The market for non-fungible tokens (NFTs) has boomed (and busted) over the past year. As businesses and asset owners continue to create and sell NFTs representing a range of physical assets, digital images, internet memes, event tickets, memorabilia, and more, the legal risks associated with buying and selling NFTs have come into greater focus than ever. This article outlines these risks and offers proven practices that emerging technologies companies can adopt to protect themselves.
Regulatory Uncertainty Reigns
One of the biggest legal risks surrounding NFTs is the uncertainty surrounding the legislative context in which NFTs exist. While certain aspects or features of NFTs may be regulated by existing laws, there is currently no uniform regulatory framework pertaining to NFTs in the US.
For example, if the Securities and Exchange Commission and other regulators determine that a specific NFT has the characteristics of a security, they may classify it as such under the Securities Act 1933 and the Securities Exchange Act 1934.
On the other hand, NFTs could be considered commodities under the Commodity Exchange Act (CEA), which defines the term to include several enumerated items and a catch-all for “all other goods and articles.” The Commodity Futures Trading Commission (CFTC) is on record as saying the definition applies to cryptocurrencies like Bitcoin and Ether, as well as renewable energy credits, emission allowances, and other fungible items. From a recipient, buyer, or investor’s perspective, it is unclear whether they would receive any protection from the US law or regulatory policy.
In addition, the ownership of the underlying digital asset that an NFT represents may bring the NFT’s copyright into question. The absence of a coherent legal framework for NFTs elevates any potential risk associated with buying and selling them. Buying NFTs might be particularly risky from a consumer welfare point of view, as lawmakers and regulators are concerned about protecting vulnerable and naive populations.
Counterfeit Products and Trademark Infringement
Hacking, phishing, brute-force attacks, and social engineering that plague online communities also present a worrying threat to buyers and sellers of NFTs. Hackers are using these and other techniques to convince individuals to willingly transfer their NFTs from their wallets. It is important to clarify that although NFTs exist on the blockchain, the key to unlocking the block and using and transferring the NFT is housed in wallets. In other words, even though it might be possible to track down stolen NFTs, it is generally difficult to recover them.
Loss or Damage to the Physical Asset
Another risk associated with NFTs is related to the loss or damage of the physical asset to which it is tied. Generally, the NFT and its underlying asset are separate assets. An NFT could be rendered worthless if the underlying asset is destroyed, lost, or stolen, even though the NFT generally includes the NFT holder’s title to the NFT. Owners of NFTs tied wine and liquor are forewarned. Dropping, partaking from, or even simply uncorking the bottle could affect the NFT’s worth.
Take Steps to Protect Yourself
- Appropriate Legal Documentation
- Legal Due-Diligence
Beyond a document review, it is often worthwhile to conduct due diligence to ensure the legitimacy of any transaction, especially if a large financial transfer is involved. Companies might be tempted to conduct their own research or perform a perfunctory background check themselves but there is a risk of missing out on important details as the catch usually lies in the details. Many law firms specialize in conducting due diligence for NFT-related transactions; engaging these experts can help avoid extremely costly or damaging situations.
- Reputable Dealers and Services
Given the cybersecurity concerns, it is important to follow some best practices when buying and selling NFTs. These include but are not limited to setting up a reputable crypto wallet, safely storing the wallet’s private keys, installing anti-virus software, and enabling two-factor authentication. To mitigate the risks of purchasing NFTs, buyers should ideally make sure that they trade only on reputable marketplaces, research what they are actually purchasing, and check that the related smart contracts accurately match the terms related to the transaction.
NFTs offer exciting opportunities for digital creators, sellers, and buyers alike. As the market continues to evolve, it is crucial that market participants fully understand the risks inherent in these products. To minimize exposure, buyers and sellers should consult an NFT attorney before transacting NFTs, as timely advice can help mitigate potentially significant legal risks. Among other things, an NFT attorney can be helpful in conducting legal due diligence, drafting legal documents, and advising on the regulatory regime applicable to NFT transactions.
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.