Non-Fungible Tokens (NFT)
As understanding of blockchain technology has grown, many are finding new and creative uses for it. One area that has become popular in the arts and entertainment industries involves the creation and sale of non-fungible tokens or NFTs. Blockchain technology allows unique pieces of digital content to be authenticated and sold, in some cases for millions of dollars. NFTs are only a few years old and as such are raising novel legal issues. Anyone contemplating creating, buying, or selling NFTs should get legal advice regarding the possible benefits and risks of such transactions.
What are NFTs?
An NFT is a digital file containing art, music, video, or similar content. The content must be a digital creation or a digital image of a tangible item. The NFT is then “minted” on a blockchain. Once it is part of the blockchain, it has a unique identifier that cannot be changed, replicated, or deleted and since the blockchain is a public database, the authenticity of the NFT is verifiable. Essentially, an NFT becomes an original digital piece of art (or a unique copy of a limited series of reproductions) that can be bought and sold as any other collectible. NFT sellers and purchasers can use the blockchain ledger – the public database of transactions – to verify the NFT, the number of times it has been previously sold, and its prior owners before purchasing.
Many in the arts, sports, and entertainment industries have begun developing and selling NFTs for substantial sums of money. For example, the NBA offers player highlights as a form of digital basketball card through its Top Shots online marketplace. Christie’s sold a digital collage from the artist “Beeple” for $69 million. A New York Times columnist wrote an article explaining the recent surge in increase in NFTs, and then turned that article into an NFT that sold at auction for 350 Ether, or approximately $560,000. The potential to develop lucrative revenue streams is likely to fuel more interest in the coming years.
What Types of Legal Issues Arise from NFTs?
As a relatively new type of transaction, the law is still developing with regard to NFTs. Intellectual property, tax, regulatory, and contract laws are some of the areas most likely to raise questions and result in potential liability.
Intellectual Property Law
Often, NFTs incorporate content from multiple sources. This can lead to a variety of intellectual property issues. If the creator of an NFT includes third-party content, there are likely to be copyright law issues. Absent permission from the rights holder, an NFT creator or seller could be liable for copyright infringement for using third-party content. While obtaining permission from the copyright holder may solve that problem, difficulties could arise if the identity of the copyright owner is not clear, given that NFTs are a new use that existing intellectual property licensing contracts may not cover. For example, a record company that otherwise owns the rights to a song may not have the right to use a sample to create its own NFT including that song, or to license that sample to a third party to be used in the creation of a new NFT.
Another complication can arise if the content was created under a work-for-hire agreement. In such arrangements, the creator’s employer typically will own the copyright for any works created by that employee within the scope of that worker’s employment, and it can similarly own any works developed by an independent contractor in certain circumstances. In such cases, the employer, and not the employee or contractor, may be considered the legal author of the work. If a buyer is attempting to purchase an NFT that contains work developed for a creator’s employer, it is important to review the terms of the employment contract to determine exactly who the buyer should purchase the work from. Purchasing the NFT from the incorrect buyer may render that purchase invalid, as the creator may not have the legal right to transfer the NFT (or a work used as a part of the NFT) to the buyer.
In some instances, permission to use these underlying works may not be required under the fair use doctrine. The fair use doctrine allows a party to use copyrighted material for purposes which benefit the public. Usually, these uses include criticism and parody, news reporting, teaching, and research. While courts normally use a balancing test to determine if a particular use of copyrighted material is a fair use, the application of the fair use doctrine as it pertains to NFTs awaits to be seen.
While there is currently no specific federal regulation of NFTs, federal, state, and international laws may apply to the transmission of funds used to purchase NFTs. Buyers may be anywhere in the world, and as such, transactions may implicate anti-money laundering and bribery laws and may be subject to compliance and trade regulations. Participants in the NFT market should evaluate whether they are in compliance with not only U.S. law, but also other global and regional laws.
Income Tax Rules
The sale of NFTs will have income tax consequences. The purchase and sale of NFTs is a taxable transfer of property and is subject to capital gains. However, in some cases, NFTs may be subject to the higher “collectibles” tax rate. Sellers may also face sales and income tax issues. Because the value of an NFT is not determined until it is sold – frequently, at auction – both prospective purchasers and sellers of NFTs should consult tax specialists to get a clearer picture of the potential tax consequences of purchasing or selling an NFT.
As with any contract, it is essential to carefully review the terms of sale of the NFT. The agreement should state the scope of rights purchased, including whether the buyer has acquired the copyright or whether the seller has the right to sell other versions of the NFT. While some buyers are claiming they did not understand what they were buying, that alone does not constitute grounds to contest the transaction. However, where a seller misrepresented the terms of sale, a buyer may have a claim alleging fraud and seek recission of the contract.
Buyers also must conduct their own due diligence to verify the seller’s rights and authenticity of the work. Someone can create a work that violates the copyright of other artists and sell it before the infringement is revealed. In such circumstances, the buyer also can sue for fraud and breach of contract. The best protection is to avoid this situation by conducting a due diligence investigation as buyers should in any transaction involving artwork or collectibles.
Forgery is also a possibility with NFTs to the extent that a buyer fails to confirm that the NFT is in fact on the blockchain and not a counterfeit transaction.
Emerging technologies like blockchain and NFTs raise unique legal issues. Creators, purchasers and sellers of NFTs should consult legal counsel to help avoid liability and protect against substantial financial losses.
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