Legal and Regulatory Challenges Related To Non-Fungible Assets
One of the hottest trends of 2021, non-fungible tokens (NFTs) have empowered a new generation of digital artists and turned many speculators and creators into millionaires and overnight celebrities. NFTs are also gaining traction in the video games industry thanks to their ability to solve problems such as the creation, management, and sale of rare commodities. NFTs are frequently used to grant players – rather than the game developer – ownership of their in-game assets. Assets created, found, mined, grown, bought, traded, and even plundered in-game can be transported across platforms and sold in real-life. Beyond the art and gaming world, NFTs are also used for verifying identity, ticketing, tokenizing physical property, and other practical functions. NFTs are unique, scarce, durable, and extendable. While there is no shortage of information about the advantages that NFTs bring to digital transactions and activities, there are several legal, regulatory, environmental, and operational challenges that must be overcome for businesses and organizations to take full advantage of this potentially game-changing technology.
As NFT applications expand beyond cryptocurrencies and into new industries, not everyone involved in the buying and selling of assets attached to them fully understands what they are dealing with. Possession of an NFT does not automatically grant ownership of the underlying artwork or another asset. An NFT merely grants the buyer the right to use the creative output or object it represents for their personal use. For example, if someone buys an NFT tied to a painting, he or she merely has gained the right to display the digital art in their token wallet. They will not have the right to reproduce, create derivative works, or sell prints or copies of the painting. From a copyright perspective, an NFT is simply a digital receipt indicating ownership of a particular version of the artwork.
Given the immature market and spotty regulation of NFTs, criminals have already found ways to use them to steal intellectual property. Several prominent digital artists have seen their work sold as NFTs without their permission and have voiced concern that once their digital art has been hijacked and inscribed in a blockchain-enabled token, they will lose ownership over their work. While the tokens can be sold, art can only be tokenized legally with the artist’s permission. Artists’ concern over losing copyright to creative output is unfounded, but the inherent difficulty in proving the place of origin of a piece of digital art places NFTs in a legal gray area for non-experts.
A principal idea behind the blockchain technology that underpins NFTs is that the ledger is not centrally located or managed. While this makes it near-impossible to reverse-engineer or fabricate transactions, it also poses a complex jurisdictional challenge, as the lack of a specific governing locale makes it subject to different and often conflicting legal frameworks. The problem posed by conflicting laws is especially important from the perspective of copyright and moral rights. For example, moral rights differ significantly among common law and civil law jurisdictions (especially those with Germanic and Napoleonic legal traditions). In France, moral rights are perpetual, inalienable, and imprescriptible while in the US, moral rights come with statutes of limitation. As a result, the rights of artists to their underlying artwork can differ from jurisdiction to jurisdiction, and in some cases, there may be no way to clearly determine applicable laws and to select a legitimate forum to consider disputes involving NFTs.
One of their most striking features of blockchain technology and NFTs is the self-executing “smart contract.” Smart contracts are sets of promises that are usually specified in a digital format that form the basis on which the parties perform their specific contractual duties. Due to their inherent uniqueness and complexity, it is difficult to say whether smart contracts fit into the legal framework governing traditional contract law. This is especially true in the United States, where no federal contract law exists. Further, at the time of this article (April 2021), there is no federal law or guidance explicitly defining the legality of smart contracts in the first place. The only exception to this is the Electronic Signatures in Global and National Commerce Act of 2000, which provides limited legal validity to smart contracts. The legal validity of smart contracts vis-à-vis NFTs, however, remains unclear, setting the stage for potentially lengthy litigation in the future.
The security that NFTs provide in assuring anonymity between contractual parties is often hailed as one of the technology’s greatest benefits. Nevertheless, this advantage is not guaranteed to continue. Some believe it is only a matter of time before the marked improvement in blockchain analytic tools wil be able to reveal identities and terms. Analysis tools such as Chainalysis, Reactor, Elliptic, and others can already trace blockchain transactions. While most are used for purposes such as tracing fraud and money laundering over the blockchain, they have the potential to track confidential and sensitive information.
NFTs raises significant issues related to consumer rights. Issues such as assigning permission and responsibility for recording transactions, the legality of digital receipts, anti-fraud and anti-money laundering procedures are critical, as many consumers have little concept of what they are buying and their rights and responsibilities in relation to NFTs. Since the legal status of NFTs as consumer goods is still evolving, many customers may be left in the lurch in the event that complications with transactions or ownership arise. This is especially pertinent since, unlike traditional bank and credit card transactions, there is no financial institution to intervene if the end-user incurs a loss due to hacks, fraud, or breach of security.
Financial and Business Challenges
Other logistical, legal, and financial challenges will need to be addressed before NFTs become universally accepted. First, most NFT transactions involve cryptocurrencies that are not legal tender in the US and are not backed by any central issuing authority or inherently valuable asset. Cryptocurrencies are regulated by individual states and presently there is no protection available to consumers in the event of fraud. Second, there are tax implications related to buying NFTs with cryptocurrencies. Many buyers and sellers are unaware that they may be obligated to pay steep taxes if they profit in cryptocurrency trades. Third, NFTs could run afoul of US sanctions law which prevents US residents or citizens from conducting business with individuals or entities operating in nations on which the US has placed economic or trade sanctions. Though there are some exceptions for the use of NFTs for artwork from sanctioned nations, buyers and sellers should consult a lawyer if they have any questions or doubts about the legality of an NFT transaction.
Despite the hype surrounding NFTs, operational problems also plague NFTs:
- They are based on decentralized networks which are not 100 percent user-friendly. This means verifying, promoting, purchasing, selling, and storing an NFT requires a basic understanding of blockchain technology. In fact, only sophisticated blockchain technology users can use NFTs effectively.
- For NFTs to be truly successful, they need to be as ubiquitous as smartphones.
- The speculative nature of NFTs may pose a challenge for the gaming industry because players may be inclined to buy and hold NFTs with an eye toward selling them in the future for a profit instead of using them within the gaming ecosystem.
As with cryptocurrencies, the legal challenges related to NFTs are likely to become more pronounced over the coming months as the media focuses more and more attention on the technology. It is important to consult an attorney before creating, launching, or buying an NFT as the regulatory framework is still evolving. An experienced attorney will be able to guide you on anti-money laundering regulations, tax implications, financial regulations, intellectual property issues, and the like. They can also prepare all the preliminary legal documents before you dive into the world of NFTs.
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