Recently, I’ve been getting a ton of inbound relating to non-fungible tokens, or NFTs.For those of you living under a rock, an NFT is an object, on
Recently, I’ve been getting a ton of inbound relating to non-fungible tokens, or NFTs.
For those of you living under a rock, an NFT is an object, on a decentralized system such as Bitcoin or Ethereum, designed to be sui generis, i.e., unique. This is in contradistinction to cryptocurrency tokens, where one unit of cryptocurrency is ostensibly no different from any other, much like one U.S. dollar is ostensibly no different from any other.
Preston Byrne, a CoinDesk columnist, is a partner in Anderson Kill’s Technology, Media and Distributed Systems Group. He advises software, internet and fintech companies. His biweekly column, “Not Legal Advice,” is a roundup of pertinent legal topics in the crypto space. It is most definitely not legal advice.
When I buy a coffee with bitcoin, the shopkeeper doesn’t inquire about individual UTXOs (at least, not for the moment, although proposals to blacklist stolen coins could change that). All that matters is the coins land in his wallet and rack up a half-dozen confirmations. With NFTs the opposite is true: The provenance of the asset and its chain-of-title matters, and it matters forever.
As a result, legal thinking needs to be applied not only to NFT systems as a whole (much as it has been for the past several years when cryptocurrency developers seek out legal opinions as to the status of their blockchain systems) but also to individual NFT assets and the manner of sale of those assets.
See also: Jeff Wilser – How NFTs Became Art, and Everything Became an NFT
Where early NFT experiments like CryptoKitties simply ignored these formalities and people bought the tokens anyway, new platforms are bringing increasing degrees of commercial, technical and legal sophistication to their products.
Here are five things worth considering. It goes without saying, this is not legal advice and I’m not your lawyer. But these might form a good jumping-off point for discussion with your lawyers as you build your offerings.
NFTs aren’t necessarily securities …
The NFT craze hearkens back to the heady days of the initial coin offering boom in 2017. ICOs allowed blockchain entrepreneurs to pre-sell coins on networks not yet built. Although the theory of these offerings was that the tokens were collectibles or commodities – one prominent project referred to its pre-sold tokens as a “tote bag,” another described its as being akin to “fuel” – the U.S. Securities and Exchange Commission took issue with many projects that followed this fundraising template. As the Telegram and Kik cases and the recently announced Ripple Labs enforcement action, make plain, pre-selling cryptocurrency tokens in the United States is not, legally speaking, a good idea.
NFTs, on the other hand, are collectibles. Legally this means they are easier to distinguish from “investment contracts” of the sort that get captured by securities laws.
The reason schemes like Ripple Labs’ have been caught within the U.S. SEC’s regulatory perimeter are because they allegedly satisfy the three prongs of the test in SEC v Howey. There is an investment of money in a common enterprise with the expectation of profits arising from the efforts of a promoter or third party. The reason this rule does not apply to, say, a gold eagle dollar or a Magic: the Gathering card is due to the absence of a common enterprise and the absence of an expectation of profit arising from the efforts of promoters or third parties.
… but NFTs can become securities or other regulated products
Let’s take a royalty contract, for example. Alice the Author wants to sell NFT-signed e-books of her popular young adult literature. She approaches Norman, the NFT platform operator, if he can make one for her. Norman agrees to do so if he can split 50% of the profits of the initial sale and get a 5% cut of all secondary market sales thereafter. Alice and Norman sign a contract and the NFT is sold to Bob, who sells it to Carol.
Without more, there is not an obvious reason that either the royalty contract, the sale to Bob or the sale to Carol should constitute an investment contract (and therefore a security). The royalty contract is a private profit-sharing agreement. The sale to Bob looks a lot like any other consumer transaction. Bob’s sale to Carol, similarly, is a private sale of a consumer good.
See also: What Are NFTs and How Do They Work?
Alice could, however, inadvertently turn a non-security into a security if she tries to be too clever about monetization. For example, if Alice fractionalized the NFT and sold fractions of a book or profits from one, that might fall foul of the securities laws.
Similarly, if Alice made an NFT that was the beneficiary of cash flows from other NFTs, that would almost certainly be a security. Also, if Alice represented that the value of the NFT would go up as a result of efforts Alice was planning to undertake to make the NFT useful as part of an online platform yet to be built – in other words the “utility…
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