What are NFTs?
Since November 2017, over $100 million has been spent on NFTs.[1] An NFT (non-fungible token) is a digital asset recorded on a digital blockchain ledger for transactions.[2] Although the technology behind NFTs has existed for years, NFTs emerged into public consciousness in 2021.[3]
While physical money and cryptocurrencies can be exchanged for one another and have set value, NFTs are not “fungible” and cannot be exchanged with one another because they have unique digital signatures.[4] For example, a dollar bill can be exchange for any other dollar bill and have the same value, but a one-of-a-kind trading card cannot be traded for another trading card.[5] NFTs exist for a wide variety of assets, including, art,[6] GIFs,[7] videos,[8]collectibles,[9] music,[10] virtual pets,[11] and even tweets.[12]
Why NFTs?
Many people do not see why NFTs are valuable since theoretically, anyone can view images online for free. But the value of NFTs lies in the fact that an NFT is a token of ownership and has built-in authentication.[13] Sellers may be incentivized to sell work through NFTs because there is not much of a market for their product otherwise,[14] they want to avoid paying galleries hefty commissions to sell their art,[15] or they want to take advantage of the NFT feature that automates royalty payments to the seller every time the NFT is sold or exchanged.[16] Buyers may want to purchase NFTs to support various artists and to get usage rights.[17] As for collectors, NFTs have speculative value just like physical collectibles, since their values change over time.
What Intellectual Property Rights for the Underlying Work are Transferred to the Buyer?
Purchasing an NFT does not necessarily give the buyer any ownership of intellectual property rights in the underlying work.[18] In most cases, the NFT holder only obtains “a non-exclusive license to the underlying intellectual property rights” and “only for non-commercial purposes.”[19] If the issuer of an NFT is a content creator, then the issuer can explicitly assign or license any or all of those rights to a buyer—"for example, the right to use, copy, display, and modify the content.”[20] If an issuer obtains content from a creator, then the issuer would only have certain assigned or licensed rights, and can only transfer those rights to the buyer.[21]
Some NFT marketplaces include in their terms of use a warning to buyers that they are not acquiring any IP rights in the work.[22] If the marketplace does not provide such a warning, IP rights remain with the rights holder.[23]
Will NFTs be Treated as a Commodity or Security?
So far, regulators have not officially classified NFTs, but they are more likely to be considered “commodities” under the Commodity Exchange Act ("CEA") than “securities” under the federal securities laws.[24] Relatedly, the Commodity Futures Trading Commission ("CFTC") has stated that the term "commodity" includes cryptocurrencies.[25] If an NFT is considered a commodity, then CEA requirements apply, including the prohibition on deceptive and manipulative trading.[26] NFTs offered on a leveraged basis may also be required to trade on a registered derivatives exchange unless "actual delivery" occurs within 28 days.[27]
A special category of NFTs called fractional NFTs (f-NFTs) could potentially be considered securities.[28] F-NFT investors share a partial interest in an NFT with others.[29] Under the Howey Test, f-NFTs could be considered an “investment contract” as long as they are “designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such.”[30] If these NFTs are considered securities, they would be subject to securities law limitations.[31] These limitations include mandatory registration of the sellers as broker-dealers, mandatory registration of NFT marketplaces, liability for material omissions or misstatements and for insider trading, restrictions on short sales, etc.[32]
Are NFTs Subject to Federal Anti-Money Laundering Laws?
The Financial Crimes Enforcement Network ("FinCEN"), the agency responsible for combatting money laundering under the Bank Secrecy Act ("BSA"), has not issued guidance for NFTs, but it has general guidance for virtual currencies that could also apply to NFTs.[33] If NFTs are considered “value that substitutes for currency,” then FinCEN could apply BSA and FinCEN regulations to them.[34] Since many NFTs are more like digital representations of ownership rather than value that substitutes for currency, however, they are unlikely to be subject to FinCEN's oversight.[35]
Taxation
When a buyer purchases an NFT with fungible cryptocurrency, the buyer incurs a capital gain/loss for the change in value of the cryptocurrency.[36] When a seller offers an NFT for cryptocurrency, the seller incurs a capital gain/loss in the change in value of the NFT.[37] Even when someone trades one NFT for another, the difference in values of the NFTs is taxable.[38] Since NFTs such as trading cards are collectibles, however, they may be taxed at the higher collectibles tax rate rather than the long-term capital gains rate, but the IRS has not officially categorized NFTs for tax purposes.[39]
Conclusion
As a fast-developing economic asset class, NFTs still face many unknown legal classifications and consequences. They raise more issues than what is discussed, including those surrounding seller royalties,[40] user data protection,[41] and persistence of underlying assets.[42] Stakeholders in the NFT market are awaiting regulatory decisions surrounding these topics.
[1] https://ethereum.org/en/nft/
[2] https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class
[3] Id.
[4] https://ethereum.org/en/nft/
[5] https://www.theverge.com/22310188/nft-explainer-what-is-blockchain-crypto-art-faq
[6] https://www.nytimes.com/2021/04/29/arts/disaster-girl-meme-nft.html
[7] https://www.theverge.com/2021/2/18/22287956/nyan-cat-crypto-art-foundation-nft-sale-chris-torres
[8] https://www.nbcnews.com/pop-culture/viral/charlie-bit-my-finger-youtube-video-sells-nft-760-999-n1268322
[9] https://beincrypto.com/marvel-launches-marvel-mightys-nft-collection/
[10] https://www.rollingstone.com/pro/news/kings-of-leon-when-you-see-yourself-album-nft-crypto-1135192/
[11] https://www.cryptokitties.co/
[12] https://www.theverge.com/2021/3/5/22316320/jack-dorsey-original-tweet-nft-cent-valuables
[13] https://ethereum.org/en/nft/
[14] https://www.theverge.com/22310188/nft-explainer-what-is-blockchain-crypto-art-faq
[15] https://ethereum.org/en/nft/
[16] https://www.theverge.com/22310188/nft-explainer-what-is-blockchain-crypto-art-faq
[17] Id.
[18] Levi, S., Ghaemmaghami, M., Neal, M., & Shapiro, A. (March 2021). “NFTs Raise Novel and Traditional IP and Contract Issues.”
[19] https://www.lawtechnologytoday.org/2021/06/nfts-and-the-law-what-do-i-actually-own/
[20] https://www.rollingstone.com/pro/news/kings-of-leon-when-you-see-yourself-album-nft-crypto-1135192/
[21] Id.
[22] Levi, S., Ghaemmaghami, M., Neal, M., & Shapiro, A. (March 2021). “NFTs Raise Novel and Traditional IP and Contract Issues.”
[23] Id.
[24] https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class
[25] Id.
[26] Id.
[27] Id.
[28] Id.
[29] Id.
[30] Id.
[31] Id.
[32] Id.
[33] https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class
[34] Id.
[35] Id.
[36] https://opengeekslab.com/blog/legal-issues-nfts/
[37] Id.
[38] Id.
[39] https://ethereum.org/en/nft/
[40] https://opengeekslab.com/blog/legal-issues-nfts/
[41] Id.
[42] Levi, S., Ghaemmaghami, M., Neal, M., & Shapiro, A. (March 2021). “NFTs Raise Novel and Traditional IP and Contract Issues.”