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Tuesday, April 20, 2021

What you should know before buying or selling an NFT in the US

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Nonfungible tokens appear to be an idea whose time has come. Originally developed for use with collectible trading-card games, NFTs can represent almost any unique asset. Outside of the gamer context, the first NFT to gain widespread popularity was probably CryptoKitties, which were released back in 2017.

Related: CryptoKitties’ Dieter Shirley on breaking Ethereum and NFTs

CryptoKitties became so popular that at one time, CryptoKitty trading clogged the Ethereum network, setting records for transaction volume. NFTs have only grown in popularity since then, and have now been developed for a range of in-game assets, digital collectibles, unique artworks and more.

Related: Not just for gamers and fanboys: Why investors should take NFTs seriously

The “Non-Fungible Yearly Report 2020” demonstrates the phenomenal growth of NFT transactions, showing an increase in market capitalization of NFTs from $141.5 million in 2019 to $338 million in 2020.

This comment focuses on NFTs associated with creative works of art. At this point in time, by far the most famous of these is “Everydays: The First 5000 Days,” a work created by the digital artist known as Beeple. That work was auctioned off by Christie’s in the form of an NFT for an astonishing $69.3 million on March 11, 2020.

Related: Storming the ‘last bastion’: Angst and anger as NFTs claim high-culture status

However, more affordable NFTs in images, paintings, photographs, songs, videos and other creative works are also being made available. For a recent example somewhat less eye-catching than Beeple’s sale, popular artist Grimes raised about $6 million selling NFTs based on 10 pieces, some of which have thousands of copies available. The sale included NFTs for 700 copies of two pieces consisting of a short video and original music for $7,500 each, as well as a single NFT for a unique video and accompanying original song that sold for approximately $389,000.

However, before anyone decides to get in on the action and start selling or buying art in the form of NFTs, it is important to have a basic understanding of what these transactions actually involve.

The information presented here is very general in nature, and this comment relies on United States federal law. The laws in other nations and some states (most notably California) may be more or less restrictive on what the purchaser of an NFT might be acquiring and the relative rights and obligations of the buyer and seller. It should, of course, be understood that this general information is no substitute for individualized legal advice, which is still a good idea.

What is an NFT?

First, it is probably important that the parties to any transaction involving an NFT have at least a basic understanding of what they are dealing with. First, an NFT is indeed a crypto asset, but it is not like Bitcoin (BTC) where every BTC is interchangeable with every other BTC. “Nonfungible” means that each NFT is unique, encoded onto the underlying blockchain with certain metadata that makes it different from every other token, even if the underlying work of art is the same. Ownership of each NFT is still tracked on the blockchain, and the programming code determines how ownership is verified and whether transfer conditions have been satisfied. However, no two NFTs are identical.

As is the case for other kinds of crypto assets, NFTs can be supported on a number of different blockchains, including Ethereum, Flow and Wax. However, certain NFT markets are compatible only with specific blockchains, which can have commercial implications for the seller and anyone who is buying with an eye toward the possibility of appreciation in value over time.

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This comment is focused on NFTs based on an underlying work of art, and so the obvious question is what a seller is actually conveying or a purchaser is actually acquiring along with the NFT.

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Sales of art in conventional transactions

Consider what happens when someone buys a unique piece of art, such as a painting, from the artist outside of the digital context. When a painting is acquired, that typically entails a transfer of the possession of the physical object. The buyer may then possess and display the painting, but their rights are not unlimited. The purchaser owns the artwork, but not the “intellectual property” associated with that content.

Although this may surprise some people, absent agreement from the artist either at the time of acquisition or later, purchasers cannot make and display or distribute copies of the painting; they cannot make derivative works from it; and in many cases, they cannot materially alter or destroy the painting. Section 106 of the U.S. Copyright Act limits purchasers’ ability to reproduce and distribute or to make derivative works based on their purchase, and the Visual Artists Rights Act protects an artist’s “moral rights” in certain visual art that is released as a single original or with fewer than 201 signed and consecutively numbered copies.

As it always seems to be the case when it comes to the law, the actual application of these rules is more complicated than that. There are some situations in which the artist does not retain the underlying copyright. For example, this would be the case if the work was done for hire or if the artist specifically signs over their copyright or “moral rights” to the buyer. In addition, copyright protection expires (albeit not until 70 years after the death of the artist).

Finally, not all “visual art” is covered by the federal Visual Artists Rights Act, and the only rights that the artist can sue to enforce under that act are the moral rights of attribution and integrity, as explained in the legislation and interpretation judicial opinions. Creative arts that are not visual in nature, such as songs, are not covered by the act at all.

Remember that this discussion applies only to the U.S., as rights in other countries may be significantly different.

What does an NFT based on an underlying work of art include?

How does all of this apply in the case of an NFT based on an underlying work of art? Of course, the purchaser of an NFT would own the unique token associated with the underlying creative work. Depending on a variety of factors, that might or might not give the purchaser rights in the underlying artistic content.

Speaking very generally, underlying copyright only transfers if the owner of the copyright provides written evidence of intent to transfer those rights. This means that in order to obtain the rights to take pictures or make copies of the underlying work of art, or to make derivative works from it, the NFT purchaser must be given permission from the seller. Without appropriate evidence to the contrary, a purchaser acquires only a non-exclusive license to display the related media in their token wallet for personal purposes. There is, for example, no right to display the media on other products, websites or digital platforms.

This is all subject to contrary agreement. For example, with regard to the $69-million auction of Beeple’s NFT for “Everydays: The First 5000 Days,” the purchase reportedly included some display rights in the image, but the artist retained the copyright. There is no public evidence that the artist agreed not to retain or make additional copies of the digital image or its component parts.

How to make sure the transaction works as the parties expect?

The best way to ensure that the parties to an NFT sales transaction are conveying and acquiring the rights that they expect is to make sure that everyone has done their homework. The purchaser should investigate and feel confident about the reliability of the NFT’s creator and platform through which the NFT is being transferred. Both parties need to decide upon, create and review appropriate documentation explaining precisely what the creator has retained, what has been transferred, and any ongoing responsibilities associated with the underlying creative work.

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From the purchaser’s perspective, it is important to investigate the creator or seller of the NFT because it is entirely possible to have sham companies posting that they have created NFTs for sale when they have no ability to do so legally. It is possible that they are lying about the existence of the NFT (relying instead on a digital image that is unrelated to any blockchain), or the NFT could be tied to a different blockchain that they do not control and cannot transfer, or the art on which the NFT is based does not legally belong to them and, instead, infringes on another party’s copyright.

In these cases, a buyer will want to know that there is a viable company on the other side of the transaction from whom rescission or damages can be sought. In addition, buyers might want to be sure that the party on the other side of the transaction is not selling NFTs to support illegal activities such as terrorism or human trafficking, and the way to do that is to investigate the seller of the NFT and the platform on which it is hosted.

As for the remainder of the issues mentioned above, the best way to proceed is for the parties to have a written agreement setting out each party’s understandings and obligations. As a starting point, Dapper Labs has created a public template for an NFT License, which currently includes version 2.0 of a document for consideration by artists looking at selling NFTs. The Dapper Labs’ template includes language that sellers can adopt to outline the rights that they intend to transfer or license to the NFT buyer. The Dapper Labs’ sample form clearly distinguishes between the token and the underlying artistic content.

The suggested language gives the purchaser of an NFT two things: (1) a personal license permitting the purchaser to display or use the underlying art, and (2) a limited license permitting commercialization of the underlying art in merchandise created by the purchaser, so long as the purchaser does not exceed $100,000 in gross revenues per year as a result of such commercialization.

Dapper Labs’ template provides suggested language only, and the agreement can be modified to suit the needs of both the seller of the NFT and the buyer. The important thing is to clearly articulate which rights are being transferred and the limitations on any licenses that are granted. The Dapper Labs’ version is one potential starting point. An online search of NFT sample contracts or NFT sample templates will give access to alternative language for consideration.

This is not, of course, a substitute for legal representation. Particularly, if a sizable purchase is contemplated, or the buyer is anticipating sizable revenue from commercialization of the underlying artistic content, personalized legal advice is highly advisable.

Can this be solved by the NFT’s smart contracts?

In order for an NFT to be linked to artistic content, it needs to carry unique information about the digital work within its programming. Theoretically, the entire artistic creation, regardless of whether it is a digital image, video, song or another kind of work, could be included as part of the computer code that constitutes the NFT. Unfortunately, this would entail keeping a significant amount of data “on-chain.” This is impractical on most blockchains because of the cost and time involved in transferring assets of that size.

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Since on-chain storage is impractical, this means that the creative work must be stored elsewhere, such as on a web server. The NFT’s code would then refer to the online web address, but this also means that the underlying digital assets are not safely stored on the blockchain, but rather off-chain.

It is of course possible to include other terms in the programming code, indicating for example what rights are to be transferred and when additional payments might be called for. At the current time, however, there is no way for these to be self-executing, and it is unlikely that most purchasers would be able to verify the contents of encoded provisions. Hence, the need for a document such as the Dapper Labs’ template is unchanged.

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It should also be noted that because the underlying artistic content is unlikely to be embedded in the NFT programming, there are open questions, such as how to ensure that the digital content will be appropriately, continuously hosted in a retrievable format by the purchaser. Without some legally enforceable obligation, there is no way to protect against the risk that the digital art might become inaccessible if the web address is changed or the server goes offline.

Again, the probable solution is to include appropriate documentation ensuring that the original seller of the NFT either assumes a legal obligation to host the digitized artwork so that it will remain unchanged and accessible to the purchaser or transfers the domain name and the obligation to maintain access to the purchaser. If the creator retains the obligation to maintain a website, the obligation needs to be binding so that subsequent purchasers can also enforce it against the original seller.

Technological advances are likely to offer additional solutions to these kinds of issues at some point in the future, but if those alternatives are being relied upon, that should also be in the agreement transferring ownership of the NFT in question.

Conclusion

This comment does not purport to offer an exhaustive list of potential issues that should be considered prior to a decision to sell or invest in an NFT. For example, there will be federal and possibly state income taxes issues to take into consideration, and in many American states, there may be sales or use tax implications as well.

In addition, purchasers need to understand the importance of adopting adequate security precautions after they purchase an NFT.

As NFTs gain in popularity, it is probable that more and more individuals will seek to create and invest in them. Given the high visibility of NFTs based on artistic works, it is likely that many NFTs will involve that kind of underlying asset. This comment is designed to provide additional information for both sellers and buyers in the NFT market because they all need to understand what they are getting into.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of UKTN.

Carol Goforth is a Clayton N. Little professor of law at the University of Arkansas (Fayetteville) School of Law.

The opinions expressed are the author’s alone and do not necessarily reflect the views of the University or its affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.