While the gold rush might have peaked, public interest in non-fungible tokena (NFTs) continues to grow, and their popularity is increasing. In February, Logan Paul sold over $5 million worth of NFTs in 48 hours, while musician Post Malone took the unique approach of inviting fans to play beer pong with him if they bought his NFTs.
Given the enormous interest in NFTs and the potential for significant profits from minting, selling, or trading them, any current or aspiring NFT sellers must be familiar with applicable securities laws to avoid running afoul of the Law.
What Exactly are NFTs?
An ‘NFT’ is a unique certificate of authenticity, created using blockchain technology to document digital ownership of an underlying physical or digital asset.
NFTs are simple to make through a process known as “minting“. While NFTs can be made on virtually any blockchain, the Ethereum blockchain is a popular choice for many NFT sellers. Minters can convert almost anything into an NFT – photographs, paintings, drawings, tweets, music, and more.
Securities Laws and NFTs
NFTs have the potential to disrupt nearly every creative industry. There is enormous profit potential associated with creating and trading NFTs, and securities laws and regulations are struggling to keep pace with the rapid development of the technology.
Any NFT seller should understand how securities laws affect their business. Failure to comply with securities laws can result in heavy fines from federal and state securities regulators, as well as court injunctions. In the most serious cases, failure to comply with securities laws could result in criminal charges. Consulting a securities lawyer familiar with NFTs and the regulatory framework that governs them is crucial to minimize these risks.
When You Hear “Security,” What Comes to Your Mind?
Stocks, bonds, mutual funds, ETFs, and other similar investments, right? While the Securities Act of 1933 specifically exempts tokens and coins (and by extrapolation, virtual or crypto-currencies) from the list of regulated securities, it also specifically includes “investment contracts” as subject to regulation. The term is used as a catch-all phrase for any asset that behaves and “feels” like security.
In addition, the U.S. Supreme Court defined an investment contract using a four-part test in the seminal case of SEC v. Howey (1946). If an investment checks the below criteria, an investment contract exists:
- Investment in money
- At a common enterprise
- With a reasonable expectation of profit
- Through the efforts of others
The Howey case considers the token’s design, issuance, and how it interacts with its platform or blockchain in analyzing whether it meets these four criteria. Despite their uniqueness, tokens share a few common characteristics.
Legal Documents Required for NFT Marketplaces
An NFT marketplace is a platform that connects NFT buyers and sellers. On these platforms, buyers can browse listed assets, buy NFT tokens, and participate in NFT auctions, while sellers can mint NFT tokens with the digital asset they’ve created. There are several legal considerations and paperwork that must be taken into account before starting an NFT marketplace.
- Service Terms And Conditions – It is critical to have legal documents for use as a contract between the platform operators and its users with clear terms of service. Complete and well-thought-out terms of service agreements can protect a company from a variety of potentially damaging legal issues. An indemnification framework to protect the company is part of this agreement, limiting its overall liability. They are critical in NFT marketplaces due to the high risk of user misconduct.
- Policy Concerning Personal Information – The law requires each business to disclose information about its data collection and use practices. Users can benefit from privacy policies that provide transparency and so provide significant peace of mind. Disclosures and other users’ options should be added depending on the privacy law framework that applies to the business, such as GDPR, CCPA, HIPAA). Marketplace operators can also build trust with their users by implementing privacy policies. Potential customers wouldt be justifiably wary of marketplaces with poorly written privacy policies.
- Entity Registration – Before launching a marketplace, a corporate entity must be established to protect the owners from liability while keeping their assets safe. They equally benefit from a stronger brand image, increasing customer satisfaction.
- Community Standards – NFT marketplaces tend to have a strong user focus due to the high volume of user transactions and user-generated content involved. As such, it is a good idea to include community standards to ensure that user interactions go off without a hitch. They can also give users guidance on how to conduct themselves in the marketplace. By defining their vision, values, and expectations, marketplace operators can build a loyal following for their marketplace.
Other Regulations and Considerations
Given the unique legal challenges posed by NFT marketplaces, other documented policies, both internal and external, may be necessary or otherwise beneficial. External policies can help a company clarify its position on specific actions and behaviors. Internal policies can assist them in implementing and standardizing their organization’s response to compliance obligations, external policies, and other legal obligations should they arise. Common examples are:
Compliance with Securities Law
Each NFT should be examined for compliance based on its unique characteristics, while bearing in mind that NFTs that underpin collectibles are not securities. These such NFTs are finished goods whose value depends on a direct sale to a customer. NFT issuers must be careful not to sell their NFTs for profit, appreciation, or dividends. An NFT’s marketing alone has the potential to turn it from non-security to security. Issuers should avoid, and NFT marketplaces should prevent:
- Using NFTs as part of a fundraising drive to build a network for upcoming sales
- Promoting NFTs through sponsorship, promotion, or third parties
- Promising potential buyers the possibility of capital appreciation for the digital asset or profit from the efforts of the creator or another third party
All communities and forums need to moderate their content. The chance of a user making an offensive or inappropriate comment is high. But with technical safeguards in place, such infractions can be easily detected and unwanted content removed.
An essential feature of NFTs is their uniqueness, and customers who purchase NFTs expect them to be 100 percent genuine. However, NFTs can be counterfeited, which causes a slew of issues. For example, it is possible for a producer to mint multiple NFTs for the same digital asset by creating exact replicas of other parties’ works (e.g. in a similar but different file format, such as MP3 vs. MP4, PNG vs. JPG, etc.) NFT marketplaces should, at the very least, prohibit any behavior that leads to the unlicensed commercialization of underlying works.
NFT marketplaces are already overflowing with user-generated content and transactions, and content-related issues surrounding intellectual property rights and licensing are a frequent occurrence. Blockchain technology itself has some limitations that could cause further problems.
NFTs and Legal Complexity – Is It Worth the Hassle?
Non-fungible tokens pose a new set of commercial, regulatory, and legal considerations that are not present with fungible tokens. Regulations and laws in the U.S. are slowly catching up with advancing technology. Among the critical legal issues is the classification of NFTs, intellectual property rights, the implications of money laundering and sanctions, cybersecurity issues, and state laws relating to virtual currencies. Investment In this asset class is evolving, and fintech companies, financial services companies, and investors must consider critical legal issues in this space and plan carefully to take advantage of potential opportunities while avoiding and minimizing areas of significant risk.
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