are not likely to be considered securities, token resales, fractional ownership, or pooling together art collections and revenue shares, in some cases they can be subject to US securities laws. Therefore, qualification as security requires a case-by-case analysis.
- An NFT is not a security merely because of its increase in value.
- The sale of NFTs as well as cryptocurrency are considered taxable property.
Thus, there is tax liability to the IRS on any capital gains achieved on the Ether. That includes NFT-for-NFT trades or exchanges.
It is worth mentioning that there is a separate tax bracket that deals with “collectibles” which may be applicable to the sales of certain NFTs.