RFIA Seeks Crypto Clarity and Consumer Protection

1000 648 David Hoppe

With more investors participating in cryptocurrency markets, the need to clarify and modernize the rules governing digital asset trading, buying, selling, and taxation has become ever more pressing. Senators Cynthia Lummis (R-WY) and Kristen Gillibrand (D-NY) responded earlier this month by introducing the Responsible Financial Innovation Act (RFIA) as a measure to protect consumers, brokers, financial institutions, coin issuers, investors, and other market participants. RFIA would expand the Commodities Future Trading Commission’s (CFTC) purview into the crypto asset sector and update Securities and Exchange Commission (SEC) parameters for regulating and taxing digital assets. The bill would distinguish between crypto “ancillary” assets to be overseen by CFTC, and crypto “securities” which, like stocks and bonds, would fall under the SEC’s jurisdiction. Other provisions contained within RFIA would include consumer protection reforms, clearer definitions of “broker” and decentralized autonomous organizations (DAOs), and more. 

Our previous article on this topic explored the bill’s key legal definitions, the cryptocurrencies that would be regulated as commodities, taxation de minimis for certain sales of digital assets, and how the Act seeks to avoid the stablecoin conundrum. Here, we will discuss additional RFIA provisions such as brokers’ roles, information disclosure, consumer protections, and DAOs.

Brokers and Selling Crypto Assets

Section 202 of RFIA narrows and clarifies the definition of a “broker” within the crypto asset space as “any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers.” It would amend the definition included in the Internal Revenue Code of 1986 and the Infrastructure Investment and Jobs Act that some have interpreted as including transaction administrators and facilitators.

The definition of “broker” excuses many employees from reporting and fiduciary responsibilities. Only people who perform the traditionally understood activities done by brokers (i.e., effecting trades for retail clients) and earn compensation by connecting crypto sellers with buyers would be subject to taxation of income accrued through these duties. Crypto miners, buyers, and other participants would not be taxed on their investments until they are converted to cash.

RFIA reforms how brokers can sell cryptocurrencies in the marketplace, requiring the reporting of certain information on digital assets. In mandating custody procedures, RFIA would require the SEC to adopt amendments to Rule 15c3-3 (the “Customer Protection Rule”) under the Securities Exchange Act of 1934 to permit broker-dealers to take custody of digital assets for customers. If ultimately enacted, RFIA would provide a meaningful and long-awaited path for broker-dealers to maintain custody of digital asset securities.

Digital Assets Safe Harbor Trading Provision

Currently, non-US citizens who trade stocks, securities, and commodities—even when using a domestic agent—are not subject to domestic taxes because their activity is not considered as being conducted within the country. To extend this protection to cryptocurrency investors, RFIA carves out an exception for digital assets. The introduction of a “safe harbor” provision for non-Americans who sell digital assets allows non-US traders without US-based offices to use a domestic financial institution to conduct their trading activities.

Section 203 creates this trading “safe harbor” exception under section 864(b)(2) which covers commodities and securities trading. Non-US based traders would not be considered conducting business “within” the US for purposes of taxation as long as they are customarily dealt with in the digital asset exchange. However, if the non-US trader does maintain a US-based office or a fixed place of business, this provision would not apply because the exchange would occur on US soil and therefore be taxable.

Consumer Protection Provisions

If enacted, the bill will provide additional protection provisions for consumers. As cryptocurrency has become more popular and mainstream, many have bought often-volatile digital assets based on incomplete and incorrect information or understanding of the risks involved. When these digital assets collapse, as occurred with Terra/UST stablecoin, millions of dollars of collective consumer capital can be wiped out. Crypto markets carry inherent risks, so consumers must have sufficient information and disclosures to help them make educated and informed investment decisions. RFIA Section 505 would require suppliers of digital assets to clearly disclose information about their product in customer agreements, including a discussion of investment risk, applicable fees, redemption procedures, digital asset treatment in bankruptcy actions, and more.

RFIA’s consumer protections extend beyond brokers and sellers. The bill also would require customer disclosure requirements from digital asset service providers, which would include digital asset intermediaries and financial institutions as defined by section 1a of the Commodity Exchange Act (7 U.S.C. § 1a). The legislation further requires that any person conducting digital asset activities pursuant to a federal or state charter, license, registration, or other similar authorization would need to be disclosed. Additionally, the Act requires the SEC to complete its Custody Rule (17 C.F.R. § 240.15c3-3) and Consumer Protection Rule (17 C.F.R. § 275.206(4)–2) within 18 months of enactment. The new rules would need to account for the regulatory changes in custody practices, digital assets, broker-dealer practices, changes in market structure, technology, and parity of state and national banks.

The legislation closely follows other emerging approaches to crypto market regulation, such as the European Union’s proposal for governing markets in crypto-assets, and amending Directive (EU) 2019/1937 (MiCA). It imposes similar mandates on token issuers, brokers, and other market participants as RFIA. 

Decentralized Autonomous Organizations

The legislation also includes provisions for decentralized autonomous organizations. These entities are relatively new phenomena but are becoming increasingly popular. There are some 4,000 DAOs with over $8 billion in assets in the US, with the majority organized in Wyoming and the Marshall Islands. These entities have become power players in the crypto and NFT spaces.

RFIA attempts to “mainstream” DAOs, at least for the purposes of categorizing them in the IRS tax code. The Act specifies that certain DAOs constitute business entities for taxation purposes. These entities must be properly organized or incorporated under a state’s DAO statute. Under the law, DAOs can be structured as an LLC, corporation, partnership, foundation, cooperative, or similar organization.

Going Forward

RFIA has the potential to reform the digital asset marketplace within the US by bringing long-overdue government regulation and clarity to the space. If signed into law, its provisions would be rolled out within certain time frames—not overnight. Some of the tax revisions would go into effect from December 31, 2022, while others would not take effect until 2025. Until then, RFIA will have to overcome the hurdles of congressional committees in order to eventually become law. This gives industry participants time to plan their strategies for dealing with increased regulation and to consult an attorney experienced in the space to reduce their tax burden and ensure they comply with the new rules on disclosure.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

UK Recognizes NFTs As Property; Implications for the US

1000 648 David Hoppe

Recently, the UK’s High Court recognized non-fungible tokens (NFTs) as “property” separate from the underlying assets or objects they represent. This decision is likely to have far-reaching implications for disputes involving digital assets and digital art. The High Court’s ruling is likely to influence how the US views NFTs when it comes to trademark, copyright, and other intellectual property rights.

Background

In a landmark decision, the UK’s High Court has ruled that NFTs are property, separate from the underlying content that they represent. The court rendered this decision in light of Lavinia Osbourne’s stolen NFTs. Earlier in the year, Osbourne, founder of Women in Blockchain, claimed that two Boss Beauties NFTs were stolen from her Metamask wallet  Earlier in the year, Osbourne, founder of Women in Blockchain, claimed that two Boss Beauties NFTs were lifted from her Metamask wallet. Boss Beauties is an NFT collection linked to images of ‘beautifully diverse, empowered women.’ Osbourne did not provide details about how criminals were able to steal the NFTs, the tokens were later listed on OpenSea, the popular NFT marketplace. It seems that these NFTs ended up in the possession of two anonymous OpenSea account holders. Osbourne filed an injunction against OpenSea seeking to reclaim the NFTs. The court issued an injunction to freeze the assets on the accounts of Ozone Networks (the host of OpenSea) and compelled OpenSea to disclose information about the two account holders in possession of the stolen NFTs.

Legal Consequences

The outcome will bear on worldwide NFT, crypto, and blockchain law on several touchpoints.

First and most importantly, it removes the uncertainty —at least in the UK—about whether NFTs constitute property in and of themselves, distinct from the artwork, songs, tweets, or other “assets” they represent. The significance of this opinion is that the court held that an NFT represents a kind of asset that can be frozen, much like a bank or investment account. Nonetheless, this case also raises some ambiguity as the court remained silent on the relationship between an NFT and the underlying asset. As things stand, simple ownership of an NFT does not convey copyright, usage rights, moral rights, or any other rights. These rights must be explicitly granted in a written contract.

Second, the ruling clarifies that, contrary to the contention of many crypto supporters, code is not law. The term “code is law” is popular among crypto enthusiasts who believe in the proposition that written code is a legitimate form of legal enforcement even if the software contains a glitch or performs in an unintended manner. Practically speaking, it means that if someone obtains an NFT simply because they are able to access the rightful owner’s private keys via phishing or other scams, it should not be considered illegal. The code, some would argue, enabled the activity, and the perpetrator acted in a manner that is consistent with and permitted by the code, whose jurisdiction should be respected. The High Court, however, took the view that a person’s legitimate claim to a particular private key is legally significant. The fact that another party is capable of taking possession of an asset doesn’t mean that ownership is conveyed or that they should be allowed to do so.

Third, the court issued an injunction against ‘unknown persons’ as the holders of the wallet containing the stolen NFTs remained incognito at the time the injunction was issued. Further, the court compelled OpenSea to provide information about the two account holders, shredding the cloak of anonymity many blockchain users find desirable when conducting financial transactions.

Finally, the court ordered OpenSea to freeze the relevant accounts so that the NFT could not be moved or traded. Rightful owners of NFTs will find such action a valuable method for preserving their intellectual property rights. Freezing an asset and preventing it from being sold or moved to untraceable accounts will preserve the chain of evidence and give investigators time to unravel the events that led to the NFT’s misappropriation. Following an investigation, legal action can then be initiated.

Implications for US Policy

The High Court’s decision reinforces and coincides with the Internal Revenue Service’s (IRS’s) existing policy of viewing NFTs as property. The IRS and scholars share the view that NFTs possess all the traditional attributes of property. The owner can sell it, trade it, give it away, and prevent others from engaging with it. There is, however, some difference of opinion as to how completely separate jurisdictions can assure the security of an NFT. According to one view, the UK’s official recognition of NFTs as property means that holders can be assured that their tokens will be secure and they will have legal recourse in the UK if their property were stolen. Conversely, other commentators have noted that since the US has not officially declared NFTs are property, NFT holders have no recourse if someone hacks into their wallet and steals an NFT. This has led some experts to opine that the UK is leading the way in preserving NFT ownership rights. The fact that NFTs already enjoy the status of property in the US, according to the IRS and other executive-branch agencies does little to fill the current legislative vacuum in assigning property rights to NFT holders. There is an urgent need for a federal law on digital assets, and discussions are underway.

Conclusion

This High Court’s decision has helped clarify the important point that an NFT should be considered property and therefore is eligible to receive all the remedies and benefits of physical possessions. It is, however, unclear as to whether US courts will follow similar reasoning even though NFTs are already considered property in certain contexts in the US as well. This ambiguity has important consequences in determining the scope of protection extended by the NFT platforms. It is particularly unclear whether courts in the US will step up to protect stolen NFTs in the same way as the UK High Court. It is best to consult an attorney specializing in NFTs for advice about the best legal strategy to keep your NFTs secure. An attorney can also draft appropriate legal documents for protecting your digital assets.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Key Highlights from the Responsible Financial Innovation Act

1000 648 David Hoppe

As cryptocurrencies and other digital assets continue to establish themselves as economic powerhouses and enter into mainstream acceptance, the call for regulation has grown louder. In an effort to protect consumers and investors, Senators Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (D-N.Y.) introduced bipartisan legislation that would create a regulatory framework for cryptocurrency markets and classify the majority of digital assets as commodities. The 69-page Responsible Financial Innovation Act (RFIA) would empower the Commodity Futures Trading Commission (CTFC) to regulate crypto markets and set new legal definitions for digital assets. The bill would also establish new federal law governing stablecoins, implement taxes on small-scale crypto payments, and codify regulatory jurisdictions. If successfully implemented, the bill would go a long way toward dispelling legal uncertainties that have plagued the cryptocurrency space and further establishing its legitimacy.

Legal Definitions Related to Cryptocurrencies

One of the most glaring holes in the digital asset space is the lack of legal definitions in the US Code. RFIA would regulate cryptocurrencies as commodities under the purview of the CTFC, which would treat them as raw commodities such as corn, coffee, gold, soybeans, and crude oil. The bill proposes to endow the CTFC with new regulatory powers to oversee cryptocurrencies, making it the primary regulator of the digital asset spot market as well as creating a new registration category for digital asset exchanges. The proposed legislation adds “digital asset” and “digital asset exchange” to definitions contained within the Commodity Exchange Act as well as definitions for “virtual currency,“ “payment stablecoins,” “smart contracts,” “decentralized autonomous organizations (DAOs),” and other related terms.

Cryptocurrencies Regulated as Commodities

Under RFIA, digital assets will be brought into the regulatory sphere, bringing some semblance of order where little currently exists. The text of the legislation distinguishes between digital assets that perform as commodities or securities and those comprising tangible, fungible assets that are offered or sold concurrently with the purchase and sale of a security. The determination of the category into which an asset falls would be made by examining the rights or powers they convey to the owner. The bill provides that digital asset companies will play the primary role in determining and carrying out their regulatory obligations while providing further clarification to regulators so they can enforce the commodities and securities laws where applicable.

Digital assets would be defined as “ancillary” if they are offered in conjunction with securities unless they behave like securities that a corporation would issue to investors for the purpose of accruing capital. The Securities and Exchange Commission’s Howey Test holds that an asset should be considered a security if four conditions exist:

  1. There is an investment of money.
  2. The asset represents a common enterprise.
  3. Contributors invest with the expectation of earning profits.
  4. Those profits would accrue solely from the efforts of others.

Organizations can avoid categorization as a “security” by satisfying specified periodic disclosure requirements. RFIA would also direct the SEC not to treat cryptocurrencies and other digital tokens like traditional securities unless the holder is entitled to privileges enjoyed by corporate investors, such as dividends, liquidation rights, and financial interest in the issuer, as outlined in the Howey Test.

If passed, the legislation would give the CFTC wider power by extending its reach into the crypto spot market in addition to creating a process whereby crypto trading platforms such as Coinbase must register their businesses. The CFTC would be authorized to generate revenue by levying fees on the companies it oversees.

Taxation Reforms for Digital Assets

RFIA also introduces changes that would define and clarify the taxation of digital assets.

Currently, any time a cryptocurrency holder sells a digital asset, he or she may be required to pay capital gains tax on the profits. Even if the digital currency is used only to buy a good or service, the transaction constitutes a disposition of that asset. If the holder makes money on the cryptocurrency because it has appreciated in value, they would be liable for the tax. RFIA will potentially eliminate this tax for small transactions.

As more merchants come to accept cryptocurrency as a form of payment, tax reform is needed so consumers will not be taxed every time they spend their Bitcoin or Ethereum. Under specified conditions, RFIA would provide a de minimis exclusion of up to $200 per transaction using virtual currency for the payment of goods and services. In other words, consumers would be able to buy products and services totaling less than $200 without incurring capital gains tax.

Avoiding the Terra-ble Problem

Even before the TerraUSD (UST) meltdown, regulators were concerned with the risk that stablecoins present in the financial system. The Federal Reserve maintains that they are “vulnerable to runs” and lack sufficient transparency about the assets that purportedly support them. The legislation seeks to implement regulations that would help avoid situations such as Terracoin arising again. Issuers of stablecoins—which are cryptocurrencies pegged to a traditional financial asset such as the dollar—would have to maintain cash or cash-equivalent reserves that would fully back their digital assets. This reserve requirement for 100 percent of the face value of all outstanding payment stablecoins is intended to eliminate the collapse of the digital asset. They would also have to complete detailed public disclosure requirements for all stablecoin issuers.

What’s Next For RFIA?

RFIA still must overcome several hurdles before it can be enacted into law. The legislation will be heard in the Senate Committee on Banking, Housing, and Urban Development, which oversees the Securities Exchange Commission, and the Senate Committee on Agriculture, Nutrition, and Forestry, which regulates commodities and the CTFC. Lummis is a member of the Banking Committee, and Gillibrand sits on the Agriculture panel. The bill is unlikely to become law before the congressional session adjourns on January 23, 2023. It would then be taken up when the new Congress convenes after the election. Even if it fails to become law, the legislation can serve as a benchmark for future bills and offer a game plan for wider crypto industry integration.

Overall, the legislation intends to clarify the legal uncertainty surrounding digital assets in the marketplace to create a new regulatory framework. Together, the CTFC and the SEC are powerful regulators who will be given more authority to oversee virtual currencies and digital assets in the US. The latter would regulate digital assets as a commodity and the former would police companies, executives, and securities for greater investor protection.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Chapter and Metaverse: Pending IP Cases in the Digital Space

1000 649 David Hoppe

Despite the current prevalence of NFTs, it is often unclear what legal rights they convey to the new owner upon resale. Owners of copyright and trademark assets underlying NFTs may claim legitimate rights that conflict with those that NFT owners believe they possess. Below we examine legal questions related to NFTs and intellectual property (IP) rights, exclusivity, and other issues in light of recent lawsuits. We will also examine the impact of unsettled legal questions on the development of the metaverse and other next-generation technologies.

Rights of Copyright Holders to Mint NFTs of Their Works

Recently, New York-based art gallery Tamarind LLC received a cease and desist letter after announcing its plan to issue a series of NFTs based on a 60-foot-long mural known as Lightning or The Guernica of India. Artist Maqbool Fida Husain’s estate claims in the letter that it maintains the copyright to the mural, which Tamarind purchased from the late artist for $400,000 in 2002. Tamarind disagrees, contending the purchase gives it the exclusive, worldwide, royalty-free license “to display, market, reproduce and resell all or any part of the artwork, including on all digital and off-line media.”

Seeking relief from the cease and desist letter, Tamarind filed a complaint with the New York Federal Court on 21 January 2022 for a declaratory judgement stating that it can proceed to mint NFTs based on Hussain’s mural. The suit asserts that Hussain agreed that he would no longer be the owner of the artwork or the intellectual property associated with it.

The case is still pending.

Rights of Trademark Holders To Mint NFTs 

While the Tamarind/Lightning case hinges on whether the IP creator conveyed copyright and trademark rights to the buyer, other cases involve buyers minting NFTs based on IP for which they definitely have not received the trademark holder’s blessing. For example, US-based sportswear giant Nike has sued StockX, an online resale marketplace selling NFTs of shoes, streetwear and other goods, for trademark infringement, trademark dilution, and other violations. Similarly, Hermès filed a lawsuit against Mason Rothschild for NFTs infringing the Birkin trademark. Such unauthorized use raises important questions regarding the NFT rights of trademark holders. As the NFT marketplace continues to expand, trademark holders are increasingly taking steps to protect their IP and assert exclusive rights to commercialize NFTs that depict or are otherwise based on their marks. 

The Benelux Convention for Intellectual Property grants trademark holders the right to prohibit third parties from using identical or similar signs for similar or identical goods and/or services. For stakeholders in digital industries and verticals, that means that trademark infringement likely occurs if a third party uses the trademark without consent and registers the trademark for classifications linked to the metaverse, extended reality, video games, digital music and art, collectibles, or NFTs. However, because NFTs are a fairly recent development and new use cases emerge daily, few companies have registered their trademarks for classes associated with the digital environment. Currently, no case law has been decided, adding to the confusion. To ensure their IP is fully protected, trademark owners should file trademark applications that encompass goods and services associated with the metaverse, virtual spaces, digital art, and NFTs. 

Non-IP Claims

One recent high-profile case raises questions concerning chain of title over NFTs. In Free Holdings v McCoy, the plaintiff, a Canadian entity, alleges that it owns artist Kevin’s McCoy’s Quantum, which is regarded by many to be the first-ever NFT. Free Holdings brought a suit before New York’s Southern District Court, claiming that auction house Sotheby’s wrongly attributed ownership of the NFT when it sold the work for $1.47 million. Free Holdings asserts that it assumed the rights to the NFT after McCoy failed to renew his ownership. According to the suit, the blockchain on which McCoy minted Quantum requires that owners renew their rights every 250 days; McCoy let his ownership expire, and the NFT went unclaimed for years, Free Holdings says.

This case is important as it is the first to address the issue of what it truly means to  own something minted using blockchain technology. While blockchain technology is supposed to provide a permanent and indisputable ledger of provenance, the complexity of the technology muddies the waters. The confusion is worsened by the inconsistent terms related to transfer of content and ownership from one blockchain to another. The court’s decision in this case should create a long-sought precedent and help establish how courts view ownership as it relates to blockchain. It could also shed light on whether blockchain is in fact the game-changing innovation that many of its supporters claim it is. 

Conclusion  

These cases are likely to have profound implications on blockchain technology and its utility in proving digital ownership in the metaverse. It is hoped that they will answer questions including whether minting an NFT is the exclusive right of copyright owners, when and how NFTs violate trademark holders’ rights, and whether minting NFTs is contrary to traditional legal principles protecting intellectual property. Of course, some of these cases may settle without providing any legal guidance, or be resolved by holdings that cannot be used as general references for future cases. Regardless of the outcome, companies in the blockchain, metaverse, and digital asset space should periodically consult with an attorney or a law firm specializing in NFTs and other emerging technologies for up-to-date legal advice on the complexities and technicalities surrounding the rights of IP holders in these spaces.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Terra Infirma: Seeking Solid Footing in the Wake of an Algorithmic Cryptocurrency Landslide

1000 648 David Hoppe

Many crypto investors – and not just speculators, celebrities, and the wealthy – have suffered major losses in the crypto market this month. As volatility grips the cryptocurrency world, two relatively lesser-known cryptocurrency coins—TerraUSD stablecoin (UST) and its linked Terra Luna token—have fallen into serious trouble. Once a darling among decentralized finance (DeFi) currencies, the Terra project’s collapse highlights several systemic risks inherent in algorithmic stablecoins.

In January this year, the platform established the Luna Foundation Guard (LFG) “dedicated to creating and providing greater economic sovereignty, security, and sustainability of open-source software and applications that help build and promote a truly decentralized economy.” That sovereignty, security, and stability took a hit on May 9 when the price of TerraUSD drastically plunged from its pegged price of $1 to 1 cent. Its sister coin, Luna, also nosedived almost 97 percent from its 2022 peak. Their precipitous drops have shaken the entire cryptocurrency market and caused other coins, including standard-bearer Bitcoin, to shed significant value. Bitcoin has decreased 25 percent over the past week and more than 50 percent in the last six months. The TerraUSD coin and its backup Terra Luna token are now practically worthless. As a result, many crypto exchanges, including Binance, OKX exchange, and FTX exchange, have delisted Terra and Luna.

Algorithmic Stablecoins Aren’t Quite the DeFi Revolution

Cryptocurrency neophytes may not be familiar with stablecoins, which are cryptocurrencies whose value is linked to another asset such as gold or the US dollar in order to reduce volatility, which is typically high for cryptocurrencies. Notable stablecoins include tether (USDT), USD Coin (USDC), Binance Coin (BUSD), and Dai (DAI). These “big four” are the largest stablecoins, with a combined market capitalization of about $160 billion. The stablecoins USDT, USDC, and BUSD are structured around centralized entities which own sufficient stores of US dollars to back every coin issued. Any investor who owns one of these coins may redeem it for $1 at any time, guaranteed. DAI stablecoin, on the other hand, is issued by a decentralized autonomous organization (DAO), Maker DAO, and each coin is backed by the collateralized value of a diversified portfolio of crypto assets.

As a stablecoin, the TerraUSD was designed to be worth $1 at all times. But unlike real asset-backed coins, TerraUSD is based on an algorithm powered by the Terra protocol. Referred to as an algorithmic stablecoin, the Terra USD incorporates the swap procedure described below to attempt to keep the coin price stable. The platform states that it uses “open market” and decentralized Oracle voting to create stablecoins that track the price of fiat currency. It relies on the Anchor lending protocol, which offers market lending yields of up to 20 percent to its users.

Critics of the Terra project voiced their concerns that Anchor was artificially propping up TerraUSD and Luna tokens. In particular, they commented that the interest yield of 20 percent was unsustainable and inappropriately incentivized investors to purchase coins in the UST ecosystem. When Terra project investors became impatient and UST investors started pulling out their coins from Anchor accounts, the unsustainability of the Terra system was confirmed.

Why Terra Crashed

Terra plummeted back to Earth when the “free market” balance it built between TerraUSD and Luna shattered. Investors bought UST and then deposited it into their affiliated Anchor accounts, which act like savings accounts offering interest accrual rates in far excess of what any bank can offer and that most mutual funds would envy. According to Coindesk, about 75 percent of all TerraUSD purchased—about $14 billion—was deposited into these accounts. In a time of rising inflation and deflating stock markets, the 20 percent interest was an opportunity too good to pass up for many.

TerraUSD is designed to maintain its value of $1 while the Luna crypto token to which it is linked is allowed to fluctuate. When the price of UST rises above $1, the Terra protocol incentivizes users to either burn or destroy their Luna and mint UST to keep it at $1. When UST drops below $1, the protocol encourages users to burn or destroy UST and mint Luna instead. Terra employs a market model to enable atomic swaps between the different Terra coin denominations and between Terra stablecoins and Luna tokens.

In response to the crisis, the Terra project halted all trading on the blockchain, and no new transactions could take place. Once it permitted trading to recommence, the damage had been done. Flaws in the Terra protocol allowed exponential minting of Luna tokens outside the exchange. Unsuspecting Luna investors started buying Luna again, but the price crashed even further. Frantic investors tried to cash out as quickly as possible to recover what monies they could. Many crypto exchanges halted trading due to the meltdown, and bullish crypto investors who sunk money into the Terra project were unable to recoup their losses on crypto exchanges.

Crisis May Spur Washington to Action

The cryptocurrency market has suffered terribly in recent weeks. Many coins lost significant value as panicked sellers offloaded coins. Millions of investors, especially smallholders, endured critical setbacks, including some who lost their entire life savings and retirement nest eggs. Other stablecoins were damaged by Terra’s fate but recovered. Tether, the largest stablecoin by market capitalization, dropped to 95 cents before regaining its footing back to $1.

Many crypto holders, including Ethereum founder Vitalik Buterin, have suggested that Terra investors who suffered the setbacks described above should be made financially whole again. Specifically, Buterin suggested that the smaller Anchor users, comprising 99.6 percent of its wallet holders, should be compensated for their losses. One potential method for this to happen is through Federal Deposit Insurance Corporation-backed accounts that protect smallholder accounts up to $250,000 per person. It would be a step that Buterin claims has precedent. Yet, he stopped short of advocating direct government regulation.

Created in the aftermath of the Great Depression in 1933, the FDIC insures smallholder bank accounts so they won’t be wiped out by market crashes. While crypto investors may be wary of crypto market regulation, the FDIC is aware of the growing demand for oversight, especially over FDIC-supported financial institutions selling crypto assets to consumers who are unaware of the risk.  The FDIC attention comes on the heels of President Biden’s Executive Order issued in March 2022, which directed the U.S. Government to “ensure responsible innovation in digital assets,” and to engage the FDIC for their technical expertise.

As the Terra project has highlighted, cryptocurrencies still have significant risks that average consumers may not realize. This latest crypto crash highlights the debate between protecting smallholder account crypto consumers and maintaining the decentralized, blockchain-based currencies for a “free market.” With U.S. banks and other traditional financial institutions around the world getting more involved in the crypto market, additional government regulation appears inevitable.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Bulls and Bears and Apes, Oh My! Investing in NFTs

1000 649 David Hoppe

Interest in non-fungible tokens, commonly referred to as NFTs, reached an all-time high over the past year. NFTs are commonly produced from digital art, collectibles, fantasy and esports, static images, memes, video clips, audio files, and a growing number of other media. These use cases are trendy and potentially lucrative, luring many celebrities and social media influencers into minting, investing, and promoting NFTs on their social media feeds. Bored Ape Yacht Club’s owners include Snoop Dogg, Tom Brady, Shaquille O’Neal, Serena Williams, Justin Bieber, and Kevin Hart, to mention but a few. This interest among athletes and A-listers also added fuel to the spark of interest among both institutional and retail investors.

NFTs As A Risky Investment Trend – What Investors Should Know

their viral reputation as their artistic content. It’s a fickle market, and value can skyrocket and bottom out within days. Non-high net-worth individuals considering a plunge into NFT investing should note that information on NFTs circulates very differently from that of stocks. One can learn about stocks through market research, brokerage firms, and overall industry trends. Unlike stocks, however, public understanding of NFTs is based largely on social media posts, trends, and word of mouth. Not all of it is reliable, and it is often unevenly distributed and incomplete.

Additionally, because the NFT market is so new, some financial advisors have cautioned their clients to steer clear of NFT investing altogether. Some suggest purchasing NFTs for fun only, rather than their appreciation potential. In other words, don’t bet the house or the kids’ college fund on a flying cat or an ennui-plagued primate. NFTs should not be relied upon for passive income or building retirement funds. Many financial strategists recommend diverse investment portfolios that allocate less than 5% in total to NFTs and never let that investment get in the way of other long-term financial goals.

Best Practices for Investing in NFTs

If you decide that the potential reward is worth the risk, here are some best practices for NFT investments.

  • Conduct Your Own ResearchThoroughly research the NFT investments that you are interested in. Research their team, trade history, set up, execution, social engagement numbers, artwork, originality, and rarities to best make informed decisions. See here for an excellent Twitter post on the topic.
  • Carefully Vet the Seller: Be sure to perform background research on the person or organization offering the NFT for sale.This is crucial because many celebrities and NFT creators have attracted impersonators who try to sell fake NFTs. Indeed, numerous celebrities and NFT creators have participated in NFT projects that turned out to be complete scams. Learn as much as you can about the seller as humanly possible. Search OpenSea, Foundation, or Rarible, which are the most common NFT markets. Other niche marketplaces exist that specialize in specific types of assets. Also, research niche marketplaces that specialize in the type of NFT that you are interested in.
  • Mind the Middle Ground: High-visibility NFT projects are often expensive, inaccessible, and overpriced. Low-end projects are much easier to get into but have limited traction or potential for financial gains. It is best to mind the middle ground when it comes to investing in NFTs.  
  • Create a Digital Wallet: This is a place where you can ‘store’ your NFTs and cryptocurrency tokens. Various types of cryptowallets exist, but arguably the best method of storage is to spread your crypto assets across different types.
  • Fund Your Account: You will need to connect your bank account or credit card to an exchange to purchase or trade cryptocurrencies. Know Your Customer (KYC) and Anti-money Laundering (AML) requirements vary from jurisdiction to jurisdiction, and this may include an identity verification process. Always protect yourself by correctly completing the identity verification process.
  • Negotiate Terms:Depending on what’s being sold, deals could include upfront payouts or a royalty on all future sales.
  • Guard Against Theft and FraudBecause crypto is difficult to trace, has no central controlling authority, and is internationally accessible, there are potentially large security risks involving user’s data, crypto, and passwords. Even cash transactions can be compromised. Purchasing cyber liability insurance is one expensive option to minimize theft and fraud. Other ways to prevent theft and fraud include common-sense strategies such as using strong and unique passwords, never (ever!) sharing your keys, avoiding public networks and WIFI, using crypto hardware wallets, and not storing anything in the cloud. Another key point is to review and validate every app and crypto exchange you use for security features and reputation.
  • Do Not Infringe on Intellectual Property Rights: Remember that the original NFT creators typically retain the copyright. Thus, buyers and investors own only the specific digital/physical copy that they purchased and the right to display depictions of that copy, unless a creative commons license applies or there is an express transfer of the underlying ownership in the terms and conditions governing the NFT. Intellectual property rights can get complicated. If you are specifically seeking intellectual property rights, you should consult with an attorney who can provide reliable advice.
  • Consider the Tax Implications: The IRS currently views crypto tokens as property and not currency, but one thing is clear: NFTs are subject to capital gains tax. But they may not receive the preferential long-term capital gains rates that stocks enjoy. NFTs may even be taxed at a higher collectibles tax rate.
  • Consult Experts: Always engage an attorney, accountant, or financial planner to assist in understanding both the short-term and long-term risk and impact of your NFT investments. Gamma Law, a San Francisco-based law firm, has been at the forefront of blockchain, cryptocurrency, and NFT market trends.  Gamma Law attorneys specialize in providing sound legal advice for NFT investments.

Despite the popularity of NFT investing, tokens remain, overall, a volatile asset class and are often saddled with high mark-ups, brokerage charges, and other fees. Still, many high-net-worth investors are willing to take the financial risk associated with investing in NFTs. According to a recent worldwide poll conducted by DeVere, out of 450 clients, 26 percent reported the desire to add NFT investments to their portfolios by the end of the 2022 fiscal year. However, as crypto investor Sina Estavi recently discovered, high-value NFTs don’t always maintain their value. In 2021, Estavi bought the NFT of Jack Dorsey’s first tweet for $2.9 million; when he listed it for sale in April 2022, bids failed to reach $14,000. The moral of the story:  investors should prepare themselves for the possibility they will lose money invested in NFTs.

If you are considering investing in NFTs, it is wise to consult an attorney experienced in the space to understand how the discussion above may impact you and your investments.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Fungible Funding: Using NFTS for Crowdfunding

1000 638 David Hoppe

Recently, more and more companies are looking to leverage non-fungible tokens (NFTs) to generate funding. NFTs’ adaptability, flexibility, and structure allow for the authenticated transfer of ownership of unique goods on the blockchain and make them a viable alternative to traditional and corporate venture capital, debt financing, and equity sales as a means for raising capital. NFTs can be made or minted from almost anything—a digital image of a sneaker, an athlete, or even a tweet. However, these and other characteristics inherent in NFTs can create complications. This article examines the legal considerations that businesses should keep in mind before using NFTs for crowdfunding or raising capital.  

Background

Crowdfunding campaigns, whether equity- or non-equity-based, invite people to participate by contributing money to help an enterprise reach specific campaign goals such as building a prototype, launching a product, or creating a marketing campaign. These acts of participation can be encoded as NFTs that document the contributions and are owned by everyone who invests in the fundraising campaign. Recently, not-for-profits such as UNICEF and the World Wildlife Fund have used NFTs for fundraising. UNICEF has launched 1,000 NFTs to celebrate the United Nations’ 75th anniversary and to raise money and awareness for education and children’s charities. For-profit businesses can adopt similar tactics to secure capital from NFTs. However, they should keep in mind several key legal considerations:

• NFTs as Securities

The Securities and Exchange Commission (SEC) is investigating whether the use of NFTs to raise money can closely resemble—and therefore should be regulated as—traditional securities. To determine whether an NFT falls under the definition of “security,” regulators apply the seminal guidelines established in SEC v. Howey. In this decision, the US Supreme Court laid out a four-prong test (subsequently known as the ‘Howey Test’) for determining whether a transaction qualifies as an “investment contract” and is thus subject to disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934:

  1. Is there an investment of money?
  2. Does the NFT represent a common enterprise?
  3. Do contributors invest with the expectation of earning profits?
  4. Would those profits accrue solely from the efforts of others?

Answering “yes” to all four questions would categorize an NFT as an investment contract subject to SEC laws. It is easy to see how NFTs used for crowdfunding purposes could fall under this definition. It is recommended to consult a securities lawyer experienced in the NFT space to determine whether compliance with securities law is necessary to raise money via NFTs.

• NFTs as Collateral

One of the biggest advantages of using NFTs for crowdfunding or other fundraising activities is their status as collateral for securing loans. Like other secured loans, if the borrower fails to pay back the loan, the lender can seize the collateral. With NFT loans, however, the NFT owner offers his or her token as collateral to borrow money in the form of ERC20 tokens, stablecoins, other cryptocurrencies, or fiat currency. If the borrower fails to pay back the loan, the borrower risks forfeiting ownership of the NFT. In the event the borrower defaults, the NFT will be transferred to the lender, who becomes the new owner. In general, any default should be advantageous for the lender as the amount lent should always be less than the value of the NFT.

Currently, few platforms facilitate startups’ efforts to raise capital via NFTs. As the trend toward NFT loans grows, however, several established platforms are becoming involved. One such platform is Arcade which provides private individuals and startup companies a means to raise capital from independent lenders and angel investors by using NFTs as collateral. The idea is to give people holding significant NFT collections a way to leverage them for investment without forcing them to sell their digital assets outright. The borrowing terms and conditions vary from platform to platform.

• Using NFTs to Attract Investors and Maximize Investor Value

On a very broad level, startup founders hope to achieve three major goals: attracting investors, increasing market share, and maximizing exit value. NFTs can assist entrepreneurs in furthering one or more of those goals. A video game startup, for instance, could use NFTs to limit and track the distribution of its software. By authenticating ownership of the intellectual property tied to the NFT, the company can distinguish pirated software from legitimate, licensed versions. This can be used to protect and increase revenue to the benefit of both the company and its shareholders. Startups, particularly those selling software, may wish to leverage NFTs as temporary substitutes for formal intellectual property protection. At the same time, it is important to understand that NFTs cannot replace traditional copyright and trademark protections and do not grant ownership over the underlying content unless explicitly stated in their terms of sale or licensing.

Any business or startup can use NFTs to raise money. The notification issued by the SEC on NFTs as securities suggests that the definition of a security under US law can be quite broad. However, commentators have suggested that the basic logic behind the Howey Test should not apply to digital assets such as NFTs. In light of unsettled business and legal questions, emerging technologies companies intending to use NFTs to raise money for their business should consult a lawyer to ensure that their use of NFTs does not run afoul of US securities laws and regulations. SEC Commissioner Hester Peirce has cautioned that certain digital assets can be considered investment products and thus subject to US securities law. This is a legal gray area and companies should proceed carefully.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Nike Kicks Up a Fuss over StockX Sneaker NFTs

1000 648 David Hoppe

StockX is a leading online sneaker and streetwear marketplace that, like dozens of other retailers, recently plunged into the NFT pool. Earlier this year, StockX announced its VaultNFT collection of digital avatars of real-world sneakers. Not long afterward, Nike also ventured into the NFT universe when it mobilized RTFKT Studios, which it had acquired in late 2021. Nike filed a lawsuit against StockX for a host of intellectual property (IP) infringement claims. Welcome to the Metaverse, where blockchain and IP law collide in a cosmos of lawlessness.

As the case plays out, we look at the legal issues involved.

Background to the NFT Feud

StockX serves as an online marketplace where consumers can buy and sell high-end shoes and streetwear. It was founded in 2015 by Quicken Loans founder and CEO Dan Gilbert. He then purchased Campless from Josh Luber—an online repository for sneaker sales data that was the predecessor of StockX. Operating much like eBay, it has become one of the most popular online destinations for consumers to purchase hard-to-find luxury shoes and streetwear.

On January 18, 2022, StockX diversified into the NFT marketplace with the launch of its VaultNFTs collection. However, rather than selling NFTs based purely upon art such as photographs, drawings, paintings and the like, the online resale platform has created an NFT-based avatar system for physical sneakers held in its inventory. The sneakers are minted “under custodial authority” as ERC-1155 tokens on the Ethereum blockchain. While the e-commerce platform sells myriad brands, the VaultNFT avatars are a proverbial step forward as they tie the NFTs to physical items, primarily Nike-branded shoes.

Nike’s purchase of RTFKT Studios—an NFT sneaker brand where one sale earned it $3.1 million in seven minutes—launched the sportswear giant onto another plane of existence. The move was true to form: Nike has always been about style and substance, using forward-thinking engineering and innovative materials to always stay one step ahead of its competitors. In February, Nike filed suit against StockX in the New York Southern District Court, alleging that StockX committed trademark infringement, trademark dilution, and related causes of action with its virtual products registered on the blockchain.

The First Sale Doctrine and Minute Lawsuit Details

The overarching issue in this case is whether or how the “first sale doctrine” applies to digital goods. The first sale doctrine is a legal principle that states a copyright or trademark owner cannot prevent a consumer who has lawfully purchased a copyrighted good—such as a CD—from selling, lending, or giving that item to another person. This principle permits the distribution (or resale) of the copyrighted materials after the initial sale by the copyright owner. Without the first sale doctrine, no person, business, or non-profit entity would be able to resell their Nikes, lend a novel, or auction a Norman Rockwell. Federal copyright law has codified the first sale doctrine, stating “the owner of a particular copy or phonorecord lawfully made under this title, or any person authorized by such owner, is entitled, without the authority of the copyright owner, to sell or otherwise dispose of the possession of that copy or phonorecord.” With trademarks, the resale of an item bearing a trademark is permissible unless likely to confuse or deceive consumers—courts have recognized these limitations for trademarks and the first sale doctrine.

The first sale doctrine predates the digital era but is still applicable. While NFTs are digital assets, copyrights and trademarks still apply, especially if the NFT represents an image, slogan, song or a sports clip. For copyright purposes, does the first sale doctrine apply to NFTs minted in the image of Nike shoes, which are linked to the actual physical asset available for purchase? Does the trademark exception apply because consumers may be confused or deceived about the relationship between StockX and Nike? How should these rights be balanced? The issues are further complicated because there are no standard terms applicable to the grant of rights in the art underlying NFTs. Until general rules are promulgated, these issues will be resolved on a piecemeal basis.

To date, the Nike v. StockX case has generated more questions than answers regarding ownership, creative freedom, public domain, and fair usage in the NFT marketplace and digital assets in general. In its complaint, Nike raises five causes of action: 1) Trademark Infringement under 15 U.S.C. § 1114; 2) False Designation of Origin / Unfair Competition pursuant to 15 U.S.C. § 1125(a); 3) Trademark Dilution pursuant to 15 U.S.C. § 1125(c); 4) Injury To Business Reputation and Dilution under the New York General Business Law § 360-1; and 5) Common Law Trademark Infringement and Unfair Competition; it seeks a jury trial and monetary damages. Nike has several federally-registered trademarks for its shoes pursuant to 15 U.S.C. § 1065 that they claim StockX is using illegally because there is no collaboration between Nike and StockX, which the latter is “using Nike’s trademarks to market, promote, and attract potential purchasers to its Vault NFTs.”

Nike asserts that “StockX has chosen to compete in the NFT market not by taking the time to develop its own intellectual property rights, but rather by blatantly freeriding, almost exclusively, on the back of Nike’s famous trademarks and associated goodwill.” Further, Nike claims that the VaultNFTs based upon Nike footwear constitute an “unauthorized and infringing use of Nike’s famous marks.” Nike’s lawyers also contend that StockX “minted” a Nike-branded NFT as an “investable digital asset” that it sold at a “heavily inflated” market price to “unsuspecting consumers” who are buying these tokens likely thinking they are approved by Nike.

Nike argues that it owns the copyrights and intellectual property rights to its real-world sneakers and that VaultNFTs avatars infringe upon these rights. VaultNFT owners can “redeem” the avatars as coupons for lowering the cost of obtaining real Nike shoes unless StockX exercises its right to not redeem the shoes under the contract. Additionally, Nike possesses common law rights in asserted marks used in connection with its goods and services in interstate commerce for the sale, distribution, promotion, and advertising. The company asserts that these marks extend to virtual products and that Nike intends to expand that use with current trademark applications by transferring them into the virtual market with its own NFTs.

Ultimately, Nike argues that the first sale doctrine does not apply in this case, allowing it to retain its IP rights because they do not transfer with the sale of its shoes. Once the shoes are sold from their stores, Nike has no say as to how they are distributed or resold. However, Nike does have a say as to how its image is used and who can profit from it.

Meanwhile, StockX contends that each of its VaultNFTs is tied to a specific product sold on its marketplace—a product StockX bought second-hand from a rightful owner/consumer. StockX says its right to use Nike branding and imagery falls within the first sale doctrine, so no copyright issues are pertinent. Further, Nike’s IP rights do not entitle Nike to control transactions in the shoes after the first sale. So, StockX can buy the shoes from a retailer or an individual and resell them as it wishes, while using Nike’s branding and imagery of the shoes in a limited way as part of the resale and marketing process. StockX argues that its NFTs are tied to the resale of Nike shoes on its marketplace and they are not original NFTs creating digital versions of Nike’s shoes. Rather, the NFTs offer proof of ownership of these goods that is recorded on the blockchain.

Copyrights can be divisible by contract from an asset or good. This aspect can be recorded on the blockchain so it will be traceable. However, NFTs are considered indivisible assets, meaning they cannot be sliced into fractional shares like cryptocurrency. Perhaps NFTs will evolve similarly to software, where NFT creators will need to obtain licensing rights from IP holders to showcase a copyrighted product. NFT and blockchain-related law is still evolving to deal with these new technologies. As the story unfolds, the Nike v. StockX case is likely to provide new legal insight as to how intellectual property rights will evolve to include NFTs and blockchain-related issues.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Bored Apes Monkeying with Punks’ Licenses?

1000 648 David Hoppe

On March 12, after weeks of online rumors and speculation, Yuga Labs, the company responsible for the Bored Ape Yacht Club (BAYC) and the Mutant Ape Yacht Club (MAYC) NFT collections announced its acquisition of CryptoPunks and Meebits from the well-known mobile software company Larva Labs. BAYC, a popular collection of 10,000 unique bored NFT apes, has generated more than $1 billion in total sales amid celebrities flocking to the NFT bandwagon. After this acquisition, Yuga Labs now owns 423 CryptoPunks and 1,711 Meebits. In this article we examine the details of the acquisition, what it means for emerging technologies companies, and specific issues related to intellectual property (IP) ownership and rights in NFTs.

IP Ownership

The acquisition shifts the IP ownership from Larva to Yuga; Yuga now owns the brand, the artworks and other IP rights for both collections.  As a result of the change in IP ownership, going forward CryptoPunks and Meebits holders will be granted the same commercial rights as BAYC owners. That means they will be able to commercialize their collectibles through a similar structure. Yuga Labs expects this development to increase the presence of the two collections on the metaverse and other related projects. Nonetheless, Yuga Labs acknowledges that Larva Labs’ projects are historical collections with established communities. It has therefore not adopted the “club” model it used for BAYC.

IP License

There is some confusion about the rights CryptoPunk owners hold with regard to their avatars and the associated licenses. When Larva Labs launched the CryptoPunks NFTs, its website did not discuss licensing terms or provide a content license or permissible use of the artwork or characters. Even their terms and conditions did not include licensing stipulations or touch upon copyrights or commercial usage. In December 2021, several CryptoPunks NFT holders expressed their frustration with the lack of communication and guidance from Larva Labs concerning licensing and IP issues. NFT holders, minters, acquirers, and other stakeholders were left to ponder several questions:

  • What was the scope of the license?
  • Under what circumstance could the license be revoked or terminated?
  • What was the validity of the DMCA provisions?
  • To what extent could license terms be adopted by an NFT minter after NFTs have already been issued?
  • What were the legal implications of product recalls in the NFT context?

The acquisition of CryptoPunks NFT by YugaLabs should help provide clarity on some of these issues.

Structure and Model

Historically, there is a stark difference between the way Yuga Labs and Larva Labs have handled IP rights. Larva Labs initially retained the IP rights to its creations, while Yuga Labs granted commercial rights to NFT owners. According to Yuga, the acquisition bestowed upon CryptoPunks and Meebits owners “the same commercial rights that BAYC and MAYC owners enjoy.” The deal suggests that there are several ways to structure the sale of these NFTs. They can be sold on a standalone basis or combined with other offerings. An attorney experienced in digital technology, licensing, and transactions can provide valuable counsel for parties contemplating a similar transfer of assets.

DMCA Takedown Notices

The absence of clearly written legal terms and a bug in the purchase payment protocol prompted Larva Labs to issue a Digital Millennium Copyright Act (DMCA) takedown notice to the OpenSea NFT marketplace for the original CryptoPunks issue. OpenSea complied, delisting Version 1, which Larva had replaced with identical V2 avatars after correcting the bug. V1 CryptoPunks owners responded with a DMCA counter-notification challenging the legitimacy of the take-down notice and seeking reinstatement by OpenSea. V1 CryptoPunks were eventually reinstated, but it remains to be seen how Yuga will handle the issue moving forward. Will it allow CryptoPunk NFT owners to submit a counter-notification to an NFT marketplace in response to the minter’s takedown or will there be some other mechanism in place?

Conclusion

The acquisition of Cryptopunks by Yuga Labs has exposed serious loopholes related to copyright ownership and licensing with regards to NFTs. It has highlighted the importance of having well-defined licensing terms, as the ultimate financial potential of an NFT lies within the scope of commercialization terms in the relevant grant of license. As a rule of thumb, licensing deals are likely to favor well-established brands over new and generative business models looking to cash in on the NFT gold rush. Incumbents and new entrants to the NFT space should be cautious before entering into any licensing deal related to NFTs and be sure to consult an attorney with current expertise in NFTs, intellectual property, licensing, and their broader legal implications.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

Whose Eyes Are In Your (Crypto)Wallet?

1000 648 David Hoppe

How much privacy should individuals be granted when it comes to financial transactions involving cryptocurrencies and wallets? Should that expectation of confidentiality change if the government believes disclosure of all or part of an individual’s cryptowallet information could help uncover crimes such as money laundering or financing for terrorist attacks? How should these concerns be balanced against the right of privacy?

Government regulators, crypto enthusiasts, criminal defense attorneys, and civil rights activists can be expected to weigh in on these issues as the Financial Crimes Enforcement Network (FinCEN) a division of the US Treasury Department, considers “Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets (the “proposed rule”) 

Like the existing Currency Transaction Reporting (CTR), the proposed rule would require that banks, money services businesses (MSBs), and virtual asset service providers (VASPs) maintain records, verify information, and file reports with FinCEN. The proposed rules would apply to every convertible virtual currency (CVC) or digital asset with legal tender status (LTDA) transaction exceeding $10,000 involving an unhosted wallet or an “otherwise covered wallet”. Financial institutions would be required to record the CVCs and LTDAs of customers and their counterparties. In addition, banks and MSBs would have to identify their customer’s counterparty if the transaction exceeded $3,000, and the wallet was unhosted or otherwise covered

Banks and MSBs would be required to collect and report more accurately under these proposed rules, which could aid government investigators by hindering money laundering and the financing of illicit businesses.

The Rocky Road to… Here

Championed by former Treasury Secretary Steve Mnuchin and introduced during the lame-duck portion of President Trump’s tenure to address “substantial national security concerns”, the proposed rule was viewed by opponents as an attempt to ramrod the regulation through without proper vetting by the industry.

Overview of a Bungled Rule Change

    • Mnuchin’s FinCEN issues a notice of proposed rulemaking (NPRM) for the wallet rules with an unprecedented 15-day consultation. Backlash ensues immediately. Most FinCEN rule considerations include 30 to 90-day comment periods and some are as long as 120 days.
    • The initial 15-day consultation ended on January 2, 2021.
    • Under fire, FinCEN extended the crypto wallet rule comment period by 45 days on January 14, 2021.
    • On January 21, 2021, President Biden froze all Treasury Department rule-making pending a review for 60 days.
    • FinCEN’s regulatory freeze ended on March 22, 2021

The proposed rule’s resurrection by the Biden administration focuses on crypto’s potential use by criminals and those who could threaten America’s national security. While a decision could come as early as September, the thousands of comments generated by the original rule could lead the government to reopen comments to ensure that the concerns of the public are adequately addressed.

Privacy Concerns

The proposed rule would entail high administrative costs. It would also defeat much of the anonymity sought by parties conducting financial transactions using crypto and administering contracts on the blockchain, a fundamental pillar that attracts investors and technology companies. Privacy is a particular concern here because crypto wallets include the owner’s complete transaction history, information that can easily be used for overall surveillance and profiling purposes.

Furthermore, with the pending explosion of the Metaverse, we are about to witness the spread of thousands of pieces of personally identifiable information. The legal framework for handling this information raises basic issues of individual privacy. For example, the federal government could easily track an individual’s digital activity if exchanges are required to provide the government with blockchain addresses, physical addresses, and names. In contrast, when a person exits a bank with physical currency, the bank can report that event, but the currency cannot be used to track that person’s location or prior transaction history.

Finally, and perhaps counterintuitively, the proposed rules could impede FinCEN’s mission of tracking malicious actors: even if the new reporting requirements drive bad actors away from U.S. exchanges, they are likely to move to offshore platforms outside of FinCEN’s jurisdiction

Implications for DeFi Platforms

The proposed rules would have to be implemented among exchanges, brokers, and other financial custodians. To ensure that funds are not sent to wallets without personal information, exchanges might have to authorize individual wallet addresses. This would almost certainly negatively impact the crypto user experience by increasing the time and effort required to complete transactions, in addition to raising the privacy concerns discussed above. 

Furthermore, it is unclear how the FinCEN proposal could be practically implemented by DeFi platforms, exchanges, brokers, and other custodians. Smart contracts lack a name or a physical address, so they cannot interact with U.S. financial systems. For a business to send a large payment using crypto, it must know the counterparty’s name and address. 

The vagueness of the proposed rule makes it unclear whether funds used in DeFi would or could be accepted by a ‘hosted’ wallet. If the proposed rules are passed, current DeFi would be unusable in the United States. Without a strategy to address the issues raised in this section, the U.S. may be significantly disadvantaged compared to other countries that adopt effective policies to encourage innovation and development in this area.

The Response

Opponents forced the approval process into abeyance shortly after the proposed rule was promulgated, with many echoing Washington, D.C.-based Chamber of Digital Commerce President Perianne Boring’s assessment of the proposed rule as “a huge overstep in privacy.”

“As anybody knows, in the crypto or the blockchain space, once you have a wallet address, you don’t only have the history of that one transaction that applies to that regulated institution, you have that person’s entire transaction history going backward and going forward,” Boring said. “That is what is an overstep and potentially would create, what I would argue, a surveillance state, which is absolutely not appropriate.”

Groups and companies such as Coinbase have already begun drafting comments in response to FinCEN’s proposal. Coin Center has set up a module for the general public to streamline the process

Compliance with Applicable Laws and Regulations

FinCEN should appreciate the magnitude of the comment period on this regulation as opposed to those for previous regulations. The Treasury Department, under a new administration, should continue completing these proposed rules incorporating changes based on feedback received during the comment period. 

The public should take advantage of this unique opportunity to provide feedback, which may be aided by input from counsel well-versed in the matter, to guarantee that perspectives from all categories of market participants are reflected as new rules are developed.

Consulting an experienced crypto attorney can help platforms, creators, and others in the convertible virtual currency space comply with all applicable laws and navigate the complex and constantly evolving legal and regulatory landscape.

Gamma Law is a San Francisco-based firm supporting select clients in cutting-edge business sectors. We provide our clients with the support required to succeed in complex and dynamic business environments, push the boundaries of innovation, and achieve their business objectives, both in the U.S. and internationally. Contact us today to discuss your business needs.

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