Introduction to NFTs
Throughout 2021, non-fungible token (NFT) artwork has sold for record breaking prices and is rapidly increasing in popularity. In the second quarter of 2021, NFT sales surged to $2.5 billion, which is a tremendous increase from the $13.7 million in sales during the first half of 2020. In March 2021, the artist Beeple sold his NFT through Christie’s for $69.3 million. In June 2021, one of 10,000 CryptoPunks NFTs created by the artist duo Larva Labs resold for $11.8 million through Sotheby’s.
An NFT is a digital asset or unit of data that stores information on blockchains. Blockchains are digital ledgers that record information chronologically in “blocks”, which are then chained together to form an irreversible timeline of data. Whereas databases store data in tables, blockchains store data in chains of blocks. Blockchains function similarly to a bank ledger in that they reveal the entire transaction history of digital assets, allowing for easy verification of asset ownership and authenticity. Most NFTs are part of the Ethereum blockchain, which is a decentralized, open-source blockchain where no single group or person has control over the blockchain. Rather, all users retain control over this blockchain. As a result, the data entered into the blockchain is irreversible and permanent—it cannot be modified, deleted, or pirated as all transactions are permanently recorded and viewable by the public.
Digital assets created on blockchains can be transferred between parties. These transferable assets are called tokens. An NFT is a non-fungible token, which means it is a one-of-a-kind asset. This is unlike Bitcoin, which is fungible and replicable. One Bitcoin can be traded for the same exact Bitcoin like $1 USD can be traded for $1 USD, but one NFT cannot be traded for the same exact NFT, similar to how there is only one real Mona Lisa in existence. An NFT is non-fungible because it contains unique identification code and metadata that distinguishes it from other tokens. NFTs can store any type of digital information—anything such as drawings, photographs, videos, documents, real estate transfers, music, games, and more.
Each NFT contains a smart contract. Smart contracts automatically control the terms and conditions under which NFTs can be transferred and are similar to normal contracts but written in software code. For example, the software code in a smart contract can provide automatic royalty payments to the creator each time the work is used or sold, or outline specific copyright and licensing rights. Smart code is permanently minted into a token on a blockchain, mostly Ethereum. Once the NFT is created, it cannot be modified or deleted. The token provides an unreplicable certificate of ownership of the work.
The rapid rise in popularity and prevalence of the creating, buying, and selling of NFTs combined with the relatively novel concept of NFTs has created legal uncertainties and evolutions.
Because smart contracts are performed automatically, the typical contract law disputes that arise from parties’ lack of performance or improper performance tend to not arise around NFT transactions. However, the marketplace in which NFTs are bought and sold could have conflicting text-based terms and requirements in transactions from the terms of the smart contract. When disputes arise out of these conflicting terms, it is unclear how these disputes should be resolved, as there is practically no case law around NFT contract disputes.
Under copyright law, when a buyer purchases an NFT, the buyer purchases the specific copy or version of the work the artist created. The buyer does not purchase the copyright to the underlying work unless stated otherwise—smart contracts can be coded to include the transfer of the copyright. However, it is possible that the seller of the NFT could falsely assert ownership of the copyright to the underlying work represented through the NFT, leading to a copyright infringement claim. Moreover, buyers unfamiliar with the realm of copyright ownership in the purchase of artwork could overvalue an NFT based on the buyers’ misconception of purchasing the actual underlying copyright. Copyright law comes into play to ensure the proper “transfer, assignment, or licensing language” in the smart contracts.
While most NFTs on the market are not securities, it is possible that NFTs can be considered a security. If so, it would be subject to various securities law, including the Securities Act of 1933, the Securities Exchange Act of 1934, and state securities regulations. Under the Howey Test, an NFT could be considered a security if it was an investment specifically designed to return a profit on investment based on the efforts of third parties. Artwork is generally not considered a security, because it is a product of an already existing work, but fractionalized NFTs (f-NFTs) could be a security. An f-NFT arrangement occurs when an investor shares a partial interest in an NFT with other investors, which could be deemed an “investment contract” under the Howey Test. Moreover, certain NFTs have governance rights in their smart contracts that outline rights surrounding profit redistribution for future holders, which could allow the NFT to be considered a security.
Data Privacy Law
The General Data Protection Regulation (GDPR) is seen as the global gold standard when it comes to data privacy law. The California Consumer Privacy Act (CCPA) is similarly consequential. Both the GDPR and CCPA provide individuals with the right to request erasure of their personal data, which is any data that is personally identifiable. However, given the immutable and permanent nature of blockchain, data cannot be deleted, and the individual’s request for erasure is impossible.
Some artists create NFTs that shift or self-replicate into new works. Mad Dog Jones sold an NFT designed to generate new and unique NFTs every 28 days. Pak, an anonymous artist, sold an NFT that contains an irreversible, one-time feature that allows the owner to initiate an action that switches the work into a new piece of art. Buyers purchase these types of NFTs without knowing what content the work will shift or self-replicate into. Though the aforementioned artists are reputable, as the popularity of NFTs continues to increase and the number of artists who create and sell works multiplies, the question of how to handle illicit content will inevitably arise. For example, under current U.S. federal law, the mens rea for conviction of child pornography possession is knowingly. This means that a buyer must know that the work would have later shifted into child pornography in order to be held liable. Law enforcement would then need to go after the creator of the work, for knowingly distributing and selling the work, in order to hold anyone accountable for this crime.
But, what if the artist is anonymous, like Pak, and law enforcement runs into issues tracing the artist’s identity? Or, what if the artist is in a jurisdiction that makes it difficult to prosecute the suspect? Under current federal law, these issues, combined with the inability of holding the owner of the artwork liable, would allow the sale, distribution, and possession of child pornography through NFTs to go unprosecuted. Similar legal complications arise with all illicit material, not just with child pornography.
The digital nature of NFTs offer numerous benefits, but as NFTs become more and more mainstream, the legal implications, uncertainties, and framework of transactions need to be solidified. NFTs and blockchain technology impacts multiple sectors of our daily lives, and the legal framework needs to adapt in order to accommodate the growing volume of transactions.
* Irene Sun is an Associate Editor on the Michigan Technology Law Review.