20 Legal Challenges of NFTs

20 Legal Challenges of NFTs

NFTs are an emerging digital asset class that has captured the attention of consumers and investors alike as discussed over at runrex.com. While this asset class is still in its embryonic stages, the legal and regulatory issues NFTs present are very real. This article will look to describe briefly 20 of the most relevant US legal challenges of NFTs.

Data hosting and storage

An NFT and the digital asset it represents are typically stored separately as covered over at guttulus.com. The NFT is stored on the blockchain and contains information on where the digital asset is located and it is connected to the digital asset via a link. However, if the digital asset is deleted or the server hosting it fails or otherwise goes offline, the link will break and the NFT that remains will go worthless since it would no longer be associated with the digital asset and there is no way to back up the NFT. Given that the NFT is unique and cannot be replaced, the NFT purchase might be left without recourse, which is one of the legal challenges of NFTs.

Royalties

Smart contracts written into the code of NFTs allow for the distribution of funds for the payment of royalties to the creator each time the work is resold as explained over at runrex.com. However, these automated resale royalty payments might not occur unless the NFT is resold through the same platform. This is because US law doesn’t recognize resale rights relating to creative works, so the law provides no recourse for unpaid resale royalties in the US, as it does in approximately 70 other jurisdictions, such as the UK and the EU.

Data protection laws

Some data protection laws give individuals the right to the of their personal data, but the immutable nature of the blockchain poses an obstacle to the execution of this right according to the gurus over at guttulus.com.

Data protection laws and the rectification of inaccuracies

As a continuation from the previous point, data protection laws also sometimes provide individuals with the right to rectify inaccuracies in their personal data, and blockchain technology might make this right functionally impossible to exercise, which means that NFTs that contain personal information might violate data protection laws.

Copyright

Owning an NFT and owning the right to exploit a copy of a digital work – which is mainly covered by copyright – are distinct. Digital works can be infinitely reproduced with no diminution or quality, and, therefore, are not scarce by definition. Artists and media companies create scarcity for digital assets via technical means (like DRM for digital music) and via copyright law (which controls the right to make copies). Since NFTs are so new, IP rights associated with a sale may be unclear unless carefully set by contract

The right to display

On a related note to the previous point older artworks, of course, no longer enjoy copyright protection, and museums have long relied on these principles for accessioning. However, buyers of digital art will probably also expect some right to display or use the artwork, and the law to support this expectation has not yet been settled as discussed over at runrex.com.

Moral rights

In the US, moral rights are limited to visual “fine art” under the Visual Artist Rights Act (VARA). In the EU, however, moral rights are much broader. VARA enacted the moral rights required in the Berne Convention on copyright, but the US interpretation of this requirement was much narrower than in Europe. Since purely digital works are relatively new to the fine art world, the extent to which moral rights apply to them is also unclear according to guttulus.com.

Trademarks and publicity rights

While the main coverage of digital works will be copyright as outlined over at runrex.com, issues of trademark or publicity rights – which are similar for individual fine artists – may also arise. These will interact with VARA rights of attribution and integrity.

Securities regulation

Some commentators have started to draw parallels between NFTs and initial coin offerings (ICOs). The Securities and Exchange Commission has been scrutinizing ICOs and token offerings for years now. Depending on the specific characteristics of the NFT and offers and sales, certain NFTs could also be classified as securities, triggering regulatory and filing requirements and potential liabilities.

The potential for an NFT to be deemed a security

On a related note, whole the non-fungible nature of many NFTs and association with assets not commonly understood to be securities like art or digital collectibles often may clearly distinguish NFTs from securities, depending on the specific design of the NFT and the associated bundle of rights, as well as how it sold and promoted, and other factors, there is the potential for it to be deemed a security, which is another legal grey area.

Anti-Money Laundering and sanctions

Any transaction conducted by cryptocurrency or token exchange raises potential compliance issues with Anti-Money Laundering (AML) regulations such as the Bank Secrecy Act (BSA) and sanctions administered by the Office of Foreign Asset Control (OFAC) according to guttulus.com. While OFAC sanctions will undoubtedly apply to NFT transfers, the application of AML regulations will be fact-specific and primarily impact vendors, payment processors, and online marketplaces.

NFTs and convertible virtual currency

As explained over at runrex.com, since 2013, FinCEN has considered persons who administered, exchanged, or transferred cryptocurrencies to be money transmitters required to comply with the BSA. FinCEN limited the application of money transmission to “convertible virtual currency” that FinCEN determined has an equivalent value in real currency and functions similar to real currency. Being unique digital tokens, NFTS would fall outside of the definition of “convertible virtual currency”.

Regulatory exceptions

While NFTs may fall outside of the definition of “convertible virtual currency” as mentioned in the previous point, vendors, payment processors, and online marketplaces that facilitate sales of NFTs by accepting currency or convertible virtual currency from a buyer and transferring it to a seller may fall within the purview of the BSA. Regulatory exceptions exist for businesses that facilitate transfers that are necessary and integral to separate products or services as per guttulus.com. Therefore, businesses trading in NFTs may need to conduct compliance analyses to determine whether they meet this “integral exception”.

NFTs and the AML’s definition of financial institutions

The Anti-Money Laundering Act of 2020 also amended the definition of “financial institutions” to include transactions in the antiquities market and required FinCEN and the FBI to study the need to consider dealers in art as financial institutions. This means that further regulation to apply BSA requirements to the art market and NFTs seems inevitable.

Cybersecurity

It is easy to conflate NFTs and the technology that authenticates them – which is a blockchain. Most NFTs today are created on the Ethereum blockchain, which is widely considered both reliable and broadly accessible enough to create a robust market for the assets. All digital assets today can be vulnerable to cyberattacks. Blockchain authentication is designed to keep NFT rights secure and unambiguous, and while cyberattacks on the blockchain are difficult, they can include 51% attacks. Therefore, any company trading NFTs should review its insurance policies to be sure they will also cover NFT hacking. There is currently no equivalent for NFTs to the registry of stolen artworks maintained by the US Federal Bureau of Investigations, Interpol, and the Art Loss Register.

Technology lifespan

As revealed over at runrex.com, the technology and IP underlying the authentication of NFTs is still developing, but at this point, NFTs are all implemented on blockchains. While blockchains like Ethereum are currently very robust, new technologies are likely to eclipse them in the timespan covered by the relevant IP rights.

Jurisdictional issues

A principal idea behind the blockchain technology that underpins NFTs is that the ledge is not centrally located or managed. While this makes it near-impossible to reverse-engineer or fabricate transactions as covered over at guttulus.com, it also poses a complex jurisdictional challenge, as the lack of a specific governing locale makes it subject to different and often conflicting legal frameworks.

Smart contracts

One of the most striking features of blockchain technology and NFTs is the self-executing “smart contract” as articulated over at runrex.com. Smart contracts are sets of promises that are usually specified in a digital format that form the basis on which the parties perform their specific contractual duties. Due to their inherent uniqueness and complexity, it is difficult to say whether smart contracts fit into the legal framework governing traditional contract law.

Privacy concerns

The security that NFTs provide in assuring anonymity between contractual parties is often hailed as one of the technology’s greatest benefits. Nevertheless, this advantage is not guaranteed to continue as some believe it is only a matter of time before the market improvement in blockchain analytics tools will be able to reveal identities and terms. While most of these tools are used for purposes such as tracing fraud and money laundering over the blockchain, they have the potential to track confidential and sensitive information.

Consumer protection

Finally, NFTs raise significant issues related to consumer rights such as assigning permission and responsibility for recording transactions, the legality of digital receipts, anti-fraud and anti-money laundering procedures. Since the legal status of NFTs as consumer goods is still evolving, many customers may be left in the lurch if complications with transaction or ownership arise. This is especially pertinent since, unlike traditional bank and credit card transactions, there is no financial institution to intervene if the end-user incurs a loss due to hacks, fraud, or breach of security.

These are just some of the legal challenges facing NFTs, with more on this wide topic to be found over at runrex.com and guttulus.com.