Tag: NFT

Introduction  

In April 2022, someone paid $130,000 for a pair of Nike Dunks. Here’s the kicker – it was for a pair of virtual sneakers. Shelling out five to six figures for a pair of exclusive shoes is not rare in the sneaker world, but paying that much for a pair of virtual kicks is unprecedented.

This sale illustrates Nike’s wider strategy in conquering the next frontier of commerce: the metaverse. In 2021, Nike started making strategic investments to grow and protect its brand in the metaverse. First, Nike submitted several trademark applications with the United States Patent and Trademark Office for virtual goods. Second, Nike announced a partnership with Roblox, an online gaming platform, to create a Nike-branded virtual world where gamers can play virtual games and dress their avatar in digital versions of Nike’s products. Third, Nike acquired RTFKT, an organization that creates unique digital sneakers. John Donahoe, Nike’s President and CEO, described the acquisition as “another step that accelerates Nike’s digital transformation and allows us to serve athletes and creators at the intersection of sport, creativity, gaming and culture.”

Nike is not the only brand exploring the metaverse. Other brands are now offering virtual merchandise through NFTs, including other sportswear brands like Asics and Adidas, luxury fashion brands like Hermès and Gucci, and even fast-food chains like Wendy’s and Taco Bell. Despite these companies’ growing activity in the space, the application of current intellectual property protection to branded NFTs is still unclear. A recent complaint filed by Nike against StockX, a popular sneaker resale platform, illustrates this uncertainty. The outcome of this case could determine the scope of trademark protection in the metaverse and will have serious implications on the commercial viability of brands’ significant investments in the space.

The Nike StockX Lawsuit

In February 2022, Nike sued StockX, a popular sneaker resale platform, after StockX began selling Nike-branded NFTs alongside physical Nike sneakers. The complaint, filed in the United States District Court for the Southern District of New York, laid out several causes of action, including trademark infringement. Nike stated that it “did not approve of or authorize StockX’s Nike-branded Vault NFTs. . . Those unsanctioned products are likely to confuse consumers, create a false association between those products and Nike, and dilute Nike’s famous trademarks.”

In its answer, StockX raises two key defenses. First, it claims that its “use of images of Nike sneakers and descriptions of re-sale Nike products in connection with StockX NFTs is nominative fair use. It is no different than major e-commerce retailers and marketplaces who use images and descriptions of products to sell physical sneakers and other goods, which consumers see (and are not confused by) every single day.” Second, StockX raises a first sale defense, arguing that “Nike’s claims are barred, in whole or in part, by the first sale doctrine permitting purchasers of lawfully trademarked goods to display, offer, and sell those good under their original trademark.” Thus, the outcome of the case turns on how courts will apply traditional intellectual property doctrines to more modern trademark issues.

StockX’s Nominative Fair Use Defense

Nominative fair use is an affirmative defense for defendants who use another’s trademark deliberately to refer to that party, for purposes such as advertising, commentary, and news reporting. To raise a successful nominative fair use defense, the user must meet three requirements: “First, the product or service in question must be one not readily identifiable without use of the trademark; second, only so much of the mark or marks may be used as is reasonably necessary to identify the product or service; and third, the user must do nothing that would, in conjunction with the mark, suggest sponsorship or endorsement by the trademark holder.”

     StockX can likely meet the first and second requirements but will struggle to meet the third. StockX can argue that it would be difficult to sell the virtual NFT Nike sneaker without using Nike’s trademarked logo and that it is only using the Nike logo as much as reasonably necessary for the consumer to identify the product. As StockX’s argues in its answer, “the image and product name on the Vault NFT play a critical role in describing what goods are actually being bought and sold.” As some have pointed out, the Nike logo “does not appear to be used by StockX separate and apart from its appearance in the photo of the shoes corresponding to the NFT.”

At issue is the third requirement regarding an implied sponsorship or endorsement. StockX’s website includes a disclaimer of any affiliation with the Nike brand, but it is unclear if this adequately safeguards against consumer protection. Nike’s complaint characterizes the disclaimer as “comically and intentionally small” and “difficult to read.” As evidence that the disclaimer does not prevent consumer confusion, Nike points to numerous social media users who expressed uncertainty as to whether Nike endorses, approves, or gets a commission from StockX’s NFT sales. This confusion is further compounded by the fact that Nike sells its own NFTs. Thus, StockX will likely have difficulty in succeeding on its nominative fair use defense.

StockX’s First Sale Defense

The success of StockX’s first sale defense requires a more complex, fact-intensive analysis. The first sale defense establishes that “the right of a producer to control distribution of its trademarked product does not extend beyond the first sale of the product.” Whether or not this rule applies to Nike’s case, however, depends on how the court characterizes the NFT. On one hand, StockX will argue that its NFTs are each tied to the resale of a physical Nike shoe – similar to a receipt –  and thus fall under the first sale doctrine. On the other hand, Nike will argue that the NFTs are standalone, separate products and thus are not protected by the first sale doctrine. To succeed on the trademark infringement claim, Nike must establish that the NFT and the physical shoe are two independent products.

On its website, StockX added a disclaimer in an attempt to address this issue directly, “Please note: the purpose of Vault NFT is solely to track the ownership and transactions in connection with the associated product. Vault NFTs do not have any intrinsic value beyond that of the underlying associated product” (emphasis added). However, this disclaimer does not preclude Nike from demonstrating that there is a separate value and that the shoe and the NFT are independent products.

First, Nike can point to the fact that the NFTs being sold on StockX are generally more expensive than the value of the sneaker itself (even if one accounts for the markup of sneakers that is common in the resale market). Nike points to this divergence in monetary value: “Thus far, StockX has sold Nike-branded Vault NFTs at prices many multiples above the price of the physical Nike shoe.” For example, as of October 25, 2022, the Nike Dunk Low Off-White Lot 50 was on sale for $715. The NFT of that very same shoe, however, was on sale for $8,500. This significant divergence in price suggests that there is an independent economic value of the NFT beyond the ownership of the physical shoe.

Second, Nike can argue that the NFTs are an independent product because NFT ownership gives consumers unique perks. When the program initially launched, StockX’s website explicitly stated that NFT “owners may also receive exclusive access to StockX releases, promotions, events, as a result of ownership.” Since the lawsuit, this language has been removed, likely because it could be used as ammunition by Nike to defeat the first sale defense. But NFT owners still get some exclusive perks. For example, the ownership of the NFT means that StockX will store the physical shoe in their “brand new, climate-controlled, high-security vault” and NFT owners will be able to flip/trade the shoe instantaneously, rather than waiting for the shoes to be shipped or paying shipping fees. The storage and the ability to bypass shipping costs associated with flipping sneakers are benefits that are unique to owners of the NFTs but are unavailable to those who only own the physical show.

Conclusion

The Nike-StockX litigation highlights the uncertainty of how traditional intellectual property law applies to more modern trademark issues. The outcome of the case will have serious implications for how companies can protect their brands in the growing world of virtual commerce.

Jeanne Boyd is a second-year JD student at the Northwestern Pritzker School of Law.

If nothing else, Facebook’s recent announcement that it plans to change its name to “Meta” is a sign that the metaverse is coming and that our legal system must be prepared for it. As the metaverse, the concept of a virtual version of the physical world, gains increased popularity, individuals will engage in more transactions involving non-fungible tokens, or NFTs, to purchase the virtual items that will inhabit metaverse worlds. Accordingly, the United States will need more robust regulatory frameworks to deal with NFT transactions, especially in the gaming industry, where NFT use will likely rise significantly.

In most other areas of digital media and entertainment, NFTs are often associated with niche items, such as high-priced autographs and limited-edition collectibles. However, in the video gaming sector, existing consumer spending habits on rewards such as loot boxes, cosmetic items, and gameplay advantages provide fertile ground for explosive growth in NFT use. This article will explore the outlook for NFTs in gaming, why gaming NFT creators should consider the potential impact of financial regulations on their tokens, and how current U.S. financial regulations could apply to this ownership model.

A. Current State of Virtual Currencies and Items in Gaming

Gaming has long been the gateway for consumers to explore immersive digital experiences, thus explaining why virtual currencies and collectible items have such strong roots in this sector. Further, given the popularity of virtual currencies and collectibles in gaming, it is no surprise that cryptocurrencies and NFTs have similarly experienced success in this space.

NFTs, or non-fungible tokens, are unique digital assets that consumers may purchase with fiat currency or cryptocurrency. NFTs can be “minted” for and linked to almost any digital asset (e.g., video game items, music, social media posts), and even many physical assets. While NFTs are blockchain-based just like cryptocurrencies, the key difference between the two is that a NFT is not mutually interchangeable with any other NFT (i.e. they are non-fungible). So why are they so special? As digital experiences continue to move to the metaverse, NFTs will serve as a primary means for consumers to connect with companies, celebrities, and, eventually, each other.

In the simplest explanation, metaverse is the concept of a digital twin of the physical world, featuring fully interconnected spaces, digital ownership, virtual possessions, and extensive virtual economies. Mainstream media has already given significant coverage to metaverse activities that have appeared in popular games, such as concerts in Fortnite and weddings in Animal Crossing. However, more futuristic examples of how NFTs and metaverse could transform our daily lives exist in the Philippines with Axie Infinity and Decentraland, a blockchain-based virtual world.

In Axie Infinity, players breed, raise, battle, and trade digital animals called Axies. The game was launched in 2018, but it took off in popularity during the COVID-19 pandemic as many families used it to supplement their income or make several times their usual salary. To date, the game has generated $2.05 billion in sales. Meanwhile, plots of virtual land in Decentraland, a 3D virtual world where consumers may use the Etheruem blockchain to purchase virtual plots of lands as NFTs, are already selling for prices similar to those offered in the physical world. For example, in June 2021, a plot of land in the blockchain-based virtual world sold for $900,000.

The growth in popularity of Axie Infinity has already caught the eye of the Philippine Bureau of Internal Revenue, which has announced that Axie Infinity players must register to pay taxes. As financial regulation of NFTs looms, it will be imperative for U.S. gaming companies to consider how federal courts and the government will recognize the status of NFTs.

B. Financial Regulation and NFTs

As NFT transaction volume grows, there will undoubtedly be greater scrutiny over these transactions by financial regulators. While the current legal and regulatory environment does not easily accommodate virtual assets, there are a two primary ways NFTs may be regulated.

1. Securities Regulation

One of the most hotly discussed legal issues concerning NFTs involves whether these tokens should be recognized as securities. Under SEC v. W.J. Howey Co., a transaction is deemed an investment contract under the Securities Act where all of the following four factors are satisfied: (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profits; (4) to be derived from the entrepreneurial or managerial efforts of others.

Intuitively, NFTs, in the form of virtual collectible items, don’t seem like traditional tradable securities as they are unique, non-fungible items. Indeed, they do not appear to demonstrate the type of “horizontal commonality” that federal courts have held to be necessary to satisfy the “common enterprise” aspect of the Howey test. “Horizontal commonality” is generally understood to involve the pooling of money or assets from multiple investors where the investors share in the profits and risk.

 However, the Securities Exchange Commission has stated that it “does not require vertical or horizontal commonality per se, nor does it view a ‘common enterprise’ as a distinct element of the term ‘investment contract.’” Therefore, the fungibility aspect of the token alone may not preclude it from inclusion under securities regulation.

A more interesting inquiry might involve assessing whether the reasonable expectation of profits associated with an NFT is based on the “efforts of [others],” as outlined in Howey. In evaluating this element of the Howey test, the SEC considers whether a purchaser reasonably expects to rely on the efforts of active participants and whether those efforts are “undeniably significant” and “affect the failure or success of the enterprise.” Under this lens, how an NFT is offered and sold is critical to consider.

For example, if one mints (i.e., creates a NFT for) a piece of graphic art that sits and passively accumulates value, the failure or success of purchasing such a NFT would likely not be highly reliant on the activities of others. As the SEC has noted, price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test. Similarly, if a consumer purchases a digital pet, like those in Axie Infinity, that actively accumulates value through winning a series of battles, the success or failure of this digital pet would also not be highly reliant on the activities of others. However, this analysis becomes more complex when considering the recent increased interest in “fractional NFTs,” or “f-NFTs”, where an investor shares a partial interest in an NFT with others. Since these fractional interests are more accessible to a larger number of smaller investors, they may be more likely to drive market trading and, as such, be recognized as securities.

2. Federal Anti-Money Laundering Statutes

Under the Bank Secrecy Act, the Financial Crimes Enforcement Network, or “FinCEN,” is the U.S. Department of Treasury bureau that has the authority to regulate financial systems to fight money laundering. Although it has yet to comment directly on NFTs, FinCEN has released guidance suggesting that the movement of monetary value through virtual currencies could trigger money transmission regulations.

A critical factor determining whether the transfer of an NFT is a money transmission service will be whether FinCEN recognizes the NFT as “value that substitutes for currency.” If the NFT’s value may be substituted for currency then the transfer of such a NFT would likely trigger money transmission regulations. If players can purchase NFTs using a virtual currency that can cash out for fiat currency, then this transfer may be subject to FinCEN regulation. Alternatively, based on FinCEN’s recent guidance, even if NFTs are purchased with virtual currency that users cannot cash out for fiat currency, money transmission regulation may be triggered. Indeed, depending on how the gaming platform facilitates the transfer of in-game currency, regulatory risks may exist when users purchase third-party goods or make virtual marketplace transactions.

Earlier this year, Congress took a significant step towards making money transmission regulations more inclusive of NFT use cases when it passed the Anti-Money Laundering Act of 2020. Under the Act, art and antiquities dealers are now subject to the same anti-money laundering regulations that previously applied to financial institutions under the Bank Secrecy Act. This development will undoubtedly have a significant impact on the potential liability that gaming platforms can face as “dealers” of NFTs.

Conclusion

The United States is still a long way away from having laws that adequately regulate the creation, selling, and purchase of NFTs. However, NFT usage continues to increase rapidly. Nearly half of all U.S. adults are interested in participating in the NFT market, and gamers are 2.6x more likely to participate in the NFT market. As regulators move quickly to keep up with the pace of this market, firms will need to stay alert to ensure that they maintain regulatory compliance.

Rohun Reddy is a third-year JD-MBA student at Northwestern Pritzker School of Law and Kellogg School of Management.