On March 11, 2021, the esteemed Christie’s auction house sold a digital artwork (titled Everydays) by an artist named Beeple for $69,346,250 USD. Beeple (real name, Mike Winkelmann) is a well-known and prolific online digital author. But he’s not exactly Vincent Van Gogh and prior to October 2020, had never sold a piece for more than $100. Strange, to say the least.
Stranger still, given Winkelmann did not really sell the artwork. Rather, he sold a non-fungible token (NFT) of the artwork on the blockchain. It was purchased by an anonymous art lover known by the pseudonym “MetaKovan” with a cryptocurrency called Ether. Now, it’s fair to wonder what MetaKovan actually owns. The purchase has a lot of people considering the legal implications of ownership of NFTs (whatever that is), and it has the SEC bracing itself for trouble.
This article does not intend to convince you of the value of NFTs. But it will try and show you how these tokens will have to be fused into an ill-suited legal framework that has to work out what to make of itself.
What is an NFT?
This is a deceptively complex question. But broken down to its most basic principles:
- An NFT is a non-fungible token based on blockchain technology. Because it is non-fungible, it is not interchangeable. It is entirely unique. This is in contrast to a dollar bill or a Bitcoin, both of which are interchangeable with other bills or Bitcoins.
- An NFT is composed of software code in the form of “smart contracts.” Smart contracts are open-sourced blockchain protocols that control the transfer of digital currency under certain terms and conditions.
- Once a smart contract is created, it is “minted” onto the token on a blockchain. This is permanent. Once the NFT is created, it cannot be modified or amended.
So what do you own once you purchase an NFT?
In most cases, the NFT holder is simply obtaining a non-exclusive license to the underlying intellectual property rights of an asset and only for non-commercial purposes. Think of how you own a painting in your house.
That concept makes sense in a world of digital works of art. Digital works of art (unlike physical works) can be reproduced with copies that resemble the original 1:1. NFTs allow digital works to at least be traded. While tokenizing a digital work doesn’t prevent it from being downloaded, it can ensure there is only one original and that the original is assigned to one individual person.
Further, smart contracts can be coded to detail the limitations on the use of an NFT. They can provide for automatic royalty repayments or limit the number of replicas that can be sold. In a world where there had previously been great difficulties in promulgating a workable system of managing and enforcing digital rights, NFTs can fill that gap.
Smart contracts will be key in this sense. NFT sellers will need to ensure that smart contracts clearly outline the rights that are being assigned as part of the NFT. For example, copyright in a work will not transfer unless it is expressly allowed for. An NFT is essentially a license to specific content. It is crucial to make sure that licence is as well-defined as possible. This is important when you keep in mind that, once minted, the NFT is permanent. No changes to that contract are coming.
Is an NFT a security?
At the risk of sounding like a lawyer: it will depend. But yes, some NFTs would almost certainly be classified as securities.
The NFT will have to pass the Howey test, first described by the US Supreme Court in 1946. That test defined an “investment contract” as a transaction involving an investment of money in a common enterprise where profits are reasonably expected from the efforts of others.
The concept of a “common enterprise” doesn’t fit neatly with NFTs, given their non-fungible quality. But in April 2019, the SEC stated that it did not view a “common enterprise” as a distinct element of the term “investment contract.” That is, of course, the SEC’s view (and not the Courts), but it no doubt sends alarms to those who think the Commission will turn a blind eye.
The other obstacle is the concept of “efforts of others.” These must be future efforts. When you buy stock in Amazon, you purchase that stock with the expectation that Amazon’s future efforts will turn you a profit. But when you purchase a painting it does not fit in that category. While it may appreciate in value because the artist is up-and-coming, the “others” are too diffuse (critics, museums, members of the public) to pin liability on (i.e. the “others” who will bear securities law liability). So, Beeple’s art won’t pass the test.
One also has to consider the primary purpose of the asset. If it is consumptive, no security is present. So an NFT of a real-world asset such as a song or photograph likely won’t be a security. That won’t prevent NFTs that have attributes indicative of securities – for example, uses for seed capital financing or widespread secondary trading – from being classified as securities.
But the key is that the non-fungibility of NFTs likely won’t preclude them from being securities. If that is proven true, it will bring along with it a raft of securities legislation.
The legal implications of NFT ownership remain murky. Most likely, it will take a couple of room-clearing court decisions to help owners and litigants navigate their waters. But it would be naive to think these issues will halt their progress. Time would be better spent trying to understand and take advantage of a burgeoning market.
About the Author
Julian Pipolo is an Australasian lawyer working at a top-tier firm predominantly in administrative law. He also has experience working with law firms on their internal legal innovation programs, including on the investment and procurement of legal start-ups, and has been involved as an advisor and employee on a number of start-ups himself.