Non-Fungible Tokens (NFTs) – The Hype, Reality and Law

Non-Fungible Tokens (“NFT”) have become the latest trend to hit the world of creatives, entertainers and retailers. Much like Special Purpose Acquisition Companies (“SPAC”) in the financial world (a product my firm is a definitive leader in – /end shameless plug), NFTs have existed for a while now, but rose to prominence in 2020 and continued to explode as we roll into 2021.

What is a Non-Fungible Token

At its core, a NFT is nothing more than a unit of data stored on a digital ledger, provided by a distributed ledger technology (“DLT”), with the most commonly known DLT being blockchain. NFTs are used to certify a unique digital asset, and can be used to identify an owner or act as proof of ownership of the underlying digital asset.  For instance, a DLT could represent a piece of digital art, a photo, a video, an audio file or any other digital asset.  That NFT would be a unique entry on a blockchain, and different and distinguishable from all other NFTs similarly stored.  In contrast, fungible tokens, like bitcoin, are not unique and are completely interchangeable.  Each bitcoin is just like every other bitcoin, and can be swapped for another bitcoin of equal value.

Just for clarity, a unique NFT does not mean that it is the only copy of the underlying digital asset. For instance, a digital picture may have multiple copies, each copy having its own NFT.  Think of it like a limited run or edition of a physical good, like a book, painting or piece of jewelry.  There may be more than one copy, but the total number is still limited.  Similar to their physical good counterparts, these NFTs may bare a numbering or other serial identification that is associated and stored with the NFT.

The purpose of associating a digital asset with an NFT is to create a durable record of identity and ownership; one that is transparent and hard to counterfeit.  Security is provided by way of the NFT being stored on and managed by the underlying DLT/blockchain the NFT resides on.  Even though a digital asset may be “copied”, only the one associated with the recorded NFT is legitimate.

History of NFTs

Even though they have become a phenomena over the last year or so, NFTs have been around since at least as early as 2014 when Kevin McCoy registered a video clip on a blockchain called Namecoin and sold it to his partner for $4 at a demonstration given at the New Museum of Contemporary Art in New York City.

The first full NFT platform was launched in 2015 under the name Etheria.  However, most of the NFTs listed on the platform never sold. Well, that is until NFTs became all the rage.  On March 13, 2021, the creator of the Etheria platform, Cyrus Adkisson, got back into his long dormant Etheria Twitter account and let the NFT hungry world know about the 914 historically relevant assets that were still available for purchase there.  By the end of that weekend, Adkisson states that he had received $1.4 million in Ethereum.

By 2017, NFTs had started to gain some traction and notoriety in certain circles.  Most notably, a game developed on the Ethereum DLT by Dapper Labs, called CryptoKitties, took the world by storm.  CryptoKitties allowed users to buy, sell and breed digital cats known as CryptoKitties (the Internet does love its cats).  Each CryptoKitty is its own unique NFT.  The game was released in October of 2017.  By early December of 2017, a CryptoKitty by the name of Genesis sold for approximately $117,712, and the game itself was blamed for a strain on the Etherium blockchain.  By the end of the first year, CryptoKitties had resulted in the breeding of over 1 million digital cats, and executed over 3 million recorded transactions.

Following on the success of CryptoKitties, Dapper Labs developed a project with the NBA, called NBA TopShot, which created collectible NFTs from NBA highlights.  TopShot NFTs may include digital assets such as images or videos of highlights, as well as stats, and other information associated with the highlights.  The platform was launched in early 2020 and reported over $230 million in gross sales between October 2020 and January of 2021. As of April of 2021, Dapper Labs raised an additional $305 million in new funding on a $2.6 billion dollar valuation.  Not bad for a company that started by selling digitally bred cats.

As of 2021, demand for NFTs have skyrocketed, and everyone is getting in the game.  From meme animations like Nyan Cat selling for $600,000, to NFT artwork by Beeple being sold at Christie’s auction house for $69.3 million, to Twitter founder Jack Dorsey selling his first ever tweet for $2.5 million.  Just a day before the posting of this blog, Christie’s closed an NFT auction for a collection of nine CryptoPunks to the tune of $16.9 million.

In the world of music, recording artists are capitalizing on the craze as well.  Kings of Leon released what is believed to be the first ever NFT album.  The release brought in approximately $2 million in the first week alone.  On top of this, artists are selling NFT “merch” to enhance revenues even further, such as Shawn Mendes’s selling of “Genies Statue” NFTs of himself.  Beyond just merch and album NFTs, recording artists are also selling royalty splits in the copyright, publishing and mechanical rights of songs and albums, meaning that purchasers of such NFTs can receive ongoing royalties from their purchased share of the music.  Bluebox, the platform offering these arrangements, calls it an “initial release offering” (IRO), allowing artists to “pre-sell music to a community who will then be able to won a piece of their art, as an NFT.”

Truly, these are exciting times for NFTs, and currently, there is no end in sight for the NFT craze.

NFTs in Operation – Smart Contracts

In general, transactions in NFTs are made possible by smart contracts, which are programs contained in the DLT/blockchain that is interfaced and altered through interaction by parties associated with the NFT (e.g., purchaser, seller).  These interactions are recorded on the DLT/blockchain and provide for authenticity of the transactions.

The underlying smart contract for any NFT can be configured to set any number of parameters and triggers to occur that may depend on events associated with the NFT.  For instance, the smart contract can: i) set out what rights associated with the digital or other assets are transferred or licensed upon execution of a transaction; ii) automate the update of the ownership of or license to the assets; iii) provide royalties or other payments to creators of the NFT or the underlying assets; iv) prevent execution of transactions based on any number of data points; and v) validate the entire transaction history for a NFT.

Smart contracts are particularly useful in association with NFTs, as they provide an almost unlimited number of ways to configure the relationship between an NFT and its creator and future owners.  For instance, one feature that is growing in popularity is the inclusion of a small royalty to be paid to the creator of an NFT (e.g., the artist of the underlying asset) after each transaction associated with the NFT.  This allows artists/authors or other creators of NFTs to benefit from the ongoing growth and sale of these assets beyond just the initial sale.

As NFTs grow in popularity, we will no doubt see the development and evolution of these smart contracts, and it will be interesting to see what creative terms are created as the market matures.

NFTs and the Law – Copyrights

Most NFTs are associated with digital content, primarily digital art, video and text.  Most of this type of content is subject to copyright protection, and therefore subject to laws applicable to copyrightable materials.  In the United States, copyright law applies to original works of authorship fixed in a tangible medium of expression.  It is well understood that these laws apply to digital content stored in electronic form (e.g., stored in the cloud or otherwise on local storage media).

One important thing to note is that in the United States, ownership of the rights in a copyright do not automatically transfer to a purchaser of a NFT.  Copyright law generally requires a contract which outlines which rights are being transferred to a purchaser upon execution of the agreement.  In many cases, contracts associated with copyrighted materials do not assign all possible rights to the purchaser, but rather provides a license to the purchaser that grants certain rights to the purchaser, while the seller retains others.  For example, a purchaser of an NBA TopShot “Moment” NFT is given the right to swap, sell or give away the underlying NFT.  However, the owner of the NFT is not permitted to use any of the art, design, media, video, photographs or other data associated with the Moment they purchased in any other way, meaning they cannot repost video or photos contained in the Moment.  The actual language of the TopShot Terms of Service is:

[You] understand and agree: (a) that your purchase of a Moment, whether via the App or otherwise, does not give you any rights or licenses in or to the App Materials (including, without limitation, our copyright in and to the associated Art) other than those expressly contained in these Terms; (b) that you do not have the right, except as otherwise set forth in these Terms, to reproduce, distribute, or otherwise commercialize any elements of the App Materials (including, without limitation, any Art) without our prior written consent in each case, which consent we may withhold in our sole and absolute discretion; and (c) that you will not apply for, register, or otherwise use or attempt to use any of our trademarks or service marks, or any confusingly similar marks, anywhere in the world without our prior written consent in each case, which consent we may withhold at our sole and absolute discretion.

This should make it clear that before purchasing an NFT, a buyer should attempt to fully understand exactly what it is they are purchasing.  In some ways, the Moment NFT is like a baseball card, and its value is going to be tied to how rare the actual rights owner (the NBA in this case) wants to make them.  The NBA could create numerous copies of a NFT for a particular Moment, completely diluting the rarity, and therefore the value, of the underlying Moment.  Sure, each Moment NFT is unique in that it represents a separate serialized NFT, but the fact that there are multiple available reduces the overall value of that particular Moment.

Further, purchasers of NFTs with such restrictions need to be careful of how they use or display the NFTs they purchase.  Under the NBA’s TopShot Terms of Service, it does not appear that a purchaser of a Moment would even be able to post images of their Moment purchase on social media sites, such as Instragram, as the Terms of Service restricts the right to reproduce or distribute the Moment or elements (e.g., artwork, video) of the Moment without consent.

The takeaway should be that a purchaser of any NFT should first understand what they are being sold, before committing to a transaction.

NFT and the Law – Patents

Not surprisingly, as inventors continue to develop and innovate on DLTs and blockchain, the same inventors have begun to improve and innovate on NFT related inventions as well.  There have been numerous patent applications filed and granted associated with the developing NFT space.  Many focused on developments in the smart contract space, storage and association with digital assets, and even tying NFTs to not only digital assets, but physical ones as well.

For instance, in December of 2019, Nike was awarded a patent for, a “System and Method for Providing Cryptographically Secured Digital Assets.”  A long and esoteric title, but what it ultimately boiled down to was that Nike had patented a system for associating the buyer of a pair of Nikes with the actual shoes purchased in order to provide a way for the buyer to prove authenticity.  However, even more ingenious was the further provision that associates the shoes purchased by the buyer with a digital version of the shoes that can be used virtually, such as in video games that allow for players to customize their in-game avatar’s skins.  This wouldn’t be Nike’s first foray into virtual skins for the video game space – I have previously written about Nike’s excellent crossover branding with the popular game Fortnite.  However, patenting the ability to associate physical goods with a digital counterpart that could be transferred from game to game builds on this ingenuity and is a wonderful compliment to their continued immense brand development.

NFT and the Law – Trademarks/Branding

While the previous discussion of Nike and the NBA should make it clear that big brands are jumping on the NFT bandwagon, it is important to further note that NFTs have a significant potential for continuing development of brand power and dominance, while also providing the ability to not only validate the authenticity of physical goods, but also create a new marketplace for virtual goods associated with those physical goods.  Those in charge of brand development and control would be wise to pay attention to the development of NFTs in these arenas, as the opportunities are skyrocketing in the space.

Luxury brands in particular have taken quick notice to this fact, with the likes of LVMH and Gucci already publicly taking note of NFTs and in some cases, applying NFTs to provide authenticity tracing for luxury goods sold under their associated brands.  Of course, this does not come without risks.  It has been theorized that counterfeiters could potentially leverage the creation of hard to discern fake NFTs in order to attempt to defraud purchasers into believing the authenticity of a good being sold.  While removing fake NFTs may be an addressable problem, those initially fooled by the fakes would still be prey to these new digital counterfeiters.

NFT – Issue and Concerns

One last thing that companies should consider when developing their own plan to take advantage of the massive popularity of NFTs is the risk that they would run afoul of other laws, rules and regulations that may apply to the trading of these digital assets.

For instance, one concern may be related federal and state claims of false advertising.  Given the complex nature of the underlying smart contracts, and how much they will vary from one NFT to the next, sellers run the risk of claims of false advertising if they are not very careful about how they word and promote their NFTs.  Is the seller really “Selling” a digital asset, when in many cases they are only providing a license to certain aspects of the underlying digital asset?

In the case of federal claims for false advertising under the Lanham Act, the buyer of an NFT may have a claim if: (i) the seller made false or misleading statement of fact as to the NFT or the digital assets that is (ii) used in a commercial advertisement or promotion that (iii) deceives or is likely to deceive the intended audience in a material way; (iv) the advertisements or sales of the NFT or digital assets were conducted interstate commerce; and (v) the buyer was caused competitive or commercial injury due to the false or misleading statements.

In order to avoid issues with claims of false advertising, sellers of NFTs should strive to be precise with the language used in promotions, listings or advertisements for NFTs, and what the buyer is getting from each transaction.  Playing fast and loose with these public statements can land the seller in a significant amount of trouble.

Conclusion

As the popularity of NFTs grow, it is important to continue to be ahead of the curve in terms of assessing and addressing potential liabilities.  Given the large sums of money being transacted in conjunction with these NFTs, making sure buyers and sellers are appropriately informed and protected should take a priority.

Further, as the market and technologies enabling the market grow, it will be interesting to follow the development and utilization of NFTs in the future.  We have already seen patents and other IP being registered to protect systems for providing attachment to both physical and digital assets, and use of digital assets associated with NFTs for useful purposes (e.g., skins in video games), it will be exciting to see where the next innovations will be.  To the extent improvements are developed, it is also important to engage counsel in order to assess whether those improvements can be protected and secured for the company making those developments.  There is a lot of open range in the field and a lot of room for next level developments.