The legal classification and regulatory environment for NFTs remain unclear, making it difficult for Web3 developers, video game publishers, and metaverse architects to be fully confident they can employ NFTs without inviting lawsuits or government investigations. Some semblance of clarity, however, may be on the horizon, as US courts in the near future will decide several potential landmark cases, regulators deliver commentary that hints at pending rulings, and industry groups weigh in with suggestions for self-policing.
Securities, Commodities, or Property?
Defining NFTs’ status among personal and business assets is a logical first step in determining whether and how they should be regulated. Some experts are convinced that NFTs constitute securities because they act as investment instruments. People purchase them in the hope that their uniqueness and scarcity will drive up their value so they can be sold at a profit.
Several high-profile court cases hinge on plaintiffs’ contention that NFTs are securities. The US Department of Justice has accused Nate Chastain, a former OpenSea executive, of insider trading based on confidential information about upcoming issuances that OpenSea would promote. The government alleges that he purchased many of those NFTs in advance and profited when the ensuing publicity on the platform increased demand and drove prices higher. Chastain’s attorneys argue that even if Chastain did as the DOJ alleges, he should not be prosecuted because his actions would not constitute criminal activity. Insider trading, they say, is only illegal if it is done using stocks or other securities and NFTs are not securities. In this view, Chastain’s actions may be the definition of workplace misconduct, but they do not rise to the level of a federal felony.
Many business models adopted by video game and Web3 companies leverage the collectibility of NFTs. That’s the premise behind NBA Top Shots Moments. The National Basketball Association contracted with Dapper Labs to distribute the Moments, which are video clips from NBA games. The value of Moments with low serial numbers, featuring stars of the game, and capturing stellar plays consistently rises to well above their initial selling price. A class action lawsuit alleges that Dapper Labs violates US securities law by actively promoting, offering, and selling the NFTs. Plaintiffs argue that Dapper Labs failed to comply with the securities disclosure requirements, downplaying the investment risks involved and inducing uninformed purchases. Dapper Labs counters that Moments are not investments but rather simply digital basketball cards offered to fans and collectors.
Finally, a Senate bill would classify most NFTs as commodities and weaken the Securities and Exchange Commission’s oversight powers. The bulk of regulatory duties instead would fall to the Commodity Futures Trading Commission, whose mission is to protect buyers, sellers, and the public from fraud, investigate misconduct and minimize the risks inherent in derivatives transactions. Categorizing NFTs as commodities would impose strict disclosure requirements, trading guidelines, and marketing standards upon sellers. Companies that allow buyers to obtain NFTs on margin or through leveraged accounts would have to operate on registered exchanges or make physical delivery of the NFT and/or the asset tied to it within four weeks of purchase.
The outcome of these court cases and the fate of the Senate bill will further define how NFTs are regulated, taxed, and transacted.
AML / KYC
According to a report issued by Elliptic, a London-based blockchain analysis company, over $540 million in crypto proceeds were processed through money laundering schemes over the last two years, including over $153 million that allegedly originated from ransomware payments. The study found that 22 NFT marketplaces, 4 NFT-based games or metaverse platforms, and 2 NFT swap services were being investigated for money laundering.
In February 2022, the United States Department of the Treasury (the Treasury) issued a Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art. The report discusses how the high-value art market, including certain NFTs, is vulnerable to financial crime and susceptible to abuse by bad actors. It also makes recommendations for art market participants to implement and maintain anti-money laundering/countering financing of terrorism (AML/CFT) programs. Similarly, in April 2022, a consortium of governing bodies, including the Internal Revenue Service, issued warnings to banks, legal authorities, and private collectors about the growing money laundering and fraud risks surrounding NFTs. This consortium is known as the Joint Chiefs of Global Tax Enforcement and was formed in 2018 to share intelligence and combat transnational tax crimes. Given these developments, it is likely that the US will require KYC measures to fight money laundering related to NFTs in the near future.
It is well established that buying an NFT does not grant ownership over the underlying asset, unless that transfer is expressly stated in the smart contract that enables the transaction. In fact, according to a recent study conducted by crypto merchant bank Galaxy Digital on the NFT marketplace, Web3’s promise of digital ownership and property rights “remains far off.” The study found that the vast majority of top NFT collections do not convey any form of intellectual property or ownership of underlying artwork or media. Nonetheless, this has not prevented many NFT buyers and sellers from trying to convince themselves and others that owning a screenplay, a handbag, a shoe, or some other possession grants them the right to mint digital assets based on them.
For example, Miramax sued to prohibit Quentin Tarantino from selling NFTs based on Pulp Fiction. The studio’s recently-settled suit noted that simply having written the screenplay does not convey IP rights to Tarantino to the movie. Tarantino’s view was that the NFTs were derivative of the screenplay, not the production.
Several other cases pertaining to NFTs and IP loom. Courts will decide a host of thorny NFT issues related to trademark infringement, copyright, and right of publicity. The recent spate of litigation pertaining to NFTs and IP suggests that new regulations may be required to address how innovators are employing NFTs in gaming and virtual worlds.
The blockchain on which NFTs are based is a public ledger, which means that anyone in the world can view its contents. The blockchain is also immutable: information contained within it cannot be altered or deleted. These factors give rise to significant privacy and data protection concerns related to NFTs. Hackers could potentially use NFT transactions to steal users’ blockchain addresses, financial activity, physical location, metaverse avatars, and more.
Given the dynamic and relatively young state of gaming, metaverse, and other digital technologies, there are no laws that specifically tackle privacy and data protection over the blockchain. Current data protection laws in the US and other countries are inadequate to address privacy-related challenges posed by the increasing use of NFTs. For example, the fact that data cannot be deleted from the blockchain runs contrary to basic data subject rights under the California Consumer Privacy Act. It seems likely that the US will eventually introduce new laws to reconcile these disconnects.
As an emerging asset class, NFTs and their marketplaces require a new set of guidelines and rules for consumer protection, particularly with regard to NFTs’ classification, IP ownership, and security.
In order to avoid or minimize legal risk, game publishers, metaverse developers, and web entrepreneurs should protect themselves by speaking with an attorney before embarking on any NFT project.
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