Published
January 4, 2022

A Legal Overview of NFTs

Where the rapid pace of innovation in the NFT ecosystem can be analogized to the nimble cheetah, the relatively sluggish pace of legislation development more closely resembles the movements of the slow-moving sloth. This inherent misalignment in speeds means that regulation has significantly lagged behind advancements in the NFT sphere, granting many opportunists the chance to capitalize and prey on unsuspecting victims in this hot but unregulated market.

This article will highlight some of the most critical legal and regulatory issues pertaining to NFTs. In particular, the discussion will center on the following four subjects:

  1. Securities Laws
  2. Intellectual Property Rights
  3. Taxation
  4. Anti-Money Laundering Rules

Securities Laws

From a US perspective, securities can include stocks, bond, and derivatives, among other formally-defined instruments. Certain assets which do not adhere to the definitions of standard securities are grouped into a catch-all non-standard securities category termed ‘investment contracts’. Assets can be deemed investment contracts based on their fulfillment of specified criteria under the Howey Test. The Howey Test arose from the landmark 1946 Supreme Court case Securities and Exchange Commission (SEC) v. W.J. Howey Co., which centered on the Howey Company’s practice of selling citrus groves and leasing them back from their buyers only to then tend to the fruits and split the resulting profits from their sales with the lessors of the groves.

Ultimately, the Supreme Court ruled that the sales and subsequent leasebacks of the citrus groves qualified as investment contracts and by extension as securities. In the process, the Supreme Court set a precedent for future cases by defining an investment contract under the Securities Act of 1933 as follows:

“… a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party”

It is important to note that the above definition shows no regard as to the speculative nature of the deemed investment contract or the matter of whether it commands any intrinsic value. Overall, the implications of an asset being deemed an investment contract are significant. Generally, securities including investment contracts must be registered with the SEC – which itself involves a process that may be terminal for an NFT project – or run the risk of being shutdown by the Division of Enforcement.

Whereas digital assets have been historically difficult to definitively classify as securities, there are some cogent arguments to be made for the status of NFTs as investment contracts under the criteria of the Howey Test: 

  1. The investment of money is unequivocally clear where NFTs are concerned as prospective owners must first purchase cryptocurrency using fiat money in order to acquire their tokens.
  2. Per the SEC, there is generally an observable common enterprise in the NFT market given that each participant’s profits are tied to the efforts of a project’s developers and investors to promote price action in the tokens. 
  3. An expectation of profits can be reasonably ascertained, especially amidst the speculative mania which has surrounded NFTs and the market for crypto-assets at large throughout 2021. Many investors have purchased NFTs with the express purpose of flipping them once they have appreciated in value and realizing substantial profits on their holdings.
  4. The criteria regarding investors’ reliance on a third-party to generate profits is arguably the most ambiguous and least easily proven part of the Howey Test when applied to NFTs. For one, it is necessarily difficult to pinpoint a third-party who bears the liability for generating profits given the digital asset market tends to rely on a decentralized network of users volunteering their time to the maintenance and promotion of a project. Further, the notion of third-party efforts refers to work that is to be performed in the future rather than that which has already taken place in the past. In the case of NFTs, their underlying smart contracts are written prior to the launch of the project and cannot be mutated post-deployment. Thus, there are open questions as to whether the unidentified third-party’s efforts can in fact be considered the source of any resultant profits from an NFT investment.

The above are but a few of the key issues surrounding the potential status of NFTs as securities; the matter becomes infinitely muddier when the full scope of the SEC’s considerations are taken into account.

Intellectual Property Rights

For the uninitiated, it is critical to note that NFTs merely represent ownership of a digital asset and not the digital asset itself. The implication of this is that while NFT holders can truthfully claim to own the underlying collectible or artwork, they lack authority to prevent others from making copies of their digital asset. In effect, this means that NFT owners hold a non-exclusive license to the asset underlying their tokens. Additionally, for most intents and purposes, ownership of an NFT-based asset confers on the holder a right to use the underlying asset only for non-commercial purposes.

The reason for this seemingly nominal ownership structure is that, in the vast majority of cases, the foundational contract behind the NFT does not purport to transfer the copyright for the underlying asset to the buyer of the token. In such instances, the original authors or developers behind the project retain the intellectual property rights to all assets underlying NFTs issued as a part of their collection, meaning they can continue to duplicate and distribute additional copies of those assets. In substance, this is no different from owning a painting in the real-world; individuals are neither assumed nor entitled to hold the copyright of a physical artwork simply by virtue of having ownership over it.

Several issues arise as a result of the lack of copyright-transfer inherent in most NFT collections. For instance, if an individual chooses to tokenize works in the public domain or for which the copyright is still valid without actually having any ownership in the work, questions abound as to the legality of their actions. Copying digital works or digitizing physical works and minting them as bootleg NFTs may constitute an infringement of copyright, however there is little in the way of case law on such matters. 

Taxation

It would appear that as tax regulators have begun to adapt to consider the tax implications of participating in cryptocurrency markets, the NFT markets have emerged to present them with a novel and potentially more complex challenge. Generally speaking, cryptocurrencies have been treated as property for tax purposes, exposing any sales transactions to capital gains tax. One can only assume that NFTs will be subject to an analogous treatment given that they effectively represent the titles to fixed assets such as artworks and other collectibles. However, without clearer guidance from tax authorities, there is little doubt that much of the massive gains realized on NFT sales in 2021 will go unreported.

Some potential complications exist that are unique to NFTs and mandate more nuanced tax treatment than what has been issued for cryptocurrencies. For instance, given that the vast majority of the assets underlying NFTs are stored off-chain, there is the natural question of whether an NFT holder can claim a capital loss in the event that the server housing the asset represented by their token is corrupted. The separation between the on-chain tokens and off-chain assets also gives rise to questions surrounding the sourcing of income. Namely, there is the matter of whether gains are to be sourced to the jurisdiction in which the NFT owner is resident, or where the controller of the underlying asset is resident.

Anti-Money Laundering Rules

Historically, investing illegally-obtained funds into high-value physical artworks was viewed as a relatively effective tactic for laundering money. However, this method has proven to have two severe limitations. For one, the actual storage and transport of physical artworks tends to be a great burden for money launderers who have cleaned their funds through the pieces. Additionally, a global crackdown against the practice of laundering money through artworks has led to more robust Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations surrounding the sale of art. NFTs lend themselves to seamless storage and transportation given their immaterial nature, and the market presently lacks the rigorous KYC and AML regulations that have taken hold in the analog art world. Naturally, this means that high-value NFTs have emerged as prime vehicles for money laundering. 

Closing Remarks

As NFTs are still a nascent innovation, the surrounding legal and regulatory environment is similarly underdeveloped. However, the recent explosion in the NFT market and the astonishingly high trading values of many tokens will no doubt compel regulators to take swift action against all the potential abuses of NFTs. There is simply far too much at stake, whether in terms of IP and securities disputes, undeclared capital gains, or laundered money, for decisionmakers to adopt a passive approach. That being said, while the entry of regulators will turn this Wild West market into a more compliant and investor-friendly environment, it will also surely have the effect of neutralizing much of its recent momentum. Whether the benefits of the former outweigh the downsides of the latter, however, is a question that can only be answered with time.

References

Clark, F., & Aujla, S. (2021, July 8). What are the legal issues concerning Non-Fungible Tokens (NFTs)? Retrieved from Lexology: https://www.lexology.com/library/detail.aspx?g=c788ee67-2467-40bb-b2e1-3c35cc5681e9

Kirchert, C., & Morse Jr., A. (2021, March 24). Deconstructing the SEC's Cryptocurrency-Suppression Program: Part One. Retrieved from JD Supra: https://www.jdsupra.com/legalnews/deconstructing-the-sec-s-cryptocurrency-3713403/

Ossio, D. B., Cranston, J., Nixon, L., & Garcia, L. (2021). Non-Fungible Tokens: The Global Legal Impact. London: Clifford Chance LLP.

Pipolo, J. (2021, June 21). NFTs And The Law: What Do I Actually Own? Retrieved from Law Technology Today: https://www.lawtechnologytoday.org/2021/06/nfts-and-the-law-what-do-i-actually-own/

Securities and Exchange Commission v. W.J. Howey Co. et al., 843 (Supreme Court of the United States May 27, 1946).

US Securities and Exchange Commission. (2019, April 3). Framework for "Investment Contract" Analysis of Digital Assets. Retrieved from US Securities and Exchange Commission: https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets

Vallabhaneni, P., & Lizaso, S. (2021, April 20). The Rise of NFTs – Opportunities and Legal Issues. Retrieved from White & Case: https://www.whitecase.com/publications/alert/rise-nfts-opportunities-and-legal-issues



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