What are the legal considerations for NFTs

What are the legal considerations for NFTs

The concept of non-fungible tokens (NFTs) was first introduced in 2012, with the rise of Colored Coins. Today, most people associate NFTs with Ethereum, and its creator Vitalik Buterin. Although the idea was first conceived by Vitalik, it was first introduced on the Bitcoin network, as a way of issuing other types of assets on top of the blockchain. In the early days, Colored Coins were basically satoshis that were used to represent something else. This concept was supposed to allow Bitcoin users to issue everything from company stocks to video to in-game items for video games. 

Many Bitcoin users were enchanted by this concept of issuing alternative assets on top of the Bitcoin blockchain. However, Bitcoin’s limited scripting language was unable to sustain such an application and various early Colored Coin proposals for Bitcoin never gained much traction. Still, the concept of Colored Coins opened many possibilities for experimentation and laid the foundation for successful NFTs that we have today.

Today, digital assets have become increasingly important. And so, in this article, we decided to explain what NTF’s are, how they work, and what are NFT legal issues you should be aware of in your interactions with non-fungible tokens. Let’s dig in.

What is an  NFT?

So, what is a non-fungible token? Well, the name says it all, non-fungible stands for something irreplaceable and unique. Unlike cryptocurrencies that are focused on making all of their network tokens identical (i.e., fungible), NFT creators make sure that each of their tokens is special and unique. An NFT can represent everything from a digital trading card, game, tweet, Gif, to paintings, songs, and other types of art. Essentially, they are just like any other collector’s item, but instead of buying a physical item, you’re paying for a file and proof that you hold the original copy. 

Just as NFT moved from Bitcoin to Ethereum, there is another transition happening in the blockchain world. Although most popular NFT projects exist on Ethereum, there is also a large number of NFT apps that use alternative blockchains. For instance, NBA top, the most successful NFT collectible game, uses Flow Blockchain, which was developed by the team behind crypto kitties. Furthermore, Axie Infinity, one of the most popular NFT collectible sets, issues tokens on the Ronin Blockchain. 

How do NFTs work?

Essentially, NFTs work on the same programming code as cryptocurrencies. But as we said, cryptocurrencies such as Bitcoin and Ethereum are fungible like fiat currencies, while each NFT is different from the other. For instance, each Bitcoin holds the same value and can be traded or exchanged easily. When it comes to NFTs, each one has a different signature and can’t be exchanged or traded as equal.

NFTs can have only one owner at a time (even if, fractional owner). NFT ownership rights are managed through a unique ID and metadata no other token can duplicate. NFTs are validated through smart contracts that assign ownerships and supervise the transferability of NTFs. When someone generates or mints an NFT, they carry out a code stored in smart contracts that complies with standards such as the ERC-721. Finally, this information is attached to the Blockchain, where the NFT is being supervised.

NFTs have generated a lot of attention and become a hit in the arts and entertainment world. However, as this technology continues to evolve,  NFTs will probably play a huge role in many real-world business cases such as licensing, certifications, real estate, logistics, etc. Personal identity management is one area in which NFTs will surely bring significant changes. Every NFT contains a code with a unique body of information. So, they could potentially be used to tokenize documentation such as medical records, degrees, licenses, various certificates, etc. Certification can be issued directly on the Blockchain as an NFT, which can then easily be tracked to its owner. So, employing NTF to store and protect identification, certification, and documentation can give users better control of their data and can prevent identity theft.

Real Estate is another interesting use-case application. When it comes to real estate, NTFs have applications for selling digital real estate in both virtual and the real world. Real estate applications are gaining momentum in games such as Decetraland, in which participants can create and purchase areas in the virtual world. With NFTs, all objects and their original producers can easily be identified. A good example of virtual real estate is the digital “Mars House” and it represents a home mounted in glass and surrounded by neon lights. In the end, the house was sold for $500,000, however, the owner could never live in it, because it is completely virtual. Furthermore, some examples of virtual real estate include a Twitter page that sells and buys real estate through virtual role-playing games such as Superworld. 

Although there are quite a few examples of virtual real-estate sales, real-world real estate NFT applications are still in their infancy. In the future, NTFs and Blockchain technology may provide an efficient way for checking and verifying ownership history. Nevertheless, this type of application can create some serious security issues. For instance, blockchain can enhance NFT security, however, it can also be hacked. Also, if a private key to an asset is lost or misplaced, access to the asset can be lost. 

NFTs can also be used in supply chains for authenticating products, ensuring quality, and confirming their origin. Although in their infancy, NFTs on the Blockchain are fit for logistics applications due to their immutability and transparency, which can keep supply chain data authentic and more reliable. What’s more, NTFs could potentially help eradicate counterfeiting, trace the movement of goods, and assure authenticity. For instance, the automotive industry can greatly benefit from this technology, as NTFs can provide information about each material and every component in a particular vehicle. 

Legal considerations for NFTs

Let’s explore some legal considerations now. While NFTs are getting more and more popular with each new release, there are still ambiguities regarding the regulations that supervise the NFT market, its ownership rights, and its legal representatives. Some of the common NFT issues involve data protection, copyrights, financial liability, contract signing, theft and hacking, etc. Interestingly, if an NFT is created to represent a work of art or any other creation, this doesn’t mean the creator or later owner will hold the underlying intellectual property rights such as the copyright. NFT owners need to acquire a license of these underlying rights from the creator or author of the original work, to be able to reproduce the original work itself.  The owner of the NFT IP rights can choose whether to grant a license and also impose other constraints on how the work can be used in the NFT. There are legal implications if you happen to breach these terms, such as an NFT marketplace terminating your user account or seeking to enjoin you from further misuse. 

Issues that impact smart contracts generally, also impact the NFTs since smart contracts are what make NFT sales possible. They are digital contracts in which agreements are written in code and operate automatically when a pre-defined set of conditions are satisfied. For example, smart contracts can automatically make royalty payments to the creator, once the NFT is resold. The code is permanently minted onto a token on the Blockchain, therefore, it cannot be replaced, deleted, or altered in any way. As smart contracts function automatically, once certain contractual obligations are made, there should be fewer legal disputes over the terms and performance of the contract. Still, there are very few legal precedents, legislation, or regulation addressing smart contracts. The questions of whether smart contracts are legally binding are constantly being raised in different contexts. 

NFTs are also subject to issues in connection with data-hosting and storage. NFTs are stored on the blockchain as separate units and hold information on the asset’s location. The connection to the digital asses is made possible through a link, and if the server hosting the link is offline, the link will break and the NFT will be lost forever. Also, since every NFT is unique, its owner can’t be replaced. Consequently, the NFT purchaser could be left without resources. Such a scenario can lead to business interruptions, severe record-keeping violations, and most importantly, loss of data.

The GDPR is based on the assumption that there is at least one natural person or legal entity for each personal data point to which the data subject can claim their rights (for example, the right to delete or modify personal data). However, blockchain technology does not require users to disclose their ID, making it almost impossible for data subjects to exercise their rights. The identification point does not violate the GDPR, but the fact that it is technically impossible to delete the personal data stored on the blockchain because the blockchain is immutable violates the GDPR. As a result, NFTs that contain personally identifiable information may violate some of our privacy principles.

Should you pay taxes on NTFs? Well, in most cases you should. In case you’re not making money on selling NTFs, then you should report the proceeds as income on a tax return. Therefore, the same laws apply to fungible crypto work for non-fungible assets. If someone invests in them, any revenues are taxed as property and subjected to the capital tax profit. However, the UK’S  HMRC has recently updated the ‘’Crypto Asset Manual’’. They state that NTFs fall into a slightly different category of digital assets. They are separately identifiable and should not be pooled with Capital Gains Tax purposes. 

The Consumer Financial Protection Bureau and the Federal State Commission have started to investigate NFTs, as they are primarily responsible for consumer protection. What they discovered is that NTFs can be a breeding ground for misinformation and false advertising. Namely, NTF buyers often have very little knowledge of what they are purchasing, and resellers sometimes represent inaccurately what they are selling. Furthermore, buyers purchasing through  NFT Marketplace are subject to liability restrictions and buyer precautions outlined in each Marketplace’s Terms of Use or Community Standards. NFT Marketplace uses these Terms of Use to exclude liability for potential counterfeiting, fraud, or fraud by users on the Marketplace.

In 2019, the FTC filed a lawsuit against Match.com. This example illustrates how the FTC used UDAP, to protect a consumer from user misinterpretation that occurred on an online platform. Namely, Match, com allegedly generated user-triggered emails, that were based on fraudulent accounts activity. Consequently, these emails led consumers to subscribe to the Match.com platform and what they found is that the fraudulent user initiating the activity was already deleted from Match.com.

As they are fully digital and potentially valuable assets, NFTs are more likely to be targeted by cybercriminals for financial reasons. The centralized NFT marketplace for storing private keys turns out to be particularly attractive. Obtaining the private key associated with the NFT allows a malicious attacker to access, move, and sell the NFT without the permission of the legitimate owner of the NFT. Also, if an NFT is stolen, it cannot be easily returned due to the decentralized and invariant nature of blockchain-based transactions.

Conclusion

Without a doubt, NFTs are changing the art world as well as the digital assets generally are changing the financial aspects of our society. Ever since Bitcoin was introduced in 2010, the world of blockchain has been evolving and it seems governments and financial institutions don’t have a way of stopping it. If you’re planning to enter the world of NFTs, but the legal issues surrounding NFTs seem too intimidating, then maybe you should seek legal advice from qualified law firms. The LATTUDE team may be a good start.