Five legal considerations for businesses taking a lead on NFTs

As organizations around the world consider the commercial opportunities of NFTs, the legal implications can be unexpected.

Two questions to ask

• As organizations look to drive revenue through NFTs, are they taking the legal implications into account?
• Are organizations aware of the steps that will trigger legal considerations?

Non-fungible tokens (NFTs), heralded as one of the building blocks of the nascent metaverse, have come a long way in a short period of time. The key to NFTs’ rapid adoption has, in part, been the technology’s ability to create uniqueness, and therefore value, in a digital world. This provides multiple opportunities for businesses to innovate and unlock long-term value. It also creates new legal implications which businesses need to understand.

There are huge sums being invested in such an immature tangible asset class. Brands and companies looking to participate in the NFT market are well advised to start their NFT projects on firm legal footing. This not only involves covering key aspects of compliance and regulation but also protecting their intellectual property and safeguarding themselves from future customer litigation.

Organizations planning to drop their own NFTs should therefore consider the following five key questions as they develop their NFT legal strategy:

1. What is the best way to assign or withhold intellectual property associated with an NFT?

Assigning the intellectual property (IP) rights associated with an NFT during a sale can be a great way to build brand community and generate a buzz around an NFT drop. Buyers may go on to use the IP in innovative ways, breathing new life into a brand. Conversely, sellers may wish to protect their brand and prevent secondary markets from forming by granting only limited licenses to use the underlying IP in certain pre-defined ways.

Whatever their preference, brands must take clear legal steps to set out whether the IP associated with an NFT is for sale and how it can and cannot be used. 

“Just because an NFT smart contract or marketplace terms and conditions say a purchaser will receive an assignment or license of IP, that doesn’t necessarily mean it will happen,” says Rob Haniver, Partner, Technology and Commercial Law at EY Law Ireland.

“While ownership of an NFT can be traded, ownership of the intellectual property rights in the digital asset associated with the NFT will not be transferred from the owner of those rights to the buyer unless the transfer is set out in the underlying smart contract and the relevant formalities under applicable law are met to ensure the rights are actually assigned,” Haniver adds.

Without such an agreement, ownership of an NFT does not automatically mean ownership of underlying content or IP rights associated with it. As a result, an NFT owner may not be permitted to reproduce, distribute, publicly perform, display or create derivative works from copies of the original.

Therefore, an NFT issuer must develop a clear IP strategy and decide what is being sold, which rights are to be granted to holders of the NFT, and which rights the issuer, the artist and secondary market platforms may need to withhold.

2.  How do consumer protection and e-commerce laws apply to NFTs?

Similar to the IP considerations outlined above, both NFT issuers and secondary marketplaces need to put appropriate terms of sale in place. These serve to protect their business interests and include provisions addressing warranties, IP rights, liability, applicable law and dispute resolution mechanisms.

To the extent consumers will be subject to these terms, operators will need to know what consumer protection and e-commerce laws will apply, which will vary from one jurisdiction to the next. Furthermore, marketplaces may be subject to specific regulation which may mandate the inclusion of certain terms in their contracts and processes governing the operation of same.

3.  What are the legal data protection considerations for NFTs?

It is widely believed that NFT activity does not generate privacy risk because transactions are not directly associated with individuals’ personal identities. For example, NFTs are typically purchased with cryptocurrency, stored on a decentralized blockchain and held using a pseudo-anonymous crypto wallet.

Look beneath the surface, however, and it soon becomes clear that individuals can be associated with transactions through a patchwork of evidence including online identifiers and avatars, blockchain addresses, transaction activity and location data.

With this in mind, it is critical that organizations carefully consider and adhere to data protection and privacy law frameworks in each of the jurisdictions where they operate and direct their business and continue to be watchful for changes in applicable data protection and privacy laws.

4.  Are NFTs subject to anti-money laundering laws?

The regulation of NFTs is still in its infancy, with regulators exploring how they are being used and the extent of their adoption. However, with increasing amounts of cryptocurrency featuring in NFT transactions, there are very real fears that NFT sales are being used to launder money.

In Europe, the area of digital assets is beginning to be regulated. There are laws in respect of anti-money laundering and, dependent on certain thresholds and activities, these laws may be triggered.

“In practice, this could mean that NFT exchanges will be subject to the same strict customer identity checks and transaction reporting requirements as other obliged entities, such as banks,” explains Magnus Jones, EY Nordic Blockchain & Innovation Leader, based in Norway.

Some businesses involved in NFT activity may claim, at least for the moment, they don’t have any AML responsibilities; however, there are compelling reasons to introduce AML measures anyway.

The need to protect brand and maintain stakeholder trust is just one example of why these businesses might consider introducing AML measures – no company wants its brand to be associated with criminal activity, however tangentially.

 5.  Are NFTs financial instruments?

This is a question some companies have been pursuing in the hope that they will be successful and their activity will be exempt from indirect tax. At first glance, some NFTs may indeed appear to be financial instruments (for example, securities), especially when they have been purchased with the expectation that they will increase in value. Examples include NFTs that are created or minted in a way that grant the issuer the rights to receive a share of the proceeds each time the NFT is resold in a secondary market, or NFTs that can be used as collateral to borrow other crypto and digital assets.

From a US securities law perspective, The Howey Test, created by the US Supreme Court in the 1940s, defines a security as an “investment contract,” with the purchaser reasonably expecting profits based on the work of other parties. Using this definition, fractional NFTs (which are divided into pieces allowing joint ownership) in particular start to look like securities. The wide range of NFT types and the diverse nature of the assets they represent, however, underscores the need to assess each NFT on its own merit for legal purposes.

There is also a serious downside to pursuing financial instrument status. NFT sellers would need to meet stringent disclosure and regulation requirements set by the regulators in order to achieve certification as a financial instrument. This can be costly and resource intensive.