The Andy Warhol of Cryptocurrency: Legal Pursuit of Non-Fungible Tokens

The works of Andy Warhol are known for their popular element and pragmatic flair. Not unlike blockchain technology, the repetitive faces of Marilyn Monroe are an appealing democratization of society’s likenesses. Indeed, both pose questions about cultural and individual copyright, and whether popularity excuses infringements on ownership. Cryptocurrency has given birth to a new form of technology responsible for enormous growth in the art trade and an accompanying slew of legal discrepancies. Non-fungible tokens, or NFTs, are a revolutionary kind of digital ledger that allows creators of art and music to tokenize unique online assets of their work. [1] Yet they come almost as an anachronism to a legal environment not entirely prepared to regulate them. [2]

Many artists want NFTs as a more secure basis for art sale, in order to exercise closer control over their work and to protect work from unlicensed use. [3] In an ideal world, cryptocurrency could accomplish these goals. Say an artist creates a work, such as a digital recreation of a sunset, and they wish to mint the image into a digital asset, or an NFT. [4] In the minting process, they will create something called a “smart contract,” in which their terms for the work are encoded. This contract is the essence of the NFT: it is the artist’s will tokenized onto a blockchain, and whether they want it to represent ownership or serve as a provision for royalties is up to them. Once created, the NFT will be irreversibly linked to the work at hand. [5]

Some debate has emerged regarding whether NFTs occupy another link in the crypto-bubble, or if they have emerged as a legitimate new trading platform in the art market. [6] Are they simply a tech-based fad or a salvific marketplace for artists? With one work of the artist Beeple selling as an NFT for over $69 million dollars through Christies, a well established fine art auctioning house, the technology has garnered significant attraction and validity. [7] However, potential limits to the appeal of NFTs have been set by concerns regarding the ability of the law to ensure their fair and proper use.

Tokenization has existed as a legal concept since time immemorial. Representing the rights or authority to something by the ownership of another item by “tethering” is a common occurrence, such as in deeds. [8] NFTs do not yet have the legal resilience of deeds and similar contracts, but establishing constancy in legal “tethering” should be one of the aims of current regulation regarding NFTs. The other question that must be asked—and answered—is how exactly copyright and intellectual property laws relate to the minting and ownership of NFTs. How might an NFT holder reclaim value if the digital asset attached to the work is destroyed? NFTs should be considered a viable currency for fine art and its trade, but this is contingent on precise legal answers to such questions. 

NFTs do hold a number of unique benefits. For instance, they allow readier monetization for creative works, especially those that are already digital. [9] They also limit the spread of non-degradable and unlicensed copies of artists’ work, affording greater personal control over creative images—which is one of the greatest issues facing artists today. [10] Despite its complexity, blockchain technology can streamline interactions between parties of art sales by removing the need for an intermediary, and even the need for trust between partners, just by the mere surety of the machine. [11] However, at present, renowned art houses like Sotheby’s and Christies have remained largely at the helm of the most expensive and high-profile NFT sales, offering a glimpse into how crypto-potential may revolutionize the high-end art market. [12]

However, the permanence of NFT formation presents two distinct problems from a legal and regulatory standpoint. First, it does not allow flexibility with respect to salability or royalties. Royalties are designed as legally bound payments made to the owner of a particular asset to allow for their use; however, problems arise if an NFT is purchased on a platform different from the one it was created on. [13] Smart contracts with programmed-in automatic royalty payments can fail across dissimilar platforms. If these royalties go unpaid, there is no provision for recourse under US law, throwing the integrity of the creator’s assets into jeopardy. [14]

With the issue of recovering value, NFTs and the asset they tokenize are usually stored separately. Similar to the difficulties surrounding royalties and recourse, if the unique and immutable digital asset fails—e.g., a server crashes or the link between the server and asset is broken—there is no copy or backup to sustain its value. [15] In other words, an NFT holder may have no legal recourse to recover both the certificate of their ownership and the value of the asset.

Furthermore, inherent to an artist's ability to create is their right to destroy. Blockchain’s unyielding technology can render the erasure of data impossible and the lifespan of a certain work injuriously infinite. This right is not limited to the art world, as some data protection laws enshrine a general right to change or delete personal information; if NFTs are in violation of this protection at large, their use in the art world could be made illegal by extension. [16]

An entirely new set of possible issues arise when the ownership of the NFT is transferred. Intellectual property law specifies that, upon the sale of an NFT, the creator of the art retains intellectual rights to the work but transfers the right to personal use by the purchaser. [17] In other words, the rights to copy, modify, distribute, etc., are retained by the seller, while the holder’s NFT contains only the rights external to commercial use. The present latitude of copyright law gives possible grounds to a purchaser who believes they are entitled to greater intellectual property rights—plausibly those associated with typical art sales and with commercial use—to seek litigation against the seller. [18] If the onus of legal answerability rests on the seller, the potential upside to adopting NFTs is called into question, especially when compared to more conventional sites of transaction, such as auction houses. If any seller risks the open potential of a client subverting a purchase with a lawsuit because of copyright vagueness, why employ NFTs in the first place?

Presented with these issues, regulators face a challenge in balancing progressive expansion and cautious prohibition when making laws over an opening field of tender. Some issues will require compromise, while others may involve lawmakers narrowing legal definitions to account for the nuances of ownership inherent to NFT sales. [19] Amending definitions of copyright and intellectual property law may heal some of the disputes over what exactly is transferred in the ownership of an NFT. Laws that enjoin purchasers to adhere to “smart contracts” embedded in NFTs rather than conventional copyright law could curtail litigation liability. The “smart contracts” are the key of immutable technology, as they ensure sellers and holders the integrity of their work on the blockchain. In the face of transactional uncertainty, they are the built-in trust of the machine.

Solutions to issues of data protection and storage could require significant trade-offs. Blockchain technology is a strong binary—it is all-or-nothing data encryption. Encoding anything into an NFT is an irreversible choice. [20] Amending one to have pliable or erasable functions fundamentally forecloses the capabilities that makes NFTs an exciting potential avenue for trade. Makers and sellers need to be able to rely on the constancy of NFTs; absent such a function, there is no guarantee that the technology will protect content.

NFTs resist straightforward classification into financial classes like securities or commodities; however, categorization could enable certain paths of legal clarification and helpfully exclude others. Various regulatory agencies, including the US Commodities Future Trading Commision (CFTC) and the Securities and Exchange Commision (SEC), have taken strong positions on their jurisdiction over NFTs. [21] Specifically, the CFTC has argued in favor of commodity classification based on the Commodity Exchange Act (CEA) of 1936. [22] Per this act, commodities are goods inherently exchangeable with others in kind that can be derived into futures or other contracts. [23] Categorizing NFTs as commodities is complicated by the vagueness of terms such as “goods” and “articles” as defined by the CEA. [24] Under the relatively wide plain meaning of these terms, NFTs may be subject to standard trading regulations and restrictions of marketplace as commodities. [25] However, other technicalities complicate the consideration of NFTs as commodities and suggest securities to be a more appropriate category. 

The US Supreme Court case SEC v. Howey (1946) set out a test to determine which investment contracts form a legal security. [26] Howey established that the contracts must be “an investment of money in a common enterprise with the expectation of profit to be derived from the efforts of others.” [27] [28] NFTs tend to fall into two relevant categories in relation to securities: bare ownership or potentially gainful investment. Simply owning a digital certificate does not classify as a security, but if that NFT is marketed as a kind of speculation or investment, then it commonly does. [29] A unique subgroup called “fractional” NFT’s (f-NFTs) further strengthens the argument that NFTs should be classified as securities. These f-NFTs are made up of a spread of distinctly released NFT tokens that represent collective ownership of the original NFT, a system of joint investment that largely resembles securities contracts. [30]

Classification into one of these categories—commodities or securities—would subject NFTs to a much more narrow and specific set of regulations. While the argument in favor of securities appears to be gaining traction, with the current commissioner of the SEC recommending compliance with securities laws for “fractional interests in NFTs,” the consensus holds that in their base form, in which they are mere proprietary minting of an asset, they do not wholly qualify as securities. [31]

Society cannot allow promising technology to be swept away by “honored in the breach” mentalities that deem inventions free from legal protection and subject them to the impulses of online grift. NFTs are and should be considered a viable currency with promising application in the art world: they provide numerous enhancements, including ease of sales, protection of originality, and for creative artists, more personalized control over their work and its trade. However, the potential of NFTs is contingent on remedying the legal landscape, possible only through enhancing definitions of intellectual copyright, instituting potential compromises in blockchain technology, and accepting the institution of legally-backed cryptocurrency as a viable future of transaction.

Edited by Mariah Hessner

Sources:

[1] Robyn Conti, What You Need To Know About Non-Fungible Tokens (NFTs), Forbes Advisor (2021), online at https://www.forbes.com/advisor/investing/nft-non-fungible-token/ (visited December 20, 2021). 

[2] An P. Doan et al, Key U.S. Legal Considerations for NFTs, Jones Day (2021), online at https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class (visited November 14, 2021). 

[3] Anil Dash, NFTs Weren’t Supposed to End Like This, The Atlantic (2021), online at https://www.theatlantic.com/ideas/archive/2021/04/nfts-werent-supposed-end-like/618488/ (visited December 20, 2021). 

[4] Ollie Leech, How to Create, Buy and Sell NFTs. Coin Desk (2021), online at https://www.coindesk.com/learn/how-to-create-buy-and-sell-nfts/ (visited December 20, 2021). 

[5] Pratin Vallabhaneni, The Rise of NFTs – Opportunities and Legal Issues, White & Case LLP (2021), online at https://www.whitecase.com/publications/alert/rise-nfts-opportunities-and-legal-issues (visited November 14, 2021).

[6] Lynne Lewis et al., Non-Fungible Tokens, Bird & Bird LLP (2021), online at https://www.lexology.com/library/detail.aspx?g=f7b4c314-0bc0-44fd-8864-c305d30dada (accessed December 20, 2021).

[7] Conti, What You Need To Know. 

[8] Julia Moringiello and Christopher Odinet, "The Property Law of Tokens," Florida Law Review (forthcoming 2022), online at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3928901 (visited December 20, 2021). 

[9] Vallabhaneni, The Rise of NFTs.

[10] Id.

[11] OECD Blockchain Primer, OECD, online at https://www.oecd.org/finance/OECD-Blockchain-Primer.pdf (visited December 20, 2021). 

[12] Elizabeth Howcroft, The New Masters: How Auction Houses Are Chasing Crypto Millions, Reuters (2021), online at  https://www.reuters.com/business/finance/new-masters-how-auction-houses-are-chasing-crypto-millions-2021-11-08/ (visited December 20, 2021). 

[13] Caroline Banton, How Royalties Work, Investopedia (2021), https://www.investopedia.com/terms/r/royalty.asp, (visited November 14, 2021).

[14] Vallabhaneni, The Rise of NFTs.

[15] Id.

[16] Id.

[17] Id.

[18] Lewis et al., Non-Fungible Tokens.

[19] Vallabhaneni, The Rise of NFTs.

[20] Id.

[21] Andrew James Lom and Rachel Browndorf, Anatomy of an NFT, Norton Rose Fulbright (2021), online at https://www.nortonrosefulbright.com/en/knowledge/publications/5995f99d/anatomy-of-an-nft. (visited November 14, 2021).

[22] Lom and Browndorf, Anatomy of an NFT.

[23] Jason Fernando, Commodity Definition, Investopedia (2021), online at https://www.investopedia.com/terms/c/commodity.asp (visited November 16 2021).

[24] Mark Rasmussen and Joshua Sterling, NFTs: Key Legal Considerations, FIA (2021), online at  https://www.fia.org/sites/default/files/2021-06/FIA_NFTs%20Webinar%20Presentation%20%28June%202021%29.pdf (visited December 20, 2021). 

[25] Id.

[26] Lom and Browndorf, Anatomy of an NFT.

[27] Nathan Reiff, Howey Test, Investopedia (2021), online at https://www.investopedia.com/terms/h/howey-test.asp (visited November 14, 2021).

[28] What Is the Howey Test? Findlaw (2018), online at https://www.findlaw.com/consumer/securities-law/what-is-the-howey-test.html (visited November 14, 2021). 

[29] Lom and Browndorf, Anatomy of an NFT.

[30] Id.

[31] Id.