Forefront by TSMP: NFTs – Art or Artifice?

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Forefront by TSMP

6 April 2022

NFTs – Art or Artifice?

With the hype over non-fungible tokens reaching ever new heights, punters need to understand the legal minefield that surrounds such investments.

By Thio Shen Yi, SC

Cover photo credit: Beeple / Christie's

A new type of cryptoasset, broadly known as a “non-fungible token” (NFT), has been making waves.

For instance, an NFT of a collage by American digital artist Mike Winkelmann, aka Beeple, was auctioned by Christie’s for over US$69 million last March. Not too shabby for someone whose works topped US$100 before October 2020.

Other headliners include an NFT of a cartoon ape accidentally selling for US$3,000 instead of US$300,000, and film studio Miramax suing director Quentin Tarantino over his planned Pulp Fiction movie NFTs.

Usually linked to collectibles such as digital artworks, videos, skins or avatars, NFTs are causing controversy and breaking eyewatering price records at every turn.

What is an NFT?

NFTs differ from their cryptoasset cousins – cryptocurrencies such as Bitcoin, Ethereum and Dogecoin, which by comparison are now old hat – by being uniquely identifiable as their moniker suggests. While cryptocurrencies are recorded in ledgers with a particular value – that is, 1 BTC is the same as any other BTC – NFT blockchains record the transfer and owner of a particular token, which is not mutually interchangeable, but seemingly unique.

NFT technology’s ability to establish a token’s provenance has wide-ranging potential value in real-world use. For instance, it could be used to prove luxury handbag authenticity (facilitating second-hand sales), or concert tickets ownership (preventing scalping).

Some NFTs already have been ascribed tangible value. Rock band Kings of Leon, for example, released an enhanced media version of its album When You See Yourself in the form of an NFT, and auctioned special “golden ticket” NFTs that guaranteed holders front-row seats to any of their concerts for life.

But as with every innovation, legal minefields lurk at the edges.

What do you get by buying an NFT?

Some are beginning to question the value being ascribed to NFTs, especially when they are typically merely a link to the actual data, with nothing preventing the underlying data from being duplicated.

One common misconception is that if you buy an NFT, you own the underlying intellectual property (IP). This is neither necessarily nor often true.

An NFT is merely an entry in a digital ledger, and “owning” it simply means taking control over that token. The original artist of the work that the NFT links to, without any further agreement, retains IP ownership. In most cases, the NFT’s owner will at best have a licence to the IP’s use. The original artist could technically, and possibly legally, mint a new NFT selling the same data again.

One immediate question, especially with the explosion of artistic NFTs, is the interplay between copyright law and NFTs. An NFT owner keen to prevent others from copying the underlying work would have to depend on what was agreed when the NFT was made; for instance, whether the original artist had assigned copyright. If it had not, which is often the case, and if the original artist has no interest in prosecuting claim, an NFT owner would be left without remedy in traditional legal theory.

Additionally, NFT buyers should consider more than just their potential rights against other infringers. Buyers themselves may be infringing copyright, if the person who minted the NFT is not actually the original artist.

An example of this possibility is the legal action Larva Labs is taking against Ryder Ripps. The creators of the popular CryptoPunks NFTs – a set of 10,000 ethereum-based tokens corresponding to a cartoonish caricature – is seeking to take down the American artist’s “CryptoPunk #3100” NFT, which is a near copy of the company’s original cryptopunk of the same name that had sold last March for over US$7 million in Ether (ETH). A similar project, CryptoPhunks has also been launched, claiming to be a permissible form of parody.

Buying NFTs from reputable or established creators may not be safe either. When cult classic Pulp Fiction director Quentin Tarantino auctioned seven “exclusive movie scenes” NFTs, Miramax objected, claiming that it owns the relevant IP rights. As contracts between directors and studios are typically private and confidential, NFT buyers have no way of checking whether the seller actually has the right to sell it.

Indeed, one of the complaints in a high-profile class action lawsuit against Dapper Labs, the blockchain startup that has been selling NBA’s “Top Shot” highlight moments as NFTs, was that the risks involved – including the fact that the purchasers would not own the highlight video’s IP – were not disclosed to the purchasers.

What is the legal status of an NFT?

The Dapper Labs claim raises another important legal issue: whether NFTs would be characterised as a form of securities, which would subject them to securities laws, including the requirements for licensing and a prospectus.

The US definition, known as the Howey test, simply requires an investment of money in a common enterprise where profits are reasonably expected from the efforts of others. The Howey test would catch NFTs bought for investment purposes. It would also catch active efforts to create liquidity, or to promote trading and value of an NFT.

There is no single answer, and whether an NFT would be classed as a security would likely depend very much on the factual circumstances and arrangements surrounding each one. Great for dispute lawyers, but a potential minefield for clients.

The issues are complicated even further by another innovation – the fractionalised NFT or F-NFT, each representing partial ownership of the original NFT. In most cases, F-NFTs are fungible, and operate like a share in the original NFT. The commonality of interests of such fractional tokens, could be relevant to them being characterised as securities under the Howey test.

Are NFTs regulated?

While no regulation specific to NFTs exists, others may apply depending on the exact nature of the tokens in question. For instance, NFTs may fall within the legal definition of cryptoassets as provided for in the UK Money Laundering Regulations, which would create a registration requirement.

NFTs remain very much in a grey zone, and it is yet uncertain if regulators will intervene to regulate market conduct. One example would be the OpenSea insider trading case. The popular platform routinely features some tokens on its front page, and the publicity has been known to generate price spikes. The OpenSea head of products was accused of buying an NFT shortly before it was featured, and flipping it later for more than £3,000 profit. While this would almost certainly constitute illegal insider trading if the NFT was a regulated security, no authorities took action. It was left to OpenSea to devise policies against such employee conduct.

Taxes

Certainly, governments would be particularly interested in figuring out how to tax cryptoassets. Many NFTs, for instance, may be viewed as collectables under US tax laws, which subjects them to a higher capital tax rate than traditional assets like stocks, bonds, and even cryptocurrencies. But other countries such as Singapore, have no tax of this nature.

However, one key consideration would be what exactly an NFT represents. What is being bought and sold – the underlying asset, or merely the NFT itself? An analogy would be the difference between selling the shares of a company versus selling assets owned by a company.

Further, given NFTs’ great flexibility, their taxability becomes even murkier if they are fractionalised, or resold with different terms. Valuation may be hard to establish in the absence of a clear market price, nor is it clear when capital gains have been realised.

With NFTs’ borderless nature, tax jurisdictional issues will also arise. Additionally, the decentralised nature of blockchain technology affords a significant risk of tax under- or non-reporting. While regulators may be keen to develop regulations to curb tax evasion, this may prove challenging as there is no clear target to regulate. Traditional regulations target financial institutions by imposing reporting obligations; but as blockchains are decentralised and distributed globally, the best bet would be to load yet more regulation on already burdened exchanges. This would however still not be able to address peer-to-peer (non-exchange) transactions.

Privacy concerns

Another potential legal issue is the potential conflict between the European Union’s General Data Protection Regulation (GDPR), which creates the “right to be forgotten”. At first glance, cryptoasset transactions seem private. The only information exchanged is a person’s public key or address, which appears as a hash (a seemingly random alphanumeric string). But this is only pseudo-anonymous. With enough information, it may be possible to identify persons and link them to specific public addresses.

This would likely satisfy the definition of personal data. Under the GDPR, individuals have a right to require their personal data to be removed. However, the immutability and decentralised nature of blockchain technology mean that this may not be fulfillable in practice.

Big mistakes

Last December, an NFT from the Bored Ape Yacht Club series of artwork was sold for merely US$3,000, instead of the intended US$300,000. The NFT’s former owner explained that he had accidentally listed it for 0.75 ETH instead of the intended 75 ETH – the standard price of Bored Ape NFTs.

The NFT was flipped for nearly US$250,000. The speed with which the transaction took place, together with the unusual fact that the buyer paid very high “gas fees” – nearly US$32,000 or 10 times the NFT’s purchase price – to ensure that the sale was processed expediently led to suspicions that the buyer was a bot, essentially an algorithm run by computers that would automatically snap up transactions if certain criteria are met.

The scenario draws a parallel with the classic case of Digilandmall.com, where opportunistic buyers ordered over 4,000 printers mistakenly listed for just S$66 instead of their usual retail price of S$3,854. The judge held that the buyers had constructive knowledge of the mistake, and because of that their conduct was unconscionable, and therefore the orders were not binding on the seller on unilateral mistake grounds.

However, would the same reasoning apply in the case of the Bored Ape sale? If the buyer was not human but a bot, could it be said to have “knowledge”? Or would the fact that it had been programmed to pay significant gas fees to secure a lower price should such a lower price come on the market indicate that it was programmed with the intention to take advantage of mistakes? There is no easy or immediate answer to this.

New laws are necessary

NFTs look set to disrupt and revolutionise the way we look at ownership of things, especially intangibles. As the digital world develops and rapidly progresses, existing laws and regulations will need to play catch up, and find ways to give effect to principles of fairness and justice in the face of unyielding algorithms. Different countries may develop these laws and regulations at a different pace, which creates opportunities for legal arbitrage. Meanwhile, caveat emptor.


This article was first published in The Business Times on 4 April 2022 under the headline “NFTs: Are they art or artifice?”. Niklas Wong is co-author.