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What you need to know about NFTs and the law

NFTs and the law

As a lawyer or other legal professional, do you really need to know about NFTs and the law? After all, non-fungible tokens (NFTs) are a new type of digital asset, seemingly more important to tech aficionados and investors than attorneys.

What do NFTs have to do with the practice of law?

The answer is this: quite a bit.

In fact, the rapidly growing NFT industry poses a number of novel legal issues that you and your peers will need to sort out. If you are able to understand and anticipate these issues, you may have a head start in the emerging NFT legal market.

What are NFTs and how do they work?

A NFT is a digital certificate of ownership of or rights to a unique asset, recorded on a blockchain ledger.

NFTs are composed of smart contracts, which are contracts where the terms agreed to by buyer and seller are directly written into lines of computer code. Once the smart contract is created, it is permanently added onto the blockchain, so that the NFT cannot be modified or altered in any way.

The NFT is referred to as “non-fungible” because it is not interchangeable with other certificates.

This is in contrast to other blockchain-based assets, such as cryptocurrency. One Bitcoin, for example, is completely interchangeable with another Bitcoin.

The theory behind NFTs is that their non-fungible nature makes them well-suited to represent the rights to unique assets.

NFTs have commonly been used to represent rights to digital assets such as digital art, collectibles, and game items. In March 2021, an artist named Beeple sold a NFT for digital art through the Christie’s auction house for approximately $69 million.

However, NFTs can also be used for other digital and physical assets, including tickets, subscriptions, and exclusive access rights.

Is a NFT a security?

One of the key legal issues arising from NFTs is whether they can be classified as securities.

The question is important because it determines whether securities regulations apply to NFTs. Treating NFTs as securities would mean they need to be registered as securities, NFT sellers would need to register as broker-dealers, and NFT marketplaces would need to register as securities exchanges.

Numerous other securities laws would also apply, such as liability for material misrepresentation or omissions.

To be considered a security, an investment must meet the Howey test formulated by the U.S. Supreme Court in 1946. This test asks whether the transaction is a monetary investment in a common enterprise where profits are reasonably expected from the efforts of others.

Whether any particular NFT meets the Howey test will likely require a case-by-case analysis. Some digital art would not appear to pass the test, since it does not involve the future efforts of others.

In addition, if the primary purpose of the asset is consumptive, such as a NFT of a song, that would cut against designation as a security.

On the other hand, NFTs could be governed by securities law under certain circumstances.

For example, the NFT could represent the license to an asset such as a song along with a right to revenue from the asset. Or the NFT could represent a fractional share, where multiple investors own an asset. Under these scenarios, the NFT may be classified as a security.

Legal challenges surrounding NFTs

The legal landscape around NFTs remains unclear since the existing legal and regulatory framework was not designed for digital assets such as NFTs.

Nonetheless, there are several areas where NFT legal challenges appear likely.

Intellectual property rights

A critical issue for NFTs is determining which intellectual property rights are transferred in the sale of a NFT.

If the NFT issuer obtains a piece of content from a creator, they only receive the rights assigned or licensed by the creator. NFT transactions could present issues about whether sufficient language is included in the smart contracts underlying the NFT so that there is a transfer of rights as intended by the parties.

Anti-money laundering laws and sanctions

NFT sales could potentially be used as a form of money laundering just like high-value physical artworks.

In fact, the U.S. Treasury Department has already published a study discussing the risk of financial crimes with NFT transactions.

NFT transactions could also run afoul of sanctions restrictions.

For example, the Treasury Department recently designated a Latvia-based cryptocurrency exchange and several associated digital wallet addresses as sanctions targets for facilitating ransomware transactions. Since one of those addresses owns NFTs, U.S. citizens are prohibited from buying any of those NFTs.

Regulatory concerns

We have already covered the regulatory concerns for NFTs possibly being classified as securities. In addition, NFTs could be subject to state laws governing virtual currency and money transmission.

The issue remains murky, because no state regulator has issued guidance on the matter. Some states have passed laws requiring virtual currency businesses to obtain licenses, and these states could attempt to apply those laws to the NFT market.

Cybersecurity concerns

NFTs could also pose as targets for cybercrime. For example, a malicious actor could obtain the private “key” to a NFT, then sell it without authorization from the rightful owner.

A recent high-profile example involved the actor Seth Green paying $260,000 to recover a stolen NFT he had purchased from the Bored Ape Yacht Club collection.

NFT theft is a legal gray area since it is unclear if the original owner does or does not own licensing rights. The legal industry needs to monitor how the law and regulations surrounding NFTs evolve along with the NFT market itself.

The bottom line – what you need to know about NFTs

As a new frontier in digital assets, NFTs pose many opportunities and risks for those buying and selling them. For legal professionals, NFTs may present similar opportunities and risks in helping clients dealing in these assets.

Realistically, you don’t need to be a blockchain expert to practice most types of law.

Still, there’s probably more overlap than you think.

For family lawyers, what happens if a client wants to include a NFT in their will? For all kinds of litigators, what if your case involves NFTs?

Even if they aren’t your specialty, NFTs are common enough that you’re likely to encounter them at some point in your legal career. It’s wise to learn the basics and build a reference library just in case you need it.

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