THE LEGAL FRAMEWORK OF NON-FUNGIBLE TOKENS (NFTS)

With the rise of cryptocurrencies and digital assets, NFTs have also become increasingly popular in the recent months and are crucially influencing the investment world. Although they have been around for almost a decade, they are now under the spotlight as they create a brand new twist on generating interest among various sectors such as fintech and Metaverse, provide major remuneration opportunities for artists all around the world, and offer a different perspective on art collecting. The phenomenon has already taken the art market by storm and showcased some colossal sale prices, with an overwhelming amount of $174 million already being spent on them since 2017.

Despite recent development and record-breaking auctions, there is still significant uncertainty about what NFTs are and the legal difficulties they represent. In this article, we explained what NFTs are and what purpose they serve as well as legal issues surrounding them and regulation attempts by the United Kingdom.

What is an NFT?


There is no single definition of NFTs. An NFT can be defined as a non-interchangeable unit of data stored on a blockchain, a form of digital ledger, that can be sold and traded.

The concept of fungibility relates to whether an asset can be exchanged equally with another asset of the same kind. A practical example of a fungible asset is the US Dollar; you can exchange a $1 bill for another $1 bill, and you will still have $1 even though your new bill has a different serial number. Cryptocurrencies such as Bitcoin and ETH coin also work this way. NFTs, or non-fungible assets, on the other hand, are valued differently based on their distinct characteristics and rarity. They are unique and cannot be replaced with anything else. Each NFT contains a digital signature or a unique identifying code that prevents them from being substituted for or compared to one another. They essentially create "digital scarcity"[1].

NFTs are blockchain-based digital assets which represent digital art, videos, music, in-game items and other forms of media. They are sold and bought online, often with cryptocurrencies, and create "irrevocable digital certificates of ownership and authenticity for a given asset, whether digital or physical".[2] They contain a distinctive token ID mapped to an owner identifier and stored inside a SMART contract which makes it easy to verify ownership and reassign the token to different users.

NFTs can be considered to be "modern-day collectibles"[3]; they allow buyers to own the original item and their built-in authentication system serves as proof of ownership. They essentially give collectors "digital bragging rights"[4], which is why many are willing to spend millions on them despite the fact that other people can easily download, screenshot or copy any of these digital assets. Most notably, a video piece by Grimes sold for nearly $400,000 and a purely digital NFT-based artwork by popular creator Beeple auctioned for $69.3 million. NFT collecting is quite similar to real-life art collecting in this sense; copies of real-life paintings by the most famous painters circulate everywhere as art prints, posters and downloadable media, but only certain people own the original works.

NFTs serve various purposes and benefits for artists, buyers and collectors alike. For artists, NFTs provide a brand new medium to sell their artwork and other creations. They get to offer their art directly to buyers and collectors rather than relying on auction houses or galleries, which also positively affects the amount of profits they get to keep[5]. Moreover, NFTs have a feature which enables artists to program in royalties so that every time an NFT is sold to a new owner, the artist concerned can receive a percentage of the purchase price.

For buyers and collectors, NFTs provide basic usage rights such as being able to post the art piece online or use it as a profile picture. However, perhaps more importantly, NFTs are usually treated as investments by buyers and collectors; with the increasing popularity of these tokens, it is quite reasonable to expect their value to increase over time and to sell it for a profit.

Although the world of NFTs is exciting, the complicated legal issues surrounding it must not be discarded. Its recent appearance has not been adequately addressed by legislation or regulations; therefore, there are still various risks and challenges one must take caution against.

NFTs and the Law


Some areas which require regulation on NFTs include intellectual property, money laundering risks, contractual issues, and estate planning. NFT creators and buyers must ensure everything is transparent and as clear as possible before and after the sale of an NFT.

NFTs and Intellectual property rights

Buying an NFT does not actually result in the buyer purchasing the digital work itself; instead, the buyer purchases a collection of code called "metadata". This metadata is "written into the blockchain and contains information about where the original work is located and who owns that particular version of the work."[6] While this does not forbid others to view or download the NFT, it does give the buyer certain rights like being able to post the NFT or use it in certain cases.

An important point to note is that the buyer doesn't actually get intellectual property rights, and this is where complications may arise. Most buyers think that they receive full copyright in the token they buy; however, NFTs are essentially artworks and the right to make and sell copies, distribute the artwork and create new works out of the said artwork remain with the creator of the NFT. Because of this, NFT buyers must ensure they do not breach any copyright that creators maintain, and creators must ensure the copyright they sustain is clearly stated in the terms of sale and that any buyer is held accountable appropriately in case of a breach.

Another matter creators and buyers must be aware of is that certain third parties might illegally try and sell a digital artwork as an NFT despite the work not being in public domain and the third party not having any rights associated with the work itself. This may result in buyers buying an artwork which the seller did not have the right to sell, and in creators having their work exploited. This would not only be breach of copyright but also go against the creators' moral rights.

Certain NFT marketplaces have account cancellation policies in case of any exploitation by platform users. For instance, LeBron James released a video of himself slam-dunking as part of a series of NBA highlight clips where fans may buy and sell these clips on the market. However, NBA retains all copyright and ownership rights, and any exploitation by a buyer will result in breach of licensing terms and their account will subsequently be eliminated.

While these safeguards are valuable, without proper regulations, they will not be adequate in the long run. Buyers must exercise strict caution when purchasing NFTs; they must ensure that the NFTs they are buying are sold on reputable and safe NFT platforms and that the works are actually sold by their respective creators. For creators, the situation is more complicated as without appropriate regulations, it is not always possible to stop opportunist third parties from selling their works without authorisation or to prevent buyers from exploiting their copyright.

NFTs and Contractual matters

As we mentioned above, NFT sales are executed through SMART contracts. These contracts are self-executing once pre-defined conditions are fulfilled; the terms of the agreement are written directly into the code of the contract and are embedded within the tokens, which allows the parties to control and track the transaction[7].

Although the use of SMART contracts may seemingly reduce trust issues between parties as well as any potential disputes arising out of regular contractual matters, the lack of regulation and legislation addressing SMART contracts creates complexities and uncertainty around using these agreements in NFT purchases. While there is nothing that should prevent a SMART contract with sufficiently clear terms being legally binding, complication may arise if the terms of SMART contracts embedded in NFTs do not match with text-based terms and conditions of the relevant marketplace[8]. A recent case involving an art collector showcased how NFT platforms changing their terms and failing to reflect the true nature of any NFT auctions may subsequently create serious contractual issues between platforms and buyers. According to Emily Gould, a senior researcher at the Institute of Art and Law, "There are still many uncertainties around NFTs and the contractual structures they can involve—from questions raised by SMART contracts to copyright and licensing issues—matters lawyers will no doubt chew over for some time to come."[9]

Risk on Money Laundering in NFTs

With the rise of NFTs and the monumental amounts of money being spent on them, money laundering activities and risks have also inevitably rose over the last few months. Recent studies and reports by the US Treasury Department evidence millions of dollars' worth of scamming activity and money laundering in the last half of 2021[10].

The EU has addressed these risks with the Fifth Anti-Money Laundering Directive (5AMLD) which was also enforced in the UK in early 2020. A crucial regulation implemented by the 5AMLD was the duty to carry out Client Due Diligence to "verify a purchaser's identity and their source of funds in advance of any transaction", which applies to any all "Art Market Participants"[11]. Apart from this Directive, the UK does not have any regulations or legislation addressing the issue, although Her Majesty's Revenue and Customs has recently seized £5,000 worth of crypto assets and NFTs, making the British tax authorities "the first law agency to seize NFTs" according to BBC News[12]. The Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017, as amended by the Money Laundering and Terrorist Financing (Amendment) Regulations 2019, also impose a "duty to register with the UK Financial Conduct Authority (FCA) before undertaking any business involving digital assets"[13].

While the FCA distinguishes between regulated and unregulated tokens, there is still yet to be guidance and regulation published by the Authority.

NFTs and Estate Planning

Another important issue which creates a legislative and regulatory blind spot is how NFTs will be regarded in wills and estate planning matters. The uniqueness of these digital assets pose issues on how they can be accessed upon the death of the creator or buyer-owner of the NFT. Suggested steps to mitigate the risk of NFTs being sold, liquidated or lost forever on death include making these digital assets known to personal representatives and beneficiaries. "Preparing an inventory which gives details of the asset(s) and how to access them (and ensuring it is regularly updated and kept securely) will assist with the administration of the estate."[14] However, appropriate and official regulations in this matter would reduce the pressure surrounding the uncertainties for both NFT buyers and sellers.

Dr Enrico Bonadio of the City Law School states "Very few lawyers understand NFTs. Difficult legal issues often arise. For minters buyers and sellers, due diligence is crucial. A proper understanding of the platforms' terms and conditions, as well as a careful consideration of the clauses of the smart contract linked to NFTs, will ensure that duties and rights of all parties involved are clear. This will mitigate the risks of litigation."[15] While NFT platforms, sellers and creators must certainly take on the responsibility of transparency, guidance is strictly necessary from official authorities and regulatory bodies to minimise the risk of exploitation for buyers and owners of these digital tokens.

In the upcoming years we will see more discussion about the legal framework of NTFs. While NFTs are growing rapidly globally, the legal and regulatory treatment of NFTs continues to evolve. We have been advising clients on NFTs particularly n England and Turkey. In this article, we examined our experience to demystify NFTs and consider some of the key legal risks.



[1] Ruby Conti and John Schmidt, 'What is an NFT? Non-fungible Tokens Explained' (Forbes, 15 February 2022) <https://www.forbes.com/advisor/investing/nft-non-f...> accessed 25 February 2022.
[2] Amazon Web Services <https://aws.amazon.com/tr/blockchain/nfts-explaine...:~:text=Non%2Dfungible%20tokens%2C%20often%20referred,asset%2C%20whether%20digital%20or%20physical> accessed 24 February 2022.
[3] Louis DeNicola, 'What to know about non-fungible tokens (NFTs) – unique digital assets built on blockchain technology' (Business Insider, 17 February 2022) <https://www.businessinsider.com/nft-meaning> accessed 25 February 2022.
[4] n 1
[5] ibid.
[6] Fred Clark et al, 'What are the Legal Issues concerning Non-fungible Tokens (NFTs)?' (Art Law & More, 8 July 2021) <https://artlawandmore.com/2021/07/08/what-are-the-...> accessed 24 February 2022.
[7] Jake Frankenfield, 'Smart Contracts' (Investopedia, 26 May 2021) <https://www.investopedia.com/terms/s/smart-contrac...> accessed 23 February 2022.
[8] n 6
[9] Riah Pryor, 'Art collector sues NFT platform Nifty Gateway over Beeple auction' (The Art Newspaper, 1 October 2021) <https://www.theartnewspaper.com/2021/10/01/art-col...> accessed 26 February 2022.
[10] Rob Lenihan, 'Criminals are Using NFTs to Launder Money, Report Says' (The Street, 7 February 2022) <https://www.thestreet.com/investing/cryptocurrency...> accessed 28 February 2022.
[11] n 6
[12] Marco Quiroz-Gutierrez, 'NFTs are now worth seizing, according to U.K. tax authorities' (Fortune, 14 February 2022) <https://fortune.com/2022/02/14/nft-uk-tax-authorit...:~:text=Britain's%20tax%20authorities%20said%20they,%2Dbe%2Dvalued%20NFT%20artworks.> accessed 23 February 2022.
[13] Joe Woodward and Nicola Scarparo, 'UK: Non-fungible Tokens (NFTs): Their Appeal, Regulation & Future' (Ontier LLP for Mondaq, 6 January 2022) <https://www.mondaq.com/uk/fin-tech/1147744/non-fun...> accessed 24 February 2022.
[14] n 6
[15] John Stevenson, 'Exploring the gaps between non-fungible tokens (NFTs) and intellectual property (IP) law' (City, University of London, 4 February 2022) <> accessed 26 February 2022.
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