Non-Fungible Tokens: The Blockchain Technology Raising Legal Issues

NFTs derive their name from the concept of fungibility because, unlike cryptocurrencies, they are not fungible. NFTs are completely unique and cannot be changed, removed, or destroyed because the data of an NFT, similarly to Bitcoin, is stored on blockchain, an immutable and decentralized digital ledger used to record transactions on a peer-to-peer network. The technology behind NFTs presents a very valuable characteristic as an asset class, verification of authenticity. Each NFT contains data that differentiates it from any other NFT, and such data cannot be replicated. Therefore, replicating NFTs is fruitless because each NFT can be traced back to the original issuer using the blockchain. The ability to trace an NFT back to the original creator removes the need for third-party verification, which increases efficiency and reduces overall costs.

The vast majority of NFTs are built using Ethereum, the decentralized open-source platform that uses blockchain technology to create and run decentralized digital applications (DApps) that enable the creation of smart contracts. Ethereum allows the use of token standards, a form of blueprints, which enable developers to build NFTs while ensuring that the NFTs are compatible with platforms, exchanges, and wallet services currently in the blockchain ecosystem. However, other platforms like Neo and Tron have released their own NFT token standards, which enable developers to build and host NFTs on their blockchains.

The Adoption of NFTs

NFTs are being adopted across many industries but the most high-profile adoption is taking place in the entertainment industry. The NBA, in collaboration with blockchain-based company Dapper Labs, launched NBA Top Shot in 2019, an NFT marketplace for NBA highlight reels. NBA Top Shot allows individuals to buy and sell NBA highlight reels, or otherwise known as moments. Since its inception, Top Shot has generated more than $300 million in sales, with an individual video clip of a LeBron James dunk selling for over $200,000. This bold move by the NBA may be the catalyst for other sports leagues. We will likely see similar marketplaces for the NFL, MLB, and more. Similar marketplaces could also be adopted by other entertainment companies such as Disney, which has a wealth of intellectual property that it could leverage on such a marketplace.

Artists are also heavily adopting NFTs. NFTs provide the ability to sell artwork in a verifiable digital form directly to consumers globally without the need for an auction house or gallery. The removal of such intermediaries allows artists to keep a larger percentage of the profits from a sale. Claire Boucher, a musician and artist, otherwise known as “Grimes” recently sold her collection of digital artwork for $5.8 million in the form of NFTs on a virtual marketplace for NFTs called Nifty Gateway. Digital artist Mike Winkelmann, better known to some as Beeple, recently sold his NFT digital art collage “Everydays: The First 5000 Days” for over $69 million at auction. Although this sale was facilitated by an auction conducted by Christie’s, a traditional intermediary, Christie’s involvement might be a pivotal moment for the validation of NFTs. Another reason artists are drawn to NFTs is the impact that it has on royalties received. Typically artists do not earn royalties from future sales of their work. However, NFTs can be programmed such that the creator receives a predetermined royalty each time their digital artwork is sold to a new owner. For example, Mike Winkelmann will receive a 10% royalty each time his NFT is sold subsequent to this initial sale.

The music industry is also adopting the technology. The band Kings of Leon recently released an album in the form of an NFT on OpenSea, a marketplace for NFTs similar to Nifty Gateway. Steve Aoki, 3lau, Ozuna, and others, like the Kings of Leon, are all taking advantage of the technological innovation that NFTs present to the industry.

Legal Implications

• Potential issues surrounding intellectual property law will likely arise as NFTs grow in popularity. When an individual purchases an NFT the individual typically receives the right to utilize the copyrighted work (i.e. image, video, or other media form) portrayed by the NFT for personal consumption. The individual generally does not expect to use the NFT and the portrayed work for commercial purposes other than perhaps reselling the NFT. However, it is important for NFT marketplaces to draft and present their terms in such a way that is legally sufficient.
• The sale of NFTs will have income tax consequences. Both NFTs and cryptocurrency are treated as taxable property. For example, if an individual purchases an NFT with Ether, the cryptocurrency on which Ethereum runs, the individual will have a tax liability on any capital gains on the Ether (whether short-term or long-term) because the IRS taxes cryptocurrency as property. The same individual will also have a similar tax liability on any capital gains on the sale of the NFT itself (whether short-term or long-term). Furthermore, NFT-for-NFT exchanges would be taxable events. There is a separate tax bracket for “collectibles” that has a higher capital gains maximum rate than for other assets (28% compared to 20%) that could apply to the sales of certain NFTs. It is always advisable to seek advice from a tax professional when affecting NFT transactions.
• NFTs can potentially have significant value and are increasingly likely to become estate assets. The lack of legal structure and existing rules surrounding NFTs will necessitate the addition of specific provisions and instructions in estate planning documents. NFTs add a complex twist to estate planning because an understanding is needed of where and how NFTs are stored and how they can be transferred legally from one individual to another through a will, a trust, or another legal instrument.
• NFT businesses need to be cautious of the risks of being treated as money transmitters because money transmitters are subject to anti-money laundering laws and assessments. The Financial Crimes Enforcement Network (FinCEN) has given guidance that a business may be deemed as a money transmitter if it accepts or transmits convertible virtual currency or if it sells or buys a convertible virtual currency.
• NFTs could potentially face scrutiny from the Office of Foreign Assets Control (OFAC) and US sanctions law, which prevents U.S. residents and citizens from conducting business with individuals or entities from sanctioned countries.

Some are wary of NFTs and are concerned with the speculative nature of this technology, but there is no denying that the trend of decentralization has pushed this technology into the limelight and has given participants in different industries a new avenue to pursue untapped markets. This disruptive technology is here to stay and will grow immensely as it experiences mass adoption.