Expanding Uses for NFTs Lead to New Legal Frontiers | Kramer Levin Naftalis & Frankel LLP

Introduction — Non-Fungible Tokens (NFTs)

Despite the ongoing “Crypto Winter,” the use of NFTs continues to rise. NFTs are associated most often with pictures, videos, and music, but developers have been finding many new and useful applications for them.^[1] As the applications for NFTs grow, the legal considerations expand, particularly when the NFTs are used in ways that touch on multiple areas of the law. Analyzing the potential legal implications for an NFT-based project requires an understanding of the law and a firm grasp of how the underlying technology is being used in this evolving space.

We created this article to provide an overview of legal issues surrounding NFTs and their many applications. This article highlights possible issues under U.S. law for this expanding and evolving technology. First, we discuss different use cases for NFTs, including some that are now common and some that are new. Notably, the categorization is artificial, as an NFT can be made to address use cases from multiple categories. Using these categories should still provide a helpful overview. For each of these categories, we discuss possible legal considerations that may come into play. These concerns are multifaceted and can run the gamut from intellectual property, privacy, securities and contracts to know your customer (KYC) procedures, anti-money laundering (AML) compliance, and corporate governance laws. Second, we discuss some of the technical innovations for NFTs, some of which have yet to see widespread adoption but can open up new use cases for the technology. In all cases, obtaining knowledgeable legal representation to identify potential legal issues is essential when developing NFT technologies or incorporating NFTs into existing projects.

NFTs by Use Case — Potential Legal Considerations

NFTs for Creative Works

Most people think of NFTs as signifying rights in a creative work, which is understandable, as this is currently the most popular use case. In this instance, the NFTs are associated with a particular work, be it an image, video, music, or writing. For example, an NFT could be linked to the image of a particular cartoon ape. In another example, an NFT can signify some ownership rights in a song or album.

The most typical legal issues with these NFTs involve contract law and IP licensing in copyrights and trademarks. This is because the NFT is purchased, and the art it is associated with may also be covered by separate rights for the copyright. Any rights to the copyrighted art must be sold or explicitly licensed to the NFT purchaser to be properly conveyed. For example, there may be issues on what rights are provided to the person who holds the NFT, including whether they can commercially exploit the art and, if so, what limitations are placed on this usage.

A common consideration is also how to notify purchasers of their rights in the underlying artwork when they purchase the NFT. This can get tricky, particularly when the NFTs are allowed to be sold on secondary markets that may or may not provide explicit notice of the ownership terms when making a purchase. Making the purchaser aware of their rights at the time of sale is important because, depending on the particular NFT, the rights may vary widely from one purchase to another.

Failure to notify a purchaser of what rights they are obtaining can lead to confusion because purchasers of NFTs often assume they are buying full ownership the actual artwork and can do what they want with them, such as exploit the artwork commercially. However, NFTs associated with video and music often do not provide any rights to the owner to commercially exploit the content. For example, a professional sports league or organization that mints NFTs associated with video clips is unlikely to give the owner of the NFT the right to exploit that video commercially. Providing clear license terms to the purchaser is a good policy to avoid customer confusion. Similarly, providing these terms in a way that remains easily accessible as the NFT is transferred requires consideration because it will vary based on how the NFT can be transferred and what rights are provided.

A new and rapidly expanding consideration is when an NFT is generated in whole or part by artificial intelligence (AI). Multiple systems have been developed to generate art and written work using AI. In this case, there may even be an open question of whether a copyright in the work even exists, but this is a very fact-specific inquiry based on particular circumstances. There may also be the layering of issues, such as when AI is fed a copyrighted piece or pieces of work to generate new works that alter, expand or build upon the work it was fed.

Another consideration that can arise under some uses for NFTs is if they are securities, meaning that they would be regulated by the Securities and Exchange Commission (SEC) if sold to customers in the U.S. While it may seem hard to believe that purchasing a cartoon picture could be considered the same as purchasing a share of common stock, the SEC has at least been indicating that this is possible. For example, if an NFT is structured so that the owner receives rewards or royalties for the use of the digital art (e.g., if it is a song being played on a streaming service), then securities implications may come into play. Additionally, promises of those issuing the NFTs to provide privileges as the community grows, say to attend exclusive events, may raise securities-related issues.

The above examples are just some of the issues that may arise, but others including KYC procedures, AML compliance, and tax compliance may also be at issue depending on how the particular NFT, and any marketplace for that NFT, are implemented.

NFTs for Video Games and Metaverse

Developers are also quickly expanding the use of NFTs in video games and virtual worlds (the “Metaverse”). For example, an NFT could be associated with having the ability to unlock the use of a particular character in a game. Or it could be used as part of an inventory system to identify the character’s equipment, where a particular set of armor is associated with a corresponding NFT. NFTs can also be sold in random “packs” similar to trading cards. In these cases, a user can purchase a pack of cards and randomly be allocated a pack unlocking certain players. Instead of these cards only being collectible pieces of cardboard, they allow the player to use them in games similar to fantasy sports matchups, which may include prizes. For the virtual worlds of the “metaverse,” an NFT can be associated with ownership of a particular plot of virtual land within that particular world. The purchaser can then develop their plot of virtual land to advertise a business or simply for their enjoyment.

On one level, there is nothing new with games using some mechanism to gate access to particular characters or items. However, NFTs provide a greater feeling of ownership to players, because these items can be associated more permanently with that character or item. Additionally, it may allow NFTs to be traded directly among players on a blockchain. To many, having the content represented on a blockchain makes it more desirable because it adds a sense of permanence to the experience.

These NFTs can have many of the same legal issues described above for digital artwork. Many include digital art as part of the NFT — think of a picture of the set of armor for your character. However, additional issues can arise if more features are added to these items. For example, securities considerations (and the SEC) may come into play if the proceeds from the sale of these types of NFTs are used to build the underlying game that they are used in. While having a sword your character uses in the videogame be deemed a security seems a bit farfetched, the SEC has generally taken an expansive view on crypto tokens being securities if the sale proceeds are used to build functionality. In particular, they have noted that selling tokens for the development of an ecosystem could show that they are being used as an investment into this ecosystem.

In the case of NFTs sold as packs of cards, they may combine three incredibly popular activities: NFT collectibles, fantasy sports and gambling. In addition to the legal considerations discussed above, this type of use that provides prizes must consider gambling and related contest and sweepstake laws, which are often regulated differently state by state. These factors must be considered specific to what is provided with the NFT at issue and the jurisdiction(s) over the purchase.

NFTs as Representing Real-World Assets

NFTs have also become linked to real-world physical assets and signify ownership or some right associated with that asset. In one example, NFTs have been proposed as a superior way to record ownership in real estate. Instead of keeping physical records on real property in a city hall archive as the definitive record of ownership, this information could be recorded on the blockchain. In this manner, it could be easily searched and verified. However, this type of ownership record does not need to be limited to real estate and has been proposed for other real-world assets, typically those of high value, such as paintings, vintage cars, watches, and gems, which benefit from having a trusted chain of title and trustworthiness of ownership. While the above are some examples, there is no limit on what type of physical assets could be matched to NFTs. These NFTs also can have particular utility for recording high-value assets in a supply chain, allowing the system user to certify the assets’ origin and confirm that they were legally and ethically sourced. Furthermore, with the advent of multiple inexpensive Layer 1 and 2 blockchains, the cost-benefit analysis for these systems has increased drastically.

The ability to transfer ownership rights in real-world physical assets already has an extensive legal background. These include issues related to contract law, real estate law, tax compliance, the Uniform Commercial Code (UCC), etc. For example, real estate has its own unique body of law governing, for example, how to record and transfer property. Any usage of NFTs for real property would be required to navigate these laws in addition to those generally governing NFTs. Even the sale of other objects can require knowledge of the law under the UCC, which may cover some transactions. All of these transfers may also trigger specific tax and recording requirements that should be considered at both the federal and state levels.

NFTs as a Form of Identity

NFTs have also been proposed as a way of providing identity, and have been discussed regarding the allowance of building a “DeSoc” or Decentralized Society. There are various proposals for how NFTs can provide a form of identity for users and thereby add “reputation” to blockchain applications.

To transact on the blockchain, no one needs to know who you are in real life. However, situations may require where a user may want to build a reputation that is proven and validated by its recording on a blockchain. You can even build up a reputation in a pseudo-anonymous fashion. This way, you can transact on blockchains without revealing your real-world identity (i.e., “doxxing” yourself, in web3 parlance), but also without abandoning the ability to build goodwill and a positive reputation among the community.

Much of the transactions on blockchains are possible without establishing identity because they are typically meant to be “trustless.” Transactions can be run by smart contracts that both parties can verify before entering into a transaction. For example, if two parties are entering a DeFi loan, a smart contract could determine when the first party deposits the required collateral, and only then release what is being loaned to them, thereby obviating the need to trust the person you are interacting with. Instead, you trust the publicly verifiable smart contract.

However, there are limits to what can be done without having a transaction tied to a particular real-life person or at least some measure of a user’s reputation. For example, the above scenario of a DeFi loan is based on what can be locked in as collateral on the blockchain. It does not consider other off-chain assets that may support the borrower’s creditworthiness or that the borrower had taken out loans before and always paid them back. Some would argue that limiting the decision to properties that can be verified on-chain is an important feature. Still, it does limit what types of agreements can be entered.

In other instances, users should be verified for anti-money laundering (AML) purposes. Instituting an AML procedure often requires an individual process utilizing “off-chain” information. It may be better to allow for a standard verification of identity (KYC) that can be completed on-chain. These types of provable identities can be helpful in systems meant to grant access to private information, such as medical records, or where a specific person must be identified for a particular right, for example, the ability to vote in an election.

However, there are several different issues with implementing identity NFTs. First, there is the concern many web3 natives have with publicly revealing their real-life identity and “doxxing” themselves. However, using these types of NFT for specific purposes may require a KYC procedure to assign the NFT. Therefore, those running the systems may also need to consider privacy laws based on how they use that real-world identity. In conjunction with privacy laws, regulations related to the necessary level of security are applied to this type of information. Finally, if used in the context of securing a loan, there are banking laws and regulations that may need to be navigated.

NFTs as a Certification or Resume

Numerous entities are now offering NFTs that act as a “certificate” for completing a course or other certification program. You can build up a blockchain-based history proving your completion and knowledge of different topics. In a typical scenario, you take an online course with a test at the end, where an NFT is granted to show completion of the course. These are already being used by several web3-oriented companies that offer training (mainly in web3 technologies) and provide an NFT upon completion.

In other situations, NFTs can be granted for other professional-based tasks that either prove experience or completion of a course. For example, a freelancer could receive an NFT from an employer establishing that they have adequately completed a project for them. This shows the certificate’s authenticity in a way that is “web3” in nature. This could serve as a digital resume that prospective employers could review.

The advantage of this process is easy to see, as a blockchain is immutable and verifiable, so it would be difficult, if not impossible, to forge a certificate. Someone seeking employment could submit an address showing their different certifications and records of task completions. Furthermore, this can still be pseudo-anonymous, where the parties do not need to know the person’s real-life identity to verify credentials or check references, as the information is all recorded on the blockchain.

Again, there are likely to be privacy issues associated with these, as the certificate is intended to be used only by a single person. It would make little sense to allow one person to sell their NFT showing they completed a course to another person who has not completed it. As such, there often need to be some constraints to limit the use of the NFT to a particular person.

The use of NFTs as a form of certification overlaps with many of the same issues relevant to NFTs used for identity, including privacy and KYC issues. They may require special provisions in terms of use for the recipient and other statements limiting liability of the issuer, including in cases where certification was used by someone who had not earned it.

NFTs as Governance Tokens

NFTs can also be used to establish voting rights in the governance of an entity. One example is seen in the ability to vote in a decentralized autonomous organization (DAO) or a similar organization based in the digital realm. While many DAOs can use standard fungible tokens for governance, there is increasing usage of NFTs associated with voting rights. In particular, if the structure of the DAO is “one person, one vote,” this may be represented by an NFT identifying the voting right of the specific person. These NFTs can also demonstrate membership in the DAO or work completed for the DAO. Furthermore, a new NFT can be used for membership each year, providing another way to identify those with a long-term commitment to the DAO.

Of course, the rights provided for those holding the NFT may need to be identified in the governing terms of the DAO. Furthermore, if the NFT is supplied with the possibility of it gaining in value or as a source of revenue, this can impact securities regulation. The use of NFTs can affect the form of the legal entity (if any) that the DAO takes and can require knowledge to address any corporate governance or tax laws adequately. KYC and privacy issues may also arise if the governance NFTs are structured to avoid a “Sybil attack,” where one person sets up multiple accounts to get more than their fair share of votes. Finally, while not specifically related to NFTs, DAOs have their own legal issues to consider, including those related to whether their members are liable for their actions.

NFTs for an Experience

NFTs have also been used to replace tickets for different events. In this case, the NFT would be assigned to a wallet and have a single use for the particular event. Given the tamper resistance of a blockchain, this would be a way to avoid forgeries. Furthermore, the issuers have ways to place restrictions on the ticket transfer. For example, collecting a fee every time the ticket is transferred between wallets. This would allow artists and venues to recoup some of the value when tickets are resold at a much higher value.

This type of NFT can also be used as proof that the person was present for a particular event. The person with the NFT ticket could keep it in their wallet as a keepsake for the event, collecting and showing them off to others if they care to do so. Similarly, NFTs can be issued to commemorate an event. For example, the Super Bowl issued commemorative NFTs for those who attended. This type of commemorative NFT can be used as a status symbol or a keepsake for those who attended the event.

This type of use can run into legal issues related to the terms of their use, as the NFT can be used as part of a contract. It is also important to lay out the terms for the NFT so that there is no customer confusion about what they are purchasing. Granting this type of NFT in a graphical form similar to a sports or concert ticket may also lead to questions on when and where the owner of the NFT can display the NFT, as the NFT may include other trademarks or copyrights.

NFTs as a License or Subscription to a Resource

NFTs have also been explored as a means of recording the right to a license or a subscription. For example, a particular NFT could be an on-chain method to show that the holder has the right to access a specific resource in the cloud. Enforcing licenses in the software context has been an issue almost since the beginning of consumer software. Using NFTs for licensing specific technologies aim to improve the ability to implement these licenses. In particular, using an NFT as a license allows for enhanced functionality for protecting against pirated software or allowing the license to be transferred or sold to another without encountering the “double spend” problem, where two people try to use the same license. Similarly, NFTs can be used in a subscription model to record the status of a subscription to a particular service.

Unsurprisingly, using NFTs to represent a license often gives rise to contract issues requiring a good grasp of how the NFT may be used — including both the intended and unintended uses. Furthermore, one of the usual advantages of NFTs, and crypto in general, is the ability to remain pseudo-anonymous. However, if an NFT is granting a license, the seller may be required to do KYC checks to ensure the purchaser is using the license for its intended purpose and that they are not a sanctioned country or entity. As such, the use of NFTs in this manner requires the analysis and balancing of the multiple intersections of the evolving laws and technical applications.

NFTs for Naming Systems

Another recent application of NFTs is to use them in a way similar to how the Domain Name Service (DNS) is used. The most prevalent system for this is called the “Ethereum Name System” (ENS), but it is far from the only system of this type. For the ENS, the top-level domain is owned and controlled by smart contracts. Users can register a name that ends in “.eth” based on the ERC721 non-fungible token contract and the name can be transferred like other NFTs. Like the DNS, the ENS can map human-readable names (e.g., kriskastens.eth) to machine-readable identifiers like Ethereum addresses.

These domains have many of the same issues seen with DNS, specifically where someone grabs a trademarked name and either attempts to profit off it or hold it as ransom from the actual owner. This has led to takedown requests related to selling these names on marketplaces. However, since these registrations are blockchain-based, they can be difficult (or impossible) to rescind from those who purchased them after they are assigned.

Expanding NFT Functionality

Our analysis above relates to the use case for NFTs. However, another way to look at NFTs is based on their technical operation independent of their use. At its most basic, an NFT is unique data recorded on a blockchain that defines its function. In the section below, we discuss some of the technologies that NFTs use, including newly developed technologies that expand their utility. This is a constantly growing and changing space, so this section is only intended to provide some examples.

Blockchain-Contained NFTs

Certain NFTs record all their information on the blockchain. This case is usually when the amount of data to be recorded is small enough that it is not cost-prohibitive to store it “on the chain.” This may be possible with numerous use cases, such as NFTs representing membership or completion of a course, but is less common with NFTs representing a creative work, which typically requires more space to store. Some estimate that only 9% of NFTs store all their data on the blockchain because of the cost of storing data. While this type of storage is advantageous to prevent the linked data from disappearing, they do have the issue of exposing the data to the world, as most blockchains are public. Furthermore, for someone who makes these types of NFTs, if there is something wrong with them, e.g., they infringe a trademark or copyright, there may be no way to stop their usage once they are on the chain.

NFT as a Link to External Data

The majority of NFTs act as a link or pointer to other data that is stored externally to the blockchain. So instead of keeping everything on the blockchain, they use a pointer from the NFT to a file stored off the blockchain. One common location was something called the “Interplanetary File System” (or “IPFS”),^[2] but it can conceivably include any location where the party making the NFT wants to store the data. Depending on what is being held in the linked data, this can impact privacy issues if it includes identifying or personal information and security issues, such as if the data is stored in a secure or encrypted manner. Furthermore, there may be issues with specifying how long the data that the NFT is linked to is stored. For example, while the NFT itself will be stored on the blockchain for as long as that particular chain exists, if the company hosting the image disappears, the actual data may disappear, leaving the NFT as a pointer to nothing.

Soulbound NFTs

A so-called “soulbound” token is intended to be specific to a particular person (or address) and will not be transferred. This way, these tokens, including NFTs, cannot be sold to or shared with others. The use of this mechanism is immediately understandable given some of the uses discussed above. For example, an NFT signifying identity or that a person has completed an educational course should not be transferrable to others who have not completed the course. Additionally, using soulbound tokens for governance rights in an entity would also be beneficial, as making voting rights that are not transferable can be helpful in many cases — for example to help prevent sybil attacks.

The fact that soulbound tokens are meant only to be assigned once makes it even more important to specify the terms of their use to avoid confusion. Any mistakes or misunderstandings may be more difficult to correct after the fact. Additionally, the use of soulbound tokens for governance requires that the entity using them understands the permissible governance structures and ensures that their usage is explained to the extent necessary under corporate governance documents.

Fractional NFTs

With the high cost of certain blue-chip NFTs, it can be cost-prohibitive for certain people to own one outright. However, to solve this, some have devised schemes to fractionalize or tokenize the ownership of the NFT to demonstrate partial ownership of the NFT, and in this manner, multiple people could share ownership in an NFT.

There are some unique legal issues associated with the fractional ownership of NFTs. While NFTs typically escape scrutiny from the SEC because their primary utility is as art or a collectible, that is more difficult to claim when you only own a fraction of the NFT. For these, it may be more closely aligned with an investment in the NFT, assuming that it will rise in value and the fraction can be sold at a profit. The use of fractional ownership in an NFT is something that the SEC has hinted may be considered a security. As such, if fractionalization of an NFT is used in a project, then its structure should be carefully considered.

Semi-Fungible Tokens (SFTs)

SFTs are generally understood to be tokens that have some properties related to both fungible and non-fungible properties. In one use case example, SFTs start out as fungible tokens and then, based on some event, are converted into NFTs. This can occur in a video game when the fungible currency inside the game can be converted into NFTs for weapons or other items. As fungible tokens can be already transferred to purchase NFTs (think buying NFTs for Ether), it may not be immediately apparent what the benefit SFTs offer. However, they are beneficial on the high-cost Ethereum blockchain, where they have significant cost savings in the conversation because of ERC-1155, a standard that some have argued can allow up to 90% savings.

SFTs may include novel legal issues with respect to whether they are viewed as securities, as they have properties of both fungible and non-fungible tokens. In this case, it will be important to consider the specifics of the particular SFT and how it is used.

Dynamic NFTs (dNFT)

dNFTs are NFTs designed to change over time according to how the smart contract governing them was programmed. The fact that dNFTs can change over time based on external conditions allows them additional flexibility. For example, if an NFT is used to represent a car, it may be useful to update the NFT with information showing that the car was serviced in a timely manner or to reflect that it was certified to meet emission standards. The NFT can also be used to describe real-world assets that are tracked in a supply chain. In another example, a dNFT of an athlete may change over a season or their career based on their performance.

Depending on their use, dNFTs will have the same potential legal issues as normal NFTs but with a higher level of complexity because of their ability to change. They will require a technical understanding of how the dNFTs will operate. For example, any contracts that govern dNFTs will need to consider how they are intended to act, as well as addressing when they operate in an unintended manner. Being able to understand both the intended and potential unintended operation of the dNFT is important, as it is sometimes impossible, but always suboptimal, to change a smart contract after deployment.

Conclusion

NFTs are an exciting technology with expanding use cases. However, as their uses expand, they will continue to intersect with new and evolving areas of law. Dealing with these novel legal issues will require understanding both the ever-changing legal landscape of blockchain technologies and how it intersects with the expanding technical applications of NFTs.

[1] The term NFT has taken on a perceived negative connotation in some circles, particularly after the NFT craze of 2021.  As such, NFTs are being referred to as “digital collectibles” and other terms.  We will use NFT here because it is still the most comprehensive term to describe this type of token.

[2] This is a distributed and open file system that can be used to store the actual artwork linked with the NFT.

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