Non-Fungible Tokens (NFTs) – Common legal implications to consider
Despite the increasing popularity in the creation, investment and trade of NFTs, one should be mindful that the legal treatment of NFTs continues to evolve and is unsettled.
Our Partner Charles To and Trainee Solicitor Holly Tang have therefore written an article setting out some common legal implications of the use of non-fungible tokens (NFTs). Amongst others, they highlighted key legal issues in relation to data protection laws, royalty payments and intellectual property rights of NFTs.
Whether you are an entertainment company, investor or independent NFT creator, it is vital to consider these practical advice.
Read the full article to find out more.
With the Hong Kong football club Resources Capital FC planning its launch of Asia’s first football non-fungible token (NFT) collectibles and Sotheby’s curated online NFT art sale in June 2021, it is certain that the popularity of NFTs is on the rise and that they are here to stay. In the second quarter of 2021, NFT sales surged to US$2.5 billion as compared to US$13.7 million in the first half of 2020.
Whether you are an investor, a creator or an entertainment company, this article will be helpful as we explore some of the legal issues behind NFTs.
What are non-fungible tokens?
An NFT is a crypto asset which represents an intangible digital item such as an in-game item, art piece image or video. Like Bitcoin, NFTs are built on a blockchain, which acts as a fraud resistant, decentralised ledger. As many will be familiar by now, blockchains are permanent, immutable, digital ledgers used to record transactions. Assets that are transferable between two parties in the blockchain ecosystem are commonly referred to as “tokens”. On the Ethereum blockchain platform, certain standards allow the issuance of tokens so that tokens can be assigned for specific uses and properties. Within the Ethereum platform, the ERC-20 token standard is used for fungible tokens and the ERC-721 token standard is used for non-fungible tokens. The properties of the tokens indicate the origin of the underlying digital asset when an exchange of tokens takes place. As Bitcoin or other cryptocurrency tokens use the Ethereum ERC-20 standard or an equivalent of it, they are identical and readily exchangeable for equal value (i.e. fungible). On the other hand, NFTs are unique digital assets, therefore they are “non-fungible”. Furthermore, the blockchain records the ownership information of each NFT, hence allowing an NFT to be traded as a stand-in for the digital asset it represents.
The rise of NFTs?
Some NFT enthusiasts see the tokens as collectibles with intrinsic value because of their cultural significance, while others treat them as an investment, speculating on rising prices. Prior to the use of NFTs, digital creators often faced limitations on their revenue because infinite copies of their works can easily be made and distributed throughout the internet without loss of quality. However, with NFTs and the ERC-721 token standard, this creates a generation of unique and finite tokenized versions of the digital creative works. Harnessing the technology, NFT creators can set both the sales price and the maximum number of replicas of their digital creative work that can be in existence, hence creating scarcity. The exclusivity and the limited number of copies should increase the value of their creation. The losses related to piracy, which artists and creators have severely experienced since the onset of the internet, can also be eliminated since NFTs cannot be replicated. Moreover, NFTs are easily accessible to any purchaser given that they can be sold on any NFT market or directly peer-to-peer. Finally, tokenized protection of assets highly increases the attraction of digital creative assets and spurs its creation. The abovementioned factors combined demonstrate why NFTs boomed in the past year as most of the world is confined to their homes during the Covid-19 pandemic, and the internet became their only avenue for creation, investment and entertainment.
Despite the excitement revolving around NFTs’ exponential growth, the legal treatment of NFTs continues to evolve and is unsettled. We highlight a few legal issues below:
Intellectual property rights
Many purchasers of NFTs are unfamiliar with the legal restrictions relating to copyrighted work. This leads to potential infringement liability. A common misconception of an NFT purchaser is that he has purchased the underlying art that is associated with the NFT.
In reality, when you buy an NFT, you are only buying one particular version of the digital work itself, a copy of the original so to speak, and a collection of code known as metadata. This metadata is saved on the blockchain and contains information about where the original work is located and who owns that particular original version of the work. Compare it to the purchase of a movie on a Blu-ray disc at your local store: The same concepts apply. A purchaser does not have the right to make unlawful copies of the movie nor sell and profit from these copies. Neither does the purchaser have the right to display it publicly and reap profits from it.
Essentially, unless the original creator has granted such rights to a third party, only the original creator is the copyright owner. Hence, only the original creator has the exclusive right to copy, distribute, modify, publicly perform, and publicly display the art. Therefore, the NFT purchaser typically only receives the token and the right to use the copyrighted art associated with the NFT for personal use.
To refrain from legal liabilities, a buyer would be best advised to conduct rigorous due diligence to ascertain that the seller really is the creator of the work or has a good title to the digital work to transfer it to the buyer. How a purchaser can use an NFT will be determined by the conditions or license terms attached to the acquisition of the applicable NFT. The platform where the NFT is acquired can choose to impose more permissive licensing terms which enables the buyer of an NFT broader rights to use the unique digital version of the work in connection with the NFT. Therefore, the NFT creator should equally be mindful of the license terms of a marketplace to avoid situations where the creator is giving more rights to a purchaser than intended.
When it comes to royalty payments, some NFTs utilize smart contracts. Smart contracts are digital contracts where the terms of the digital contract are written in the code and are embedded within the purchased tokens. Smart contracts are programmed to execute automatically once a predefined set of conditions are fulfilled. The code itself is permanently minted into a token on the blockchain so it cannot be replaced, deleted or amended.
With respect to its role in NFTs, smart contracts are incorporated so that a portion from the sale price will be paid to the original NFT creator as royalty payments. Given that the contractual terms are performed automatically upon a triggering event, this dramatically reduces the level of trust required before a payment can be made. However, smart contracts in NFTs generally operate in tandem with the text-based terms and conditions of the marketplace where the NFT is acquired. This leaves room for potential confusion and uncertainty if the two fail to match up in any particular respect. Additionally, unless the NFT is resold through the same platform where it was initially listed, the automated resale royalty payment mechanism may not occur.
Data Protection Laws
Like in many other jurisdictions, the Hong Kong Personal Data (Privacy) Ordinance gives individuals the right to remove or correct their personal data. However, given the immutable nature of a blockchain, it makes it functionally impossible for purchasers to execute such a statutory right. Therefore, NFTs that contain personal information may violate data protection laws.
Parliaments and lawmakers around the globe are finding solutions to embed NFTs into a modern legal framework. Privacy laws must be obeyed even by latest technology.
Accurate link to NFTs
An NFT is hosted on a distributed ledger technology platform, which typically does not enable storage of large files, such as digital assets. Therefore, an NFT is typically connected to its underlying digital asset via a link. If the digital asset is stored on a conventional server, there is a risk that the server could shut down due to power cuts or machinery faults.
Another potential risk is that the underlying file of the NFT or the link is maliciously changed or deleted. All these risks break the link between the asset and its corresponding NFT. Therefore, NFT purchasers must check the authenticity and security of the link, and that the server hosting the digital asset is reliable. A reliable NFT seller will greatly minimise the related risks as set out.
Despite the legal issues raised, it is certain that NFTs are here to stay. NFTs will continue to strongly influence a transition to a more digital world. Digital creators are reaping the benefits from the uprising of NFTs since their work can imbue physical properties like scarcity, uniqueness, and proof of ownership. Through NFTs, digital work can be better protected and monetized. As the NFT market continues to evolve, with significant infrastructure likely to be built in the form of intermediaries, tokenization platforms, distribution channels, so do the legal and regulatory issues.
Please contact our Partner, Mr. Charles To (email: [email protected]), or our Trainee Solicitor, Ms. Holly Tang (email: [email protected]) for more information.