Author | Inal Tomaev
Authorized by Wu Shuo to compile and publish
This article seeks to identify and address the legal issues facing the NFT industry.
origin
NFTs are cryptographic tokens (digital certificates) recorded in a blockchain registry that confirm ownership of nearly anything in the digital or even physical world (such as images and real estate). Each NFT is unique and has its own value due to its connection to an asset.
The concept of using NFTs as a way to represent and manage real-world assets on the blockchain can be traced back to Meni Rosenfeld’s article “Overview of Colored Coins” published on December 4, 2012. In the article, Rosenfeld introduced the concept of “colored coins”, which are similar to Bitcoin, but add a “token” element that gives them a specific purpose or utility, making them unique. The author suggests that these tokens will not only be used in blockchains, but also for connecting real-world applications.
On May 3, 2014, digital artist Kevin McCoy created the first NFT — “Quantum”—on the Namecoin blockchain. “Quantum” is a digital image of a pixelated octagon that changes color and pulsates, resembling an octopus. This early use of NFT technology has become a prototype for the entire digital art field.
From a technical point of view, the blockchains available at the time (mainly Bitcoin) were not designed to be used as databases for tokens representing asset ownership. The active development of NFTs began with the emergence and popularity of Ethereum.
It’s also important to distinguish between three options for the relationship between NFTs and the primary assets they represent:
1. On-chain: All transactions involving NFTs are recorded on a single blockchain and can be easily verified using a blockchain explorer. An example of this is the recent sale of real estate as an NFT.
2. Off-chain: Transactions are recorded not only on the blockchain but also in a centrally managed database. An unusual example can be found on OpenSea, where a tungsten cube representing a 2,000-pound weight is sold.
3. The legal relationship that exists between the on-chain and off-chain is called “follow-up rights”, where the second party is dependent on the first and requires a certain degree of rights.
utility
NFTs are particularly popular in the art world, where the uniqueness of a work is highly valued. As a result, NFT owners are often seen as “the chosen ones.”
However, many people associate NFTs with strange, colorful pictures that sell for millions of dollars. In fact, NFTs can represent a wide range of assets, both digital and physical, that have value in both the virtual and real worlds.
NFT should not be limited to the field of crypto art. More precisely, NFT is a technological tool that can provide new opportunities in both worlds.
Here are some examples of how NFTs can be used.
● Digital Art
One of the main uses for NFTs is in the art and collectibles space. Traditional works of art, like paintings, are valuable because they are one-of-a-kind — created by hand using unique techniques and materials. Digital files can be easily copied, but NFTs provide a way to prove ownership of a unique digital or physical asset. NFTs offer creators a new way to monetize their digital art and collectors a new way to own and trade unique items. NFT platforms may even offer the possibility of automatic royalties for artists on future sales, but this depends on the platform (platform examples — OpenSea, Rarible).
Representative works: Art Blocks, Murakami Flower Seeds
● PFP
NFTs that are PFPs or "profile pictures" are often found on Twitter, where they are associated with a specific account. If a PFP is verified by Twitter, the user may receive a special pendant or badge for their avatar. PFP ownership can also allow users to join certain communities and access games or other products created by those communities.
Representative examples: BAYC, CryptoPunks
● Virtual Land
These NFTs represent areas of digital land owned by users on the Metaverse platform and give owners the ability to use the land for various purposes, such as advertising, communications, gaming, work, or rental.
Representative examples: The Sandbox, NFT Worlds
● Games
Represents objects in the game, such as avatars, weapons, animals, and land.
● Membership
NFTs can also be used to solve user privacy and data processing issues. There is no need to remember multiple platform passwords, and they can be resold on the secondary market for a profit.
Representative examples: Proof, Premint
● Community-NFT
NFTs can also provide some benefits when participating in online and offline social activities.
Representative example: VeeFriends
● Music
NFTs that represent digital content such as music or videos typically distinguish between the rights of the holder and the creator. In most cases, users receive the tokens themselves, which entitles them to sell, transfer, or otherwise dispose of the tokens. However, any intellectual property rights associated with the tokens remain owned by the creator, and token holders may only be entitled to a portion of the royalties from streaming as co-investors.
Representative examples: Royal, Rocki, Sound
● Brand
The popularity of NFTs has prompted many brands to investigate their potential uses as digital assets and their potential for integration with web3.
Representative examples: Adidas, Nike (acquired one of the most famous NFT studios — — RTFKT)
● Account/Domain
In web 2.0, traditional accounts or domain names do not belong to users in the full sense. For example, Twitter owns all account information and has the right to revoke or delete accounts. NFTs can be used to create a decentralized, blockchain-based account system, where each account is verified by a digital certificate.
Representative examples: ENS, Unstoppable
The uniqueness of NFTs can also come in handy in other areas:
● Identification tools (e.g. SoulBound Token)
NFTs can serve as universal IDs for a variety of digital services and databases, such as voting systems, attendance tracking, medical records and certificates, and can even be used as a way to identify anonymous individuals in legal proceedings.
● Real Estate
NFTs can be used to represent ownership of real estate assets.
● Logistics
NFTs can be used to track and verify the movement of goods through the supply chain.
Legal Status
From a legal perspective, NFTs can be complex objects with different legal properties depending on the circumstances. This may make NFTs subject to regulations in different regions, including taxes, licenses, and other requirements.
Below is an overview of the main jurisdictions’ stance on the legal status of NFTs.
● United Kingdom
In the UK, there are no specific regulations for NFTs, which are considered a type of crypto asset. The Financial Conduct Authority distinguishes between three types of tokens:
○ Guarantee: providing the rights and obligations under an investment agreement, including shares, deposits, insurance, etc. Regulated by the Financial Services and Markets Act 2000.
○ E-money: Electronically stored monetary value that is subject to anti-money laundering regulations.
○ But most NFTs do not fall into the above categories and are therefore not regulated.
● European Union
Like the UK, the EU has no specific regulatory or legal definition of NFTs, and there is no agreed regulatory regime between member states.
On October 5, 2022, the European Commission published the Regulation on Markets in Crypto-Assets (MiCA), which is expected to be the final version of MiCA, subject to further consent by Parliament in 2023, and its scope does not include NFTs.
However, the proposed regulation would explicitly apply to NFTs that grant the owner certain rights, such as rights to financial instruments, rights to profit, or other benefits. In these cases, NFTs could be considered securities. NFTs may also be subject to EU national legislation.
● China
In China, cryptocurrencies are banned, but individuals can trade NFTs. Currently, China has no laws and regulations specifically targeting NFTs. However, on April 13, 2022, the China Internet Finance Association, the China Securities Association, and the China Banking Association jointly launched an initiative to prevent NFT financial risks. Although this move is not a regulatory act under Chinese law, it reflects the government's overall attitude towards NFTs.
According to the initiative, NFTs are not considered cryptocurrencies or virtual currencies. However, the following points should be observed:
○ NFTs should not include securities, insurance, credit, precious metals or other financial assets.
○ The non-fungible nature of NFTs should not be weakened by dividing property or other means.
○ There should be no concentrated trading.
○ Virtual currencies such as Bitcoin, Ethereum, and USDT should not be used as pricing and settlement tools for issuing and trading NFTs.
○ Conduct real-name authentication for individuals who issue, trade, and purchase NFTs, and properly preserve customer identity information and NFT issuance transaction records.
○ Active cooperation in anti-money laundering efforts is required.
○ No investment in NFTs should be made directly or indirectly, and no financial support should be provided for NFT investments.
● United Arab Emirates
Regulation of NFTs and crypto assets here is usually at the free economic zone level. For example, the Abu Dhabi Free Economic Zone (ADGM) recently released a consultation document titled "Proposals for Improving Capital Markets and Virtual Assets." ADGM believes that companies need to obtain a license from the free zone financial regulator to trade NFTs, and that NFTs may be subject to ADGM's anti-money laundering and sanctions regulations. These proposals are still in the consultation stage, but market participants should consider them.
Dubai Free Zone (DMCC) has introduced a license for the NFT marketplace. In addition, NFTs may be subject to the "Crypto Asset Rules" that apply to crypto assets that are securities or traded on exchanges. Depending on the nature of the underlying assets, anti-money laundering requirements may be relevant.
● Singapore
The Monetary Authority of Singapore (MAS) has announced that it will not regulate the NFT market as it believes that the market is still in its infancy and does not want to regulate people's investments. However, under Singapore law, if NFTs have the characteristics of capital market products under the Securities and Futures Act (SFA), they will be subject to MAS regulatory requirements.
For example, if the NFT represents rights to a portfolio of shares listed on a stock exchange, it will be subject to securities issuance, licensing and business conduct requirements, similar to other collective investment schemes.
Similarly, if an NFT has the characteristics of a digital payment token under the Payment Services Act (PSA), special restrictions and obligations may be imposed on sellers of such NFTs.
USA
Currently, there are no clear regulations for NFTs in the United States, but they should be considered crypto assets. The Responsible Financial Innovation Act (RFIA) is being considered, which would create the first comprehensive regulatory framework for digital assets in the United States.
The bill classifies most digital currencies as commodities, meaning they will be regulated by the Commodity Futures Trading Commission (CFTC). The RFIA provides clear standards for determining when a digital asset is considered a commodity and when it is considered a security.
Prior to this, the nature of NFTs as regulated objects was determined by the U.S. Securities and Exchange Commission (SEC), which generally applied the "Howey test." The current approach to regulating all crypto assets is reflected in comments from SEC Chairman Gary Gensler, who stated that "securities laws should apply to crypto assets."
In general, the approach of all analyzed jurisdictions is similar: we are not yet sure what NFTs are, but if they are similar to regulated objects (commodities, currencies, securities), we will not hesitate to regulate them.
Additionally, there is a trend towards increased regulation of crypto assets and NFTs (the FTX case gives another reason why), with the US expected to take the lead in this effort in 2023.
copyright
Beware, spoilers!
Owning an NFT does not automatically grant copyright to the object behind the NFT.
Under Section 102 of the U.S. Copyright Act, protection for “original works of authorship fixed in any tangible medium of expression” is automatic and belongs to the author once the original expression is fixed.
This includes eight categories of work: literary works; musical works, including any accompanying words; dramatic works, including any accompanying music;
Pantomime and choreographic works; pictorial, graphic and sculptural works; cinematographic and other audiovisual works; sound recordings and architectural works.
NFT images are pictorial works.
Copyright protection grants the holder the right to copy, distribute, publicly display, perform, and create derivative works based on the original work, as well as the right to prohibit others from doing so. When purchasing an NFT, the authenticity of the work can be confirmed through the blockchain.
But it’s important to note that purchasing an NFT does not automatically grant copyright to the object behind it, and it is the buyer’s responsibility to ensure that the work does not infringe any existing copyright.
Let me emphasize this. One benefit of buying an NFT is that the authentication process is done on the blockchain. When you buy an NFT from a well-known artist, the authenticity of the NFT is verified by the original seller’s association with the artist (the marketplace is responsible for verifying this). You can trust that the NFT you purchased is authentic, no matter how many times it has been resold, because everything can be tracked using a blockchain explorer. However, the blockchain does not provide information on whether the NFT you purchased is a copy of another artist’s copyrighted work.
Under Section 504 of the U.S. Copyright Act, selling a work that infringes a copyright, even unintentionally, automatically subjects the seller to actual and/or statutory damages of $750 to $30,000 per infringement. If the violation is found to be willful, the damages increase to $150,000 per violation. It’s important to note that this is per violation, meaning the number of NFTs involved in a sale could result in multiple violations.
Currently, there are some complexities surrounding the transfer of rights through NFTs. While NFTs and copyrights are separate entities, the transfer of one may also involve the transfer of the other. For example, the Bored Apes Yacht Club's terms and conditions state that "When you purchase an NFT, you will fully own the Bored Ape of the underlying art." This suggests that ownership of the NFT includes ownership of the underlying artwork.
An interesting aspect of NFTs is that it is possible to separate the token from the rights it represents. For example, the owner of a Bored Ape NFT (which includes both the token and the associated artwork) might decide to transfer the rights to the image used on a t-shirt to A, while selling the NFT itself to B.
According to the Bored Ape rules, the transfer of NFTs should include all rights associated with them. This means that A would be in violation of the rules by doing so, because B did not transfer the right to use the T-shirt image to A. However, it can also be understood that B does not participate in the transaction between the owner and A regarding the portrait rights, so there is no infringement. If B also uses the image in the Bored Ape NFT to make a T-shirt, the same logic can be implied.
This problem could potentially be solved by treating the rights associated with NFTs as real property rights, where the encumbrances follow the object. I found only one project that takes this approach. World of Women operates under this model and is subject to French law. However, this solution may not completely solve the problem.
Under Section 204(a) of the U.S. Copyright Act, “No transfer of ownership of copyright shall be effective except by operation of law unless the instrument or note or memorandum of assignment is in writing and signed by the owner of the rights being transferred or by such owner’s duly authorized agent.” This requirement applies to both physical documents and electronic agreements, such as those involving “click if you agree” options.
This only applies to the initial purchase, which is when the owner in the example above completes the first transaction. Later in the chain, no one checks any boxes or signs any documents. This is a separate question. If you are interested, there is a good article on the relationship between smart contracts and legal contracts. That is, the logic goes like this:
● The owner of the NFT is also the copyright holder of the content behind the NFT.
● The owner of an NFT transfers the NFT through a smart contract, which does not affect the content behind the NFT unless otherwise specified.
● According to the law, the transfer of rights requires a separate document.
● This document must be signed by the copyright owner.
An important aspect of copyright is understanding the concept of derivative works of original content. In my opinion, derivatives can be even more valuable than the original in some ways. Let me explain: the value of the original work can often be determined by the number of derivative works. In other words, the uniqueness of the original author's true innovation can be "measured" by the network effect of the number of derivative works (virality).
From a legal perspective, a derivative work is a work based on one or more existing works. This includes translations, musical arrangements, stage adaptations, film adaptations, sound recordings, artistic reproductions, reductions or any other form of processing, transformation or adaptation.
Copyright in derivative works applies only to those parts introduced by the author of the derivative work that are different from the existing material and does not imply any exclusive rights in the existing material. There are two key criteria for identifying derivative works: originality and legality.
originality
Derivative works must be original and capable of being copyrighted in their own right. This requirement helps ensure that the author of the derivative work has contributed a substantial amount of original expression to the final product. If a derivative work simply copies the original work with little or no original content, it may not be considered a derivative work and thus not eligible for copyright protection.
legality
It is also important to know whether the creation of derivative works is legal. If a copyrighted work is used without the copyright owner's permission, copyright protection does not apply to any part of the derivative work that illegally uses the original content. In order to create a derivative work that can be copyrighted and potentially sold, permission must be obtained from the copyright owner of the original work.
The ability to create derivative works is often cited as a key factor in the success of the Bored Apes Yacht Club series. The Rules of Bored Apes grant an unrestricted, worldwide license to use, reproduce, and display the acquired artwork to create derivative works, including for commercial purposes. However, these same rules also state that when an NFT is purchased, the buyer fully owns the underlying Bored Ape artwork. This creates a contradiction because it is unclear what rights are being transferred for commercial use if the buyer already owns the artwork. Perhaps they were trying to emphasize the independent right to create derivative works, but they did not do so effectively.
It is important to note that copyright law treats NFTs in the same way as traditional works of art, as copyright takes precedence over the blockchain in this case. When artists create a new work of art, they automatically acquire the copyright and some exclusive rights in that work. These rights include the right of attribution, the right to the author's name, and the right to inviolability of the work, which cannot be transferred. Other rights, such as the right to reproduce, create derivative works, or distribute copies of the work, can be the subject of a contract and transferred to others for commercial purposes. In order to avoid any potential conflicts, it is crucial to clearly define the number of rights that an NFT transfers.
To understand how copyright infringement is currently being addressed in the context of NFTs, it helps to look at some public cases.
● Benjamin Ahmed 和 “Weird Whales”
A 12-year-old programmer named Benjamin Ahmed sold 3,350 computer-generated “Weird Whales” NFTs for nearly £300,000, but it was later discovered that the project’s graphics were copied directly from another project. The original creator of the graphics has yet to come forward.
● Quentin Tarantino vs. Miramax
Director Quentin Tarantino announced that he will be selling seven NFTs related to the 1994 film Pulp Fiction. The NFTs will include an "uncut first handwritten script" from the film and an "exclusive personal commentary" by the director. The film's distributor Miramax filed a lawsuit against him, claiming that he did not have the legal rights to create and sell NFTs and that he misled consumers about Miramax's involvement in the creation of NFTs. The case is currently pending.
● Hermès vs. Mason Rothschild
French fashion house Hermès has filed a lawsuit against California artist Mason Rothschild’s NFT project “MetaBirkin,” which depicts Hermès’ Birkin bag and its trademark. Hermès argues that Rothschild misappropriated the Birkin trademark and profited from the sale of more than 100 digital collectibles. The case is currently under trial.
● Nike v.s. StockX
In February 2022, Nike filed a lawsuit against online sneaker company StockX, accusing it of selling its "Vault" NFTs without permission. Nike claims that StockX intentionally used its trademarks to create NFTs without permission and misled consumers about Nike's involvement in the creation of NFTs. The case is currently under trial.
● SpiceDAO
Cryptocurrency project SpiceDAO made headlines after paying $3.5 million for a copy of the unpublished script manuscript for the film Dune with the intention of creating an NFT based on it, only to later discover that the acquisition of the manuscript did not include such rights.
● CryptoPunk vs. CryptoPhunk
This case involves two sets of punk pixel images, CryptoPunk is the original and CryptoPhunk is a pirated copy. Larva Labs, the original creator of CryptoPunk, notified the NFT market OpenSea of copyright infringement and removed the CryptoPhunk series from the website in accordance with the Digital Millennium Copyright Act.
● HitPiece
The HitPiece website was accused of selling NFTs featuring the work of many musicians without permission. The site was found to be selling NFTs featuring content from Disney, Nintendo, John Lennon, and many other companies. The original site was taken down and the developer quickly relaunched it. As far as I know, the situation did not escalate into a legal case.
To combat copyright infringement in the NFT space, online gallery DeviantArt and California startup Optic are using image recognition technology and machine learning to analyze smart contracts and identify infringing NFTs on the market. Optic works closely with NFT marketplace OpenSea. It looks like projects that prove NFT originality will be a trend in 2023.
license
In the process of creating an NFT, such as a PFP collection, there can be several participants:
● Project owner
The author, producer, founder and thinker of the concept. This is the person who starts the project and brings everyone together.
● Creator/Creator
The creative person who brings a project to life, whether he is the creator or a hired expert.
● Investors
Buyers of NFTs.
● Community
This typically includes anyone involved in the project, from the owner to subscribers to a social network. This can include creators, authors of derivative works, sponsors, promoters, influencers, and others who have an interest in the project and may contribute to its development.
market
● NFT trading platform.
These parties will need to address issues related to the transfer of rights, such as the ability to create derivatives, parodies, merchandise, and resell NFTs.
To address these issues, NFT market participants have recognized the need for clear rules to govern intellectual property and have proposed their own NFT licensing schemes.
In 2018, Dapper Labs (known for its work on CryptoKitties and NBA Top Shot) offered the first known NFT license, and in August 2022, the a16z VC fund released its vision for NFT licensing. In the summer of 2022, Creative Commons licenses were widely used in NFT sales. a16z wrote a great article about why NFT creators choose CC0 tools (Creative Commons has multiple license variations) to transfer rights.
By accepting a CC0 license, the copyright holder agrees to waive their copyright and related rights in the copyrighted work to the fullest extent permitted by law. Thus, the work is effectively "dedicated" to the public domain. If for any reason this waiver of rights is not possible, CC0 acts as a license granting the public an unconditional, irrevocable, non-exclusive, royalty-free right to use the work for any purpose.
This means that NFTs governed by CC0 have no restrictions on the commercialization of the NFTs or using them in any way the owner sees fit. Owners of NFTs governed by CC0 are equal to the creator in terms of owning the NFT collection.
However, since no one owns the artwork under the CC0 license, this also means that anyone (even those who do not own the NFT) can use the artwork for any purpose, including creating an NFT. This creates a paradox, if you can't prohibit others (not even the owner of your NFT) from using the art associated with your NFT, why spend resources to create an NFT? The only reason to do so is to promote the ideology of the NFT, not for financial gain.
In practice, there are several main options for determining the scope of rights transferred via an NFT, which can be categorized as follows:
● The buyer does not gain any rights other than the right to display the NFT
● Buyers gain limited commercial rights related to the NFTs they own
● The buyer obtains all commercial rights associated with the NFT they own
● Copyright owners may waive their exclusive rights in copyrighted works to the fullest extent permitted by law.
Another issue with NFT licensing agreements (besides determining the scope of the rights being transferred) is the asymmetric control that copyright holders have over the license. If the copyright holder believes that the license agreement has been violated, or for any other reason, or for no reason at all, the copyright holder can modify or revoke the NFT owner's NFT license at its sole discretion by updating the terms and conditions, even without any notice. This ability to change the license agreement at any time is likely to be a major concern for the entire NFT industry, as the rights of each NFT owner can be unilaterally limited or completely revoked.
Given the multiple options for determining restrictions on NFT transfer rights, I recommend that NFT creators consider current and potential issues in the industry specifically for their own projects and discuss them with community members in the spirit of web3. After all, it is the community that holds the power in this industry. Only in this way can they formally determine how the license will be related to their NFTs and ensure that the possibility of unilaterally changing the terms of the license agreement is excluded.
Dispute Resolution
The NFT industry is still too new to have a lot of legal precedent to analyze. However, the rules of intellectual property law can (and should) apply to disputes about authorship and the use of someone’s intellectual property in the creation of an NFT.
There are several key questions that the court may be interested in:
● Is there any evidence of use of other people’s intellectual property?
● Has the person claiming to have infringed their copyright established authorship?
● Is there any damage?
● What is the offender’s purpose?
● What specific actions did the offender take in response to the violation, and what were the results?
There may be more questions, but these are enough to understand the court’s logic. The answers to these questions will help the court distinguish between punishable conduct undertaken for profit and other conduct, and judges may also consider the “fair use doctrine” in their decisions. This doctrine was created by Anglo-American law in the 18th and 19th centuries and allows limited use of someone else’s copyrighted material without permission.
The doctrine includes four factors that the courts need to consider:
● The nature of the copyrighted material
In order to prevent private ownership of works that are supposed to be in the public domain, courts need to know where the idea came from. In this context, known facts and ideas are not protected by copyright, only by their specific expression, such as a description, method or scheme. If known information is reinterpreted in this way, it may be considered an expression of authorship.
● Scope and significance
These two factors should be considered together. The court first determines how much of the disputed information (e.g. a fragment of text or a photograph) is relevant to the original work. Generally speaking, the less it is relative to the overall use, the more likely it is that the use will be considered fair. However, the significance of the disputed information also plays a role, and usually this second factor is more important in law.
● Impact of violations
Use is considered unfair if it harms the copyright holder's ability to profit from the original work and occurs in a way that displaces demand.
The court may also consider additional criteria specific to the case to provide greater clarity.
If we apply the fair use doctrine to the situation between CryptoPunk and CryptoPhunk, it will be the basis for the court’s decision. It will be interesting to see how the court rules, but since OpenSea has resolved this issue internally, we can only speculate how the court might handle this case.
The anonymous offending creator of CryptoPhunk stated in an open letter that the purpose of creating this series was "parody and satire" (which falls under the doctrine's "purpose and nature of use" standard). However, after considering the other criteria, the offending creator seems to:
● Failure to adequately adapt the original work (first criterion)
● Use of material already in the public domain (second criterion)
● Uses a lot of original ideas with only minor changes (third criterion)
● Significant impact on the copyright holder's reputation and revenue (first and fourth criteria)
● Know the original author (additional criteria)
Given these factors, OpenSea’s solution seems reasonable.
in conclusion
Despite the principle of openness, the industry needs rules to function properly. Players who are serious about the NFT industry and plan to stay in it for the long term will quickly adapt to these rules, understanding that they are there to protect everyone. Understanding the legal status of their future digital assets, how they can be transferred, and the scope of rights contained therein will help create a more reliable industry for NFT creators.
As the industry develops, contentious situations are likely to increase. Potential areas of contention in the NFT space include: royalties; disputes over the scope of rights in license transfers; NFT theft; counterfeit (confusingly similar) NFTs; taxation; advertising and promotion; hacking; personal data; identifying offenders; completing transactions using NFTs as collateral; and liability of NFT marketplaces.