What does owning an NFT of an asset really mean? One of the important requirements of ownership is control. How much control do we get over an asset owning an NFT of it? If we buy an NFT on an artwork, what kind of rights do we get over the artwork?
Before we get into that, we need to understand how NFTs are classified legally - as the regulations applicable will depend on the legal classification, and in turn, decide the type of ownership.
This is the 2nd part of a Series - Read the Part 1 here https://www.fintechna.com/articles/evaluating-nfts-beyond-the-hype/
Legal Classification of NFTs
All NFTs are linked to specific smart contracts on blockchain networks. For example, for CryptoKitties NFTs this is the smart contract.
Smart contracts are self-executing digital contracts that contain the terms of the agreement an NFT represents. The terms are embedded within the NFT tokens.
Why are we talking about smart contracts though?
To point out that NFTs may behave very differently based on the smart contract codes and the legal classification of NFT may not be absolute. As the smart contract for an NFT controls the rights granted to the NFT owners, the classification of NFT may vary case by case based on the codes of the smart contract.
Some of the possible legal classifications of NFTs are :
Commodity, Security, or Property Rights?
Commodity
The question of NFTs being classified as commodities arises as regulators around the world are likely to classify cryptocurrencies as commodities.
The classification of NFTs as commodities is still not clear though. NFTs are different from cryptocurrencies as NFTs refer to another asset of value rather than being value reserves themselves.
So, NFTs can be classified as Securities or Property Rights depending on the rules in the smart contracts.
Security
For NFTs to be classified as securities it has to pass the ‘Howey Test’ which requires an investment contract (a prerequisite for security) to offer an expectation of future profit and the profit should come from the efforts of a promoter or a third party. A possible use case may be a real-estate developer issuing NFTs that represent an interest in a project that is yet to be built and use the NFT sale proceeds for the project expense.
A related classification of NFTs can be as derivatives. A derivative can be a contract that derives its value from the prices of underlying securities. If the value of the NFT is tied to the value of the asset it represents, it can be classified as a derivative.
NFTs that can be classified as securities may lead to legal challenges as trading securities are often highly regulated. Confusion around the legal classification of NFTs can be problematic. A petition was filed with the Securities and Exchange Commission (“SEC”) on 12 April 2021 recommending the regulator enact a framework for the regulation of NFTs.
Property Rights
NFTs can also be classified as rights over the referenced assets.
So, the question arises of what kind of rights are transferred with NFTs. Do the NFT owners receive copyright over the referenced assets?
There are two kinds of rights -
Usage rights i.e. rights granted to an individual by the creator to use something for a specific purpose and a particular period. Usage rights can be further classified for personal use and commercial use.
Copyrights i.e. exclusive legal rights to edit, print, sell, publish, distribute, etc.
So, what kind of rights do the NFT holders receive - there is a lot of confusion about it.
Some NFT creators are being proactive about the rights and clarifying the rights to the NFT holders. For example, Dapper Labs Inc., the Canadian company behind CryptoKitties, created an NFT License. Apart from other rights, the license allows the NFT holders to use the Kitty art to commercialize their own merchandise, provided that the NFT holders are not earning more than $100,000 in revenue each year from doing so. At the same time, the NFT License restricts the NFT holder from selling the art or gaining intellectual property rights over it. So, it is quite clear that NFT does not transfer the IP rights attached to the underlying asset.
The problem is that companies dealing with NFT are not always transparent about the ownership of rights. Consider Decentraland a virtual world created with NFTs. While Decentraland is marketed as a “virtual world owned by its users”, section 12.1 of their terms of use say that
“All title, ownership and Intellectual Property Rights in and to the Site and the Tools are owned exclusively by the Foundation or its licensors…For the sake of clarity, you understand and agree:
(i) that any "purchase" of LAND, ...does not give you any rights or licenses in or to the Foundation Materials.. other than those expressly contained in these Terms; and
(ii) that you do not have the right to reproduce, distribute, or otherwise commercialize any elements of the Foundation Materials (including, without limitation, the Foundation’s copyright in and to the art and drawings associated with the Tools and content therein)...”
So, the users do not own any intellectual property rights and rights reproduce, distribute, or otherwise commercialize the virtual assets.
Enforceability
The value of a contract comes down to how enforceable it is. Another major aspect regarding the legality of NFTs.
As mentioned before, NFTs are guided by smart contracts. The issue is that smart contracts are not yet recognized by current regulations. In some jurisdictions, regulators have started to analyze smart contracts to evaluate their legality. For example, in the UK the Law Commission has called for evidence regarding smart contracts.
Another issue with the legal enforceability of NFTs is the international nature of blockchain networks. Are the legal rights provided by NFTs enforceable globally?
To remove ambiguity NFT sellers can issue off-chain contracts recognized by current regulation and link these contracts with the NFTs.
Let us end this part with a legal challenge created by NFTs - money laundering. Art markets are often linked with money laundering. In recent years, regulators are trying to take Art markets under the purview of anti-money laundering regulations. The sudden rise of NFTs raises questions about whether these transactions are being used by art dealers to circumvent the anti-money laundering regulations.
Now, let us move to the potential real-world use cases of the NFT technology in the next part: https://www.fintechna.com/articles/evaluating-nfts-beyond-the-hype-part-33/
