NFTs: Key U.S. Legal Considerations for an Emerging Asset Class
The Situation: Non-fungible tokens are an emerging digital asset class that present a unique set of commercial, regulatory, and other legal considerations.
The Result: The current U.S. regulatory and legal framework is slowly catching up to the developing technology. Key legal issues include how NFTs can be categorized, intellectual property rights, anti-money laundering and sanctions implications, cybersecurity concerns and state laws governing virtual currencies.
Looking Ahead: As the asset class matures, U.S. regulations and laws are catching up to the developments and increased interest in the technology—with other applicable global regulatory regimes already in place. Investors, financial services and fintech companies in this space should consider key legal issues and make careful plans for exploring potential opportunities in this space.
NFTs, or non-fungible tokens, are an emerging digital asset class that have captured the attention of consumers and investors alike. Although the technology that makes NFTs possible has been around for several years, NFTs have very much emerged into public consciousness in 2021. Celebrities, creators, and athletes are investing in NFT technology and exploring ways to commercialize their brand, image, or work through issuing NFTs. While this asset class is in its nascent stages, the legal and regulatory issues they present are very real. Below we briefly describe NFTs and some of the most relevant U.S. legal issues.
What are NFTs?
In general terms, an NFT is a digital asset, based on computer code and recorded on a blockchain ledger to prove ownership and authenticity of a unique asset. Its "non-fungible" nature distinguishes an NFT from other digital assets. Most other blockchain tokens are created to be fungible or "interchangeable." For example, two different bitcoin ledger entries are interchangeable, and being the holder of either allocation would give the owner the same rights as the other. Almost anything can be represented by an NFT providing it is a unique asset—for example, real property titles, cars, houses, and other merchandise, as well as digital assets such as images, documents, videos, and tweets. In one recent case, a unique digital artwork represented by an NFT was auctioned off at Christie’s for $69 million.
At its essence, NFTs bring unique assets into the digital space and make ownership of that asset verifiable. In technical terms, NFTs are often created on the Ethereum blockchain through the ERC‑721 token standard written in the Solidity programming language. NFTs are now also being created on the EOS, Cardano, Flow, and Tron blockchains.
What Are Some Key Legal Considerations Surrounding NFTs?
The existing regulatory and legal environment was not designed to accommodate digital assets, including NFTs. Nonetheless, there are some key issues that have emerged while investors, financial services and fintech companies, and other commercial interests explore this space. Simply stated, there is no "free lunch" on the regulatory front for NFTs, and this asset class also presents other commercial and legal issues—many of which have current solutions, but may require compromises:
Will an NFT be Treated as a Commodity or Security (or Something Else) in the U.S.?
By their nature, NFTs can be linked to a variety of different assets and represent numerous rights and obligations, making them challenging to classify. Although regulators so far have not provided official guidance about NFTs, it is possible that an NFT could be considered a "commodity" under the Commodity Exchange Act ("CEA"), which defines the term to include several enumerated items and a catch-all for "all other goods and articles." The Commodity Futures Trading Commission ("CFTC") has also stated that the "commodity" definition includes cryptocurrencies, like Bitcoin and Ether, as well as renewable energy credits, emission allowances, and other intangible items. NFTs share some similarities with cryptocurrencies in the sense that they too are purchased, sold, and held using blockchain technology.
If an NFT is considered a commodity, the CEA may apply in one of two possible ways. First, the CEA's general prohibitions on deceptive and manipulative trading may apply to NFT transactions effected on a "spot" basis, i.e., fully-funded, unleveraged transactions. If an NFT is offered on a margined or leveraged basis, however, additional requirements could apply—including the requirement to trade the NFT solely on a registered derivatives exchange—unless the transaction results in the "actual delivery" of the NFT within 28 days. The CFTC recently issued an interpretation on "actual delivery" for digital assets used as a medium of exchange that can be helpful in considering these issues.
Looking beyond the CEA, many NFTs available on the market today appear unlikely to be considered "securities" under the federal securities laws for a number of reasons. An NFT could be considered a security, however, if it were designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such. One potential example of such an arrangement could be a "fractional" NFT ("f-NFT"), where an investor would share a partial interest in an NFT with others. Depending on the facts and circumstances, f-NFTs could be considered an "investment contract" under the Howey Test.
If an NFT (or f‑NFT) is considered a security, then common securities law issues would be present—e.g., registration or exemption of the offering under the Securities Act of 1933; registration of the sellers of those instruments as broker-dealers under the Securities Exchange Act of 1934 ("Exchange Act"); registration of the marketplaces on which the instruments are sold as securities exchanges under the Exchange Act; securities law liability for material omissions or misstatements and insider trading; restrictions on short sales and market stabilization around an initial offering; and so on.
What Intellectual Property Rights are Transferred in a Sale of an NFT?
In general, the rights that accompany an NFT are determined by the seller of the NFT. NFTs contain metadata that describe the corresponding assets to which they are bound. For many NFTs available today, each asset underlying the NFT is created by someone who owns intellectual property rights in the asset and decides what rights to grant the NFT buyer. If the issuer of an NFT is a content creator, then the issuer will have all rights in the content and can create NFTs that correspond to that content assigning any of those rights to a buyer—for example, the right to use, copy, display, and modify the content. If an issuer obtains content from a creator, then the issuer would only receive the rights such creator assigned or licensed to the issuer, and will only be able to assign or license those limited rights to the buyer. Common issues that could arise in NFT transactions include ensuring that sufficient transfer, assignment, or licensing language (including any restrictions on the buyer's right of use) is included in a sale to effect the transfer of rights in the manner intended by the parties to the sale.
Are NFTs Subject to Federal Anti-Money Laundering Laws and What About U.S. Sanctions?
The Financial Crimes Enforcement Network ("FinCEN") is the bureau of the U.S. Department of Treasury with regulatory authority over the financial system to combat money laundering under the Bank Secrecy Act ("BSA") and other related laws. To date, FinCEN has not issued guidance specific to NFTs, but it has published guidance generally about how the BSA and FinCEN regulations relate to virtual currencies that could apply to NFTs. One question is whether FinCEN regards NFTs to be "value that substitutes for currency." If NFTs are considered substitutes for currency, then FinCEN could consider NFTs to be subject to the BSA and FinCEN regulations. Since many NFTs are more like digital representations of ownership in unique assets than value that substitutes for currency, however, it seems that many NFTs available on the market should not be subject to FinCEN's oversight. Depending on the facts and circumstances, certain other business activities related to the transfer, sale, and custody of NFTs may implicate FinCEN regulations.
The Office of Foreign Assets Controls ("OFAC") administers most U.S. sanctions programs. Similar to FinCEN, OFAC has not provided guidance specific to NFTs, but it has explained that U.S. sanctions apply to digital transactions and currencies in ways similar to traditional activities. Further, OFAC has pursued enforcement actions involving cryptocurrency transactions and blockchain technology. The possibility of persons subject to U.S. sanctions participating or benefitting, directly or indirectly, from activities involving NFTs present the primary avenue of risk exposure; moreover, NFTs present circumstances that OFAC has identified in other scenarios as presenting heightened risks for potential violations. While details will vary with different structures, the potential lack of transparency and decentralization associated with the use of blockchain technologies can present difficulties in preventing sanctioned persons from participation. Further, NFTs may present many of the same issues that OFAC recently identified as associated with artwork, including a high degree of anonymity, the use of intermediaries, concealability, and subjective valuation. Given these considerations, those participating in NFT transactions should pay heed to sanctions considerations.
Are NFTs Subject to State Laws Governing Virtual Currency or Money Transmission?
Given the superficial similarities between NFTs and some virtual currencies, it is reasonable to consider whether NFTs are subject to state laws governing virtual currency or money transmission. To date, no state regulator with oversight of virtual currency or money transmission has issued guidance directly about NFTs. Depending on how a particular state defines money transmission, it is possible that some may try to claim regulatory oversight over certain NFTs or certain business activities related to NFTs.
In addition, some states have passed laws addressing the operation of companies engaged in virtual currency businesses. New York and Louisiana are two examples. Each state has a list of activities it deems under its laws to constitute virtual currency business activities, which can include for example: exchanging, transferring, controlling, administering, or issuing virtual currency. Both states require companies that engage in such activities to obtain a license or charter and post surety bonds or fund an account for the protection of customers. Depending on the characteristics of the NFT, it is possible that either state could try to apply its virtual currency law to the NFT marketplace. However, many current NFTs available on the market should not be subject to those statutes.
Do NFTs Give Rise to Unique Cybersecurity Concerns?
As a fully digital and potentially valuable asset, NFTs likely will be targeted with greater frequency by cybercriminals for financial gain. Centralized NFT marketplaces that store private keys may prove especially attractive. By obtaining the private key associated with an NFT, a malicious actor can access, move, and sell the NFT without authorization from the NFT's rightful owner. And once stolen, given the decentralized and immutable nature of blockchain-based transactions, the NFT is not so easily returned.
An online NFT marketplace recently acknowledged that a small number of its user accounts were compromised in so-called "account takeovers" in which an unauthorized third party acquired the credentials (e.g., passwords) needed to access user accounts. The incident highlights a key vulnerability inherent in all user-facing online platforms—users inevitably may be the most common point of compromise and are susceptible to phishing attempts, brute force attacks, and other tactics designed by malicious actors to obtain account credentials.
To mitigate the risk of loss and legal exposure, NFT platforms should consider administrative, technical, and physical safeguards, such as multi-factor authentication to better protect the security of private keys and account access credentials, need-based access controls, periodic risk assessments, and written policies that clearly document the same.
The inherently cross-border nature of NFTs also raises complex issues of applicable law and regulation that may arise if NFTs are sold globally, and it should be noted that other jurisdictions already have regulatory regimes which will be relevant to NFTs (such as the EU's proposed Markets in Crypto-Assets Regulation) which we will address in a follow up publication.
This is a dynamic space that should be monitored as the asset class evolves, markets develop, and the law and regulations begin catching up. But enough is known today about the key issues, such as those set forth above, to develop careful plans for exploring potential opportunities in this space.
Four Key Takeaways
1. NFTs are an emerging asset class that have captured the attention of consumers and investors in the U.S., but have outpaced the regulatory and legal framework.
2. Key to understanding the use and value of any NFT are the intellectual property rights granted, for example, the right to use, copy, display, and modify the content.
3. There is no direct state regulatory guidance on NFTs, though a few states have created laws that could hold NFTs under their purview. FinCen has not issued any guidance specific to NFTs, but it has published guidance generally about how the BSA and FinCEN regulations relate to virtual currency that could apply to NFTs.
4. NFTs likely will be targeted with greater frequency by cybercriminals for financial gain or by persons otherwise restricted from traditional markets. NFT platforms need robust controls to guard against such risks.