(c) Ars Electronica

The rise and rise and rise of NFTs… but what are they and are there any legal risks?

You are probably wondering what Paris Hilton, Edward Snowden and Eminem have in common.  Well, they have all released NFTs.  The market for non-fungible tokens (NFTs) is booming right now and is only likely to continue to grow over time as cryptocurrencies and blockchain technology become more accessible.

In light of NFTs’ exponential growth in popularity, it is essential to understand the legal risks associated with NFTs if you’re interested in purchasing NFTs yourself or needing to advise a client.

What are NFTs?

An NFT is a unit of data stored on a digital ledger that certifies a digital or physical asset as unique and therefore not interchangeable.[1]

An asset is ‘fungible’ if it is interchangeable or replaceable by another identical item.  For example, fiat currencies (e.g. $AUD or $USD) or cryptocurrencies.  A ‘non-fungible’ asset, on the other hand, is unique and therefore not interchangeable.  For example, an original Picasso is non-fungible for this reason: it’s one of a kind.

‘Token’ is shorthand for digital asset.

It is the unique and scarce characteristics of NFTs that make them such hot commodities and why they have become so popular.  The value of an NFT is in its ability to prove ownership and originality.

What types of items can be NFTs?

NFTs can create unique digital assets or can be linked digitally to tangible assets.

For example, unique digital NFT assets could include things such as artworks, collectables (e.g. Pokémon cards and Marvel merchandise), video footage, games and music (e.g. the Kings of Leon record that was released as an NFT album).  The list goes on.

Comparatively, NFTs can also be linked digitally to tangible assets to reflect ownership, such as to real estate or vehicles.  Who knows, we may all decide to tokenise our houses one day.

Where do they exist?

NFTs are ‘minted’, i.e. created, using smart contract protocols on a suitable blockchain, commonly on the Ethereum blockchain.  Subsequently, NFTs are stored in blockchain-based wallets.

NFTs are traded using cryptocurrency (such as Ether, which is the cryptocurrency associated with the Ethereum blockchain) and a transaction record is created on the blockchain which serves as authentication and verification of the NFT transaction.

Each NFT is comprised of metadata which makes it non-fungible.  Each time an NFT is transferred, that transaction is recorded on the blockchain.

Are NFTs regulated in Australia and what are the considerations?

As you may expect, there is no legislation in Australia that specifically deals with NFTs.  However, that does not mean that they do not fall within the bounds of existing regulatory frameworks.

In Australia, this may include consumer laws (such as the Australian Consumer Law), tax laws and intellectual property laws (such as the Copyright Act 1968 (Cth)).

It is also important to consider that regulatory frameworks for NFTs will likely be introduced across the globe as time passes and this may change the ownership, use and disposal of NFTs.

Here are a few things to consider at the moment:

Copyright

On its own, the purchase of an NFT only grants the purchaser ownership over the specific version of the work that has been purchased.  It does not provide the purchaser a proprietary right to every copy or version of the work.  However, whether the purchaser obtains the copyright in an NFT when it is purchased is a controversial question.

In most instances, when a person purchases an NFT representing a work in which copyright subsists, they are only purchasing the NFT itself, and therefore are not granted the copyright in the underlying work. Generally, the creator of the underlying work will retain rights in the underlying intellectual property.

That being said, this position can be varied by a contractual arrangement.  This can occur by way of a contract of sale and an assignment, standard terms and conditions that apply to the purchase can be incorporated into the smart contract that governs the NFT transaction.

Given the global nature of NFTs, it is also important to understand that the position in relation to copyright will vary depending on the jurisdiction.

Any person wanting to purchase an NFT should undertake a thorough due diligence process to understand whether the person selling the digital works is the true owner of the works, and thereby entitled to grant the rights associated with the NFT. It might also be necessary to investigate whether any other licences have been granted in respect of the underlying work, and whether any terms associated with the work prevent the creator from creating future copies (which could de-value the NFT being purchased).

If it is important to the purchaser to obtain the intellectual property rights in the work underlying the NFT, they must carefully review the terms of the purchase to ensure that the terms reflect their intention, including in any smart contract.

Data protection laws

Some data protection laws grant persons the right to erase their personal data or correct inaccuracies.  However, the nature of blockchain might make this right functionally impossible to exercise.  NFTs that contain personal information could potentially contravene data protection laws, which could result in penalties.

Reliance on blockchain

NFTs are created by smart contract protocols and exist on a blockchain.  Ownership and access to the NFT is reliant on maintenance of the blockchain and ability to access the wallet in which the NFT is stored.  If a purchaser loses their ability to access their wallet, then the purchaser could also potentially lose control over the NFT.

Taxation

Another area of law that has not quite caught up to NFTs is taxation.  According to the Australian Taxation Office, the tax treatment of non-fungible tokens follows the same principles as other cryptocurrencies.  On this basis, the tax treatment of an NFT will depend on your use and your reasons for holding and transacting with the NFT.  For example, there may be capital gains tax implications arising from an NFT transaction.  Before purchasing an NFT, the tax implications should be considered.

What is next?

With the exponential rise of NFTs, the law has not quite caught up and there remains a significant amount of legal ambiguity surrounding many different aspects of NFTs.  Complex legal issues will arise with the commercialisation and ownership of NFTs, and with them a growing need for thorough due diligence. For this reason, it is essential that legal advisers remain up to speed on developments in the law and technology as they are emerge.

[1] Dean, Sam (2021-03-11). “$69 million for digital art? The NFT craze, explained”. Los Angeles Times.