Non-fungible tokens (NFTs) are becoming increasingly popular. In comparison with fungible tokens such as Bitcoin and Ethereum which can be divided into smaller parts, each non-fungible token is indivisible and has its own distinct value. NFTs can be attached to various digital items, including videos, audio recordings, trading cards, digital art, and animation. NFTs confirm the ownership of the respective digital items by recording the details of transactions in a digital ledger called blockchain. Since the ledger is public and distributed over numerous Internet-connected computers, it cannot be destroyed or altered.

Thanks to over-the-top media attention and growing interest from investors, NFTs can have astronomical prices. For example, in March 2021, the BBC reported that an NFT related to a digital artwork was sold at Christie’s auction house for $69 million. Taking into account the rising value of NFTs, entrepreneurs may consider launching new NFT marketplaces. However, due to the only recent introduction of NFTs (the first NFT was created in 2014), there is still much legal uncertainty regarding the regulation of NFT platforms.

Investors and entrepreneurs interested in creating NFT marketplaces should consider their legal responsibilities and ramifications of still-developing regulation. Dotting the legal i’s and crossing the t’s is essential to successfully and sustainably create, operate, and profit from an NFT marketplace. This article provides a guide to the major issues involved.

Documentation

NFT marketplaces must have at least two essential documents in place to protect their operators from legal headaches. Terms of service govern the relationships between the NFT marketplace operator and its customers as well as the relationships between the buyers and sellers of the NFTs featured on the platform. An attorney who is well-versed in contracts, end-user license agreements, and digital technology can draft terms that will stand up to legal challenges and scrutiny. Well-drafted terms decrease the chance of disputes arising between the NFT marketplace and its users. Furthermore, your terms can minimize or eliminate your liability in case of disputes between buyers and sellers. The terms should include provisions for how any disputes arising out of or in relation to the terms will be resolved. Arbitration can be a cost-effective and discrete method of dispute resolution and may faciliate reaching an agreement without the potential reputational damage of public litigation. Your lawyer can advise on whether binding or non-binding arbitration or some other dispute resolution method would be more advantageous in your situation.

As the operator of an NFT marketplace, you will likely process your customers’ personal data in order to allow them to conduct payment transactions. Keeping that data safe and secure is a critical task. Many jurisdictions require processors of personal data to clearly disclose their practices in a privacy policy. The fines for privacy violations can be devastating. In 2019, the US Federal Trade Commission (FTC) imposed a $5 billion penalty on Facebook for violating consumers’ privacy. An infringement of the EU General Data Protection Regulation (GDPR) may lead to a fine of €20 million or 4 percent of the infringer’s worldwide annual revenue, whichever is higher.

In addition to terms of services and a privacy policy, NFT marketplaces displaying, or selling user-generated content may add an additional layer of protection in the form of community guidelines. These guidelines can embed the values of the NFT marketplace in the minds of its users and can be used as a basis to identify and terminate the accounts of users who violate those values such as by posting racist, sexist, homophobic, or otherwise negative content.

Intellectual Property Protection

For a NFT marketplace to operate smoothly, it is necessary to verify and safeguard proper intellectual property rights for each participant through each step of every NFT transaction. For example, the owner of a piece of digital content may need to provide the operator of the NFT marketplace with the rights to publish the digital content in digital galleries, catalogs, compilations of work, and other promotional materials. Without such rights, the NFT marketplace may be unable to provide the services required by buyers and sellers. On the other hand, if the NFT marketplace demands NFT creators and owners cede overly generous rights to their content to the NFT marketplace or other third parties, IP owners may be reluctant to use the NFT marketplace, limiting the operator’s effectiveness.  An IP and licensing contract attorney with experience in digital technology sectors can ensure a fair allocation of intellectual property rights.

Securities Laws and Regulations

The United States and other countries are exploring how best to regulate transactions involving NFTs.Like art, fine wine, and other collectibles, many NFTs possess aesthetic as well as monetary value, which has caused some jurisdictions to struggle to decide whether to treat them as securities similar to stocks, bonds, and options. Although in many cases NFTs may not constitute securities, certain types of NFTs may fall within the scope of the securities legislation. If a NFT marketplace needs deals with securities, it may be required to register as a broker-dealer of securities and comply with all applicable securities-related requirements, including those of the US Securities and Exchange Commission (SEC) and any relevant self-regulatory organizations.

NFT marketplaces can take steps to deflect SEC scrutiny and penalties by focusing upon NFTs’ aesthetic qualities and utility rather than their resalability and potential for value appreciation. A rigorous legal analysis of NFTs traded through a NFT marketplace may help its operators avoid sanctions for violating the applicable securities regulations which may include jail sentences.

Consumer Protection

Most major jurisdictions have adopted laws to protect consumers who purchase goods or services.  In the US, for example, the Federal Trade Commission Act prohibits deceptive or unfair advertising in any medium. An advertisement is likely to be deceptive if it misleads consumers and affects their decisions, opinions, or behavior about buying a product or service. An advertisement will be considered unfair if it causes or is likely to cause an injury which is substantial, not outweighed by other benefits, and not reasonably avoidable.

If an NFT marketplace fails to adequately inform its customers about what they are purchasing and the risks involved, the FTC may argue that the operator of the NFT marketplace is engaged in deceptive or unfair advertising. This, in turn, may lead to hefty fines

Taxation

In general, the US Internal Review Services (IRS) considers NFTs to be “property” and, therefore, anyone engaged in their purchase and sale may be required to pay sales tax and capital gains taxes. NFT marketplaces, therefore, should have in place mechanisms for collecting and remitting sales tax and accurately documenting sale prices, commissions, and other fees. To date, no state tax authority has explicitly acknowledged that NFTs are subject to sales and use tax. Nevertheless, some states have built-in legal frameworks that are sufficiently broad to encompass NFTs if the NFTs in question can be viewed (such as in the case of trading cards or artwork) or heard (audio files, for example).

NFTs offer exciting opportunities for a broad range of participants, including marketplace facilitators. As with any business venture in an emerging market, is prudent to perform due diligence to weigh the potential benefits against market, opportunity, and legal risks.

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.