February 24, 2022

The Legal Factors Companies Must Consider When Exploring NFTs

This article by Tariq Akbar, LegalEase Solutions, was published on February 24, 2021 on Forbes.com

Multimillion-dollar JPEGs, six-figure video files, virtual real estate — these are just a few of the use cases associated with nonfungible tokens (NFTs). While many talked-about NFTs involve collectible-type items, organizations are looking to join the fray as adoption takes off. Many companies and creators are minting and distributing NFTs to offer token holders membership benefits and commercial licensing rights and are allowing users to buy virtual clothing and other digital items.

NFTs can offer an intriguing opportunity for companies, considering it’s a space that has already seen sales volumes reach $2.5 billion over the first half of 2021. However, organizations looking to explore NFTs will find the regulatory landscape governing them less defined than those addressing more established currencies. As the CEO of a company that works on the compliance side of digital assets, here is what I believe companies looking to explore the space should expect when weighing whether to pursue NFTs as well as the regulatory questions and nuances they should consider.

How NFTs Could Help Companies

NFTs are unique in that they constitute an immutable, verifiable way to prove ownership of underlying assets. Unlike Ethereum or Bitcoin, which are interchangeable and fungible currencies, NFTs are one-of-a-kind, time-stamped tokens that verify an owner’s right and title to the asset it describes. NFTs often consist of two parts: the token, which represents the holder’s proof of ownership on the blockchain and hosts the code that distributes royalties and executes smart-contract commands; and the asset, to which the token is linked. Separate servers usually store NFT assets, which holders can only access through links embedded in their tokens.

For creators and companies that are exploring the adoption of digital assets, the technology could be a game-changer. It resolves the degradation of value issues that come from the copying of digital files and other property, all while giving creators the ability to explore new revenue streams and control the terms and use of their assets through smart contract technology. And now, with talks of the developing metaverse heating up in light of Facebook’s recent branding pivot and increased publicity for metaverse-focused blockchain projects such as Decentraland, Sandbox and Enjin, NFTs may become even more essential to the future of the digital economy.

NFT Legal Issues And Compliance Pitfalls

Companies, however, should tread carefully before exploring digital collectibles and NFT-based assets. After all, the laws governing these assets are still unsettled. Cryptocurrency and blockchain transactions do not necessarily stick to nation-state regulations, leading to complex cross-border considerations. In essence, the main issues surrounding NFTs are two-fold: the contracting issues accompanying the space and the compliance needs that accompany NFT sales. The legal function can step into the fray to clarify these issues in ways that protect that company and all NFT participants involved.

On the contract front, there is a massive amount of transactional work in the area where institutions are buying and selling NFTs. Organizations should solidify the terms and conditions governing these transactions and can do so by embedding metadata into the NFT through relevant property tags. Incorporating this metadata into your NFTs is essential, as it describes the properties that underlie NFTs’ identity and value. Metadata information can include descriptions of the rights underlying NFTs and more critical elements that help NFT marketplaces display NFT assets to interested users, such as asset names and preview images. Legal can help drive this process by building out clear metadata and smart contract terms that can help inform new holders about their IP rights and compensate original creators appropriately.

Legal considerations, however, can be more convoluted on the compliance front. For one, the very transparency of NFT ledgers could present a double-edged sword for companies facing stringent data privacy compliance requirements. Theoretically, an individual who purchases an asset from a German or Californian company could turn to the token’s digital ledger to track ownership chains and learn the identities of those owners. While these ledgers’ immutability underscores NFTs’ value proposition, they would also make it impossible for companies to comply with consumers’ requests to erase or amend data under GDPR or CCPA requirements.

There is also the issue of whether the SEC will regulate NFTs as securities and subject NFT creators to its oversight. Friel v. Dapper Labs, Inc., the first-ever class action NFT lawsuit, may foreshadow the types of issues companies should be considering as they launch their NFT initiatives. In this suit, the plaintiffs allege that Dapper Labs, which launched the popular NBA Top Shots application, sold Top Shot Moments NFT bundles as unregistered securities that would be considered investment contracts under the Howey Test. They also claim that Dapper Labs used its control over the Top Shots application to prevent NFT holders from cashing out their assets as a way of propping up the platform. The outcome of this case could be consequential for companies considering launching marketplaces and fractional NFT offerings, which could raise unique securities considerations. 

These, of course, are not the only legal issues that companies should be weighing. For one, it is possible that the CFTC could classify and regulate NFTs if it considers them to be nonfinancial commodities. There has also been discussion about whether the IRS will eventually tax NFTs as “collectibles,” even though Section 1(h)(4) of the Internal Revenue Code is unclear whether Congress intended to limit this definition to “tangible” items. As this groundbreaking area continues to mature, GCs and law firms should monitor upcoming domestic and international regulatory developments that could affect the space.

Despite the potential legal and compliance issues accompanying them, NFTs hold much promise for companies and are worth exploring for their revenue potential. Education and awareness will be the main obstacles to progress and certainty in the NFT space. Once companies and users start adopting NFTs and achieving a level of comfortability with the technology, we will likely see more organizations using these assets to effect large-scale change. GCs and their legal departments are well-positioned to help companies start this process.

The information provided here is not legal advice and does not purport to be a substitute for the advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.

Tariq Akbar,
Chief Executive Officer, LegalEase Solutions tariq.akbar@legaleasesolutions.com

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