NFTs: What Are They and What Are Your Rights and Liabilities as an Owner
On July 1, 2021, the original source code for the World Wide Web sold for $5.4 million at a Sotheby’s auction. This was not the actual source code, which is open source and freely available in the public domain, but rather a non-fungible token (NFT) version of the source code. NFTs, a new block chain based asset, have been making waves as everyone — from artists, sports leagues, to exiled whistleblowers and institutional investors — looks to participate in the craze by creating and selling digital assets for millions of dollars. (See also) So, what are NFTs, and what property rights and liabilities do buyers take on with their purchases?
What are Non-Fungible Tokens?
Non-fungible tokens, or NFTs, are unique digital assets stored on blockchain and used to create authenticated digital ownership of a scarce asset. The concept was first introduced by Vitalik Buterin, creator of the fungible crypto currency Ethereum, in December 2012 with “Colored Coins.”
An NFT uses “smart contracts,” which are open-sourced blockchain protocols outlining specific terms and conditions for the transfer of digital ownership. The smart contract is then permanently “minted,” or stored onto a blockchain token (most commonly Ethereum) creating an immutable record of the token’s history, from its creation all the way to its most recent sale. The secure digital storage of ownership records is one of the chief benefits of NFTs as a vehicle for storing wealth, especially compared with similar markets, like art, which are often plagued with authentication problems.
In 2017, the potential for digital assets as a means to store and create wealth was first initiated when CryptoPunks launched the world’s first marketplace for NFT digital art on the Ethereum blockchain. The project’s creators distributed 10,000 different claimable cartoon characters to entice market participants, and the characters were quickly claimed and subsequently traded in a freely formed secondary market.
State of the Market Today
Today, the NFT market is exploding. For example, on August 28, 2021, just four years after launch, CryptoPunks crossed $1 billion in all time sales. Much of this growth has occurred over the past twelve months. During 2020, NFT sales are estimated to have totaled a mere $94.7 million; however, for 2021 NFT sales have sky rocketed all the way to $24.9 billion. Much of this growth occurred in the second half of the year with sales volume growing from a combined $2.1 billion during Q1 and Q2 to a combined $22.3 billion during Q3 and Q4. Despite current volatile equity markets, NFTs continue to remain popular during 2022, with OpenSea, the largest NFT marketplace, announcing a record $5 Billion in transaction volume for the month of January.
Much of the NFT growth has been attributed to increased demand and acceptance for cryptocurrencies, coupled with an increased participation in public consumer trading during the COVID-19 pandemic. The explosive growth has drawn increased media attention, which has further fueled its virtuous cycle. Today, blue-chip companies like Coca-Cola are issuing their own NFTs, while institutional investors and fund advisors like Andressen Horowitz are investing heavily in the NFT marketplace, demonstrating confidence in its continued growth. Accordingly, this formerly fringe product has come under increased legal and regulatory scrutiny.
The scope of transferred property rights with NFTs
The rights acquired by an NFT purchaser vary widely based on how and where the NFT was acquired. In most cases an NFT holder, similar to a purchaser of a physical collectible, is purchasing a non-exclusive license to the underlying intellectual property rights of the asset for a non-commercial purpose. However, unlike a physical collectible, a digital NFT is easily and cheaply created, reproduced, or downloaded. A crucial distinction is that an NFT holder is merely acquiring the rights to the blockchain token imprinted with the intellectual property, and not the underlying intellectual property itself. Furthermore, for many NFTs the blockchain is unable to store the actual underlying digital asset, so what is actually being bought is an imprinted link to the asset. As a result, the underlying copyright only transfers if the copyright’s owner assents to such transfer in writing alongside the transfer of the digital asset.
The totality of the rights associated with the token are defined by the smart contract. Thus, there is a huge importance on the drafting of the smart contract coded into the token during an NFT transaction, which is an element not evinced during a physical collectible sale.
Smart contracts are the coded instructions of the NFT defining the scope and limitations of use. Depending on where the NFT is acquired the license agreement can vary immensely. The NBA Top Shot platform is an example of a proprietary marketplace, meaning the NFTs are created by a single market operator who does not allow third party transactions. For their platform, Top Shot has promulgated an internal standard NFT license agreement. These kinds of agreements stipulate that the buyer receives, “(i) a personal license to use and display the art associated with the NFT, as well as (ii) a commercial license to make merchandise that displays that art associated with the NFT, a license subject to a $100,000 gross revenue per year limit.” Given the market operator is minting all listed products, this concentrates even more control in the market operator and typically transfers the fewest rights to the subsequent owner, as evidenced by Top Shop limiting the ability of future owners to commercialize their purchase.
On the other end of the spectrum is OpenSea, an example of an “open” marketplace that allows anyone to mint and sell NFTs and enables customizable licenses. For example, an NFT of a tungsten cube sold for $200,000 and included the right to touch a physical one-ton tungsten cube stored at Midwest Tungsten Service headquarters once per year. This market offers financial freedom, but also features high risk of fraud due to ease of access, lack of market oversight, and difficulty in tracing actual wallet ownership.
In the middle are curated marketplaces, which require artists to apply to have their items listed by the market operator; however, unlike proprietary marketplaces, any creator can apply to have their NFT listed so long as the NFT conforms with the market operator’s regulations. Approval generally requires the NFT seller to abide by the market’s standard license agreement, similar to the proprietary market.
Regardless of who is dictating the terms, NFT license agreements cover a variety of issues tied to which property rights are being transferred. Typically, this includes many common terms and conditions such as indemnification clauses, buyer and seller rights, and definitions for various duties and obligations amongst others. However, the intrinsic qualities of an NFT also necessitate some atypical clauses such as ownership of platform IP, digital wallet verification, and outlining the commercialization or transfer rights. The most important and heavily scrutinized term of an agreement though is how the agreement handles the ownership of the copyright connected to the token. Thus, understanding the terms contained in these agreements is essential to evaluating and participating in this fast growing and evolving digital marketplace.
The potential for copyright infringement and liability for NFTs
While blockchain can authenticate the transactions, blockchain is unable to inform the buyer if the seller has rights to underlying copyrighted work or is merely selling someone else’s copyrighted work. This is important because section 504 of the Copyright Act holds even an innocent actor who unknowingly violated somebody else’s copyright automatically liable for both actual and statutory infringement damages. Recently, an NFT of Whales produced by a 12 year old programmer was sold for thousands of dollars, only for the images to later be discovered to have been copied directly from another project. Assuming the use constituted infringement (the issue has not yet been litigated), the buyer at a minimum is liable to return the NFT to its rightful owner and handover any profits. Furthermore, if the buyer knew there was a potential infringement and still sold the NFT, the statutory liability could be over a million dollars.
NFT case law is still being developed, with the first cases just now working their way through the legal system. As the market continues to grow, more regulatory agencies, including the SEC, are taking a closer look at security status and potential acts of fraud. However, until the regulatory status is cleared NFTs exist in a caveat emptor market. The onus is on the purchaser to verify the terms of the license agreement they are acquiring, the status of the seller, and the underlying intellectual property. While blockchain makes the verification and authentication process easier, it still has gaps creating additional liability, especially for copyright infringement.