Marketing assets

Exponential growth of non-fungible tokens dragged by legal issues

As the global economy increasingly goes digital, innovators and existing market players are finding new ways to tokenize assets and expand their uses. The exponential growth of non-fungible tokens (NFTs) has spurred interest in tokenizing many types of assets. An NFT is a digital certificate of ownership or rights to a single asset, the ownership of which is recorded on a blockchain. NFTs have been commonly used to represent digital art, photos, videos, audio files, collectibles, game items, tickets, and other digital assets. However, they can be used to represent virtually any digital or physical asset as well as rights (e.g. tickets, subscriptions, exclusive access, etc.).

Whether you’re a gaming company considering tokenized virtual goods, an artist looking to tokenize digital art, or a brand owner looking to get into digital fashion or other types of NFTs, there are potential legal issues to consider. you need to be aware. Tokenization may involve several US laws, including those relating to licensing, securities, anti-money laundering, sanctions, intellectual property, gambling, and others. Below is an overview of some of the potential legal issues related to NFTs.

Examples of legal issues with NFTs

  • Ownership/license rights: Ownership and license rights are threshold issues with NFTs. Typically, the buyer owns the token but can only receive a license for the asset represented by the token (for example, if it is a form of digital media). Typically, the creator of the asset will retain copyright in the asset. A variety of license terms may apply, ranging from personal, non-commercial rights to extended commercialization rights. Whatever business model you want, the rights afforded to the buyer should be clearly and precisely communicated in marketing communications and license terms. Inaccurate marketing that, for example, suggests that a buyer “owns” an asset to which they have only a limited license can lead to various legal claims and other issues. License terms should delineate rights and clearly specify what a buyer can and cannot do with their purchase. It is also important to ensure that there is affirmative acceptance to have a valid contract.

  • Intellectual Property Rights Clearance – If you create an NFT for a digital asset that includes content (e.g., artwork, music, or video clips) or trademarks that you do not own or do not have a valid user license, you may be held responsible for infringing third party intellectual property. If you do not have the necessary rights to the intellectual property used in your NFT, you also do not have the right to grant the buyer your token. If you misrepresent the rights that are conveyed as part of the sale of your NFT, you may be subject to additional claims. Exchanges or platforms that sell or display digital assets that incorporate third-party copyrights or trademarks, even unknowingly, may also be subject to intellectual property lawsuits.

  • Securities Law – Most NFTs that represent only one asset and have only one owner are probably not securities. However, in certain circumstances they can. An NFT may be subject to U.S. securities law if it has securities-like characteristics or if it otherwise satisfies the Howey test: in particular where there is an investment of money or other type of consideration in a joint venture with a reasonable expectation of benefits to be derived from the efforts of others. A case-by-case Howey analysis is crucial in determining whether a particular NFT is a security. However, depending on the facts, NFTs may implicate securities laws when:

    • NFTs represent pre-sales of digital assets for use on a platform that is not yet built and the proceeds from the sale are used to build the platform;

    • There is “pooling” or “fractionalization” of digital assets (e.g. art where artists pool assets and share revenue and/or where multiple NFTs represent fractional ownership of an asset by several investors);

    • NFTs represent a license for a digital asset (eg, a song) and a share of the asset’s revenue (eg, a percentage of sales).

  • Anti-Money Laundering – In some cases, NFTs (especially high value ones) can be used to facilitate money laundering. The United States Department of the Treasury has published a study on the facilitation of money laundering and the financing of terrorism through the art trade. Among other considerations, the study discussed the financial crime risks associated with digital art and NFTs. The study found that the high-value art market has certain inherent qualities that make it potentially vulnerable to a range of financial crimes.

  • OFAC/Sanctions—NFT sales must also adhere to sanctions restrictions. These include Specially Designated Nationals and Stranded Persons (SDN) transactions involving work worth more than $100,000. Recently, the Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned a Latvia-based exchange, Chatex, its associated support network and two ransomware operators for facilitating the financial transactions of ransomware actors. In total, OFAC designated Chatex and 57 cryptocurrency addresses (associated with digital wallets) as SDNs. This is the first time that NFTs have been publicly impacted as “blocked property” – because one of the designated cryptocurrency addresses owns non-fungible tokens (NFTs). Since U.S. persons are essentially prohibited from transacting with the persons and entities associated with the designated cryptocurrency addresses, trading in these NFTs is also prohibited for U.S. persons.

  • Gambling—Because players pay for a chance to win an NFT, and the NFT can be freely traded on a secondary market, they can be considered a “thing of value” and potentially involve gambling problems. An example of using NFTs in this way is in blockchain games. The increased use of chance-based mechanisms in games (e.g. lootboxes, social casino games) has led to increasing scrutiny under gambling laws and more class action lawsuits. Many traditional game publishers have won legal cases against them because their terms of service only grant a license to use in-game currency and in-game items and prohibit their sale , transfer or exchange. In these cases, the courts have generally concluded that these in-game currencies and items have no value for gaming purposes. This basis may not apply to NFTs where gaming companies promote true ownership and ability to sell cryptocurrencies and NFTs through secondary markets. This is one of the reasons why many blockchain-based games use less chance-based mechanics and more gaming or user-generated content business models.

  • NFT Insider Trading Policy – ​​Companies creating NFTs and marketplaces selling NFTs must adopt an NFT Insider Trading Policy. There have recently been high profile incidents of employees and executives of NFT companies and marketplaces engaging in activities that could be deemed unfair or illegal. These incidents create unwanted press for these entities. NFT insider trading policies often prohibit buying NFTs based on material nonpublic information. They also prohibit various types of transactions on corporate NFTs that are designed to inappropriately manipulate the perceived price or trading volume of such NFTs.

Conclusion

With proper advice from a lawyer, the vast majority of NFTs created by reputable companies can easily comply with applicable laws and avoid these and other legal issues. It is important to work with a lawyer who understands the legal issues that can arise with NFTs and who can identify and advise you on relevant legal issues based on the specific facts of your NFT. The attorney can also write a license for your NFT based on your trading choices and write a custom NFT insider trading policy for NFTs related to your business.

Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XII, Number 104