NFTs and the Legal Issues Surrounding Crypto Art

By: Lawrence G. Walters & Bobby Desmond

An Introduction to NFTs

The coronavirus pandemic has had a devastating impact on artists that rely on live events to earn a living. To make up for the income lost to cancelled and postponed events over the last year and a half, many artists began selling cryptographic artworks called NFTs earlier this year, creating a cultural and financial phenomenon. From a comic book-inspired Batman painting worth more than $500,000 to fine art auction house Christie’s first ever NFT which sold for $69 million, NFTs can sell for astonishing prices. The sale of NFTs has even been parodied on Saturday Night Live, and an NFT of that SNL clip sold for $365,000 on Open Sea, a popular NFT marketplace.

In 2020, there were a total of $250 million in NFT sales. In April 2021 alone, there were more than $200 million in NFT sales.

But what is an NFT? Unlike a Bitcoin, which can be interchanged with any other Bitcoin without gaining or losing value, NFTs are non-fungible tokens. An NFT is a certificate of ownership and authenticity of a one-of-a-kind asset which is executed through open-source codes (called smart contracts) that are used to record transactions and are transparently stored on a permanent digital ledger called the blockchain. Numerous blockchains support NFTs including the most popular Ethereum platform. Other blockchains may provide additional functionality for more complex NFTs such as EOS, Cardano, Flow, and Tron. The immutable nature of these blockchains help to better ensure that NFTs are not stolen, altered, or destroyed.

The process of writing the smart contract and storing the NFT on the blockchain is known as “minting.” Any unique asset may be linked to an NFT through the minting process, whether it is a digital asset (like a document, image, audio, or video file) or a physical asset (like an oil painting, concert ticket, or plot of land.) This article focuses on NFTs that are used to monetize digital assets.

Once an NFT is minted, the NFT is permanently linked to an underlying digital artwork through a decentralized peer-to-peer protocol such as the InterPlanetary File System. The NFT can then be sold peer to peer or with the help of an online marketplace or auction platform which allows NFT collectors to display their new purchases with pride.

Common Legal Issues

Ownership

Typically, the owner of an NFT does not own the underlying artwork, which remains the property of the artist. The artist typically retains all copyrights in the work, including the right to copy, distribute, modify, and publicly perform or display the work. The buyer generally purchases the NFT along with a limited license to use the underlying artwork for personal use, such as publicly displaying the artwork on an online NFT marketplace, such as OpenSea.

Licenses and Royalties

The specific rules of any given NFT are determined by the artist during the minting process. For example, an artist may choose to grant broader or narrower rights to the underlying work, an artist may choose the maximum number of copies that may be made and sold, or an artist may require automatic royalty payments on all resale transactions. It is important to understand that the specifics of any smart contract may be dependent upon the marketplace where the NFT is bought and resold. For example, in most cases, automatic royalties will not be generated if an NFT is initially sold on a marketplace but later resold on a different platform or peer-to-peer. Interoperability is a key issue being address by the platforms as the NFT market grows.

Intellectual Property Infringement by an NFT Seller

Because an NFT seller is offering a license to the underlying artwork, an NFT should only be minted by the owner of the underlying artwork. It is important to ensure that the minter of an NFT has the right to all underlying copyrights and trademarks and does not violate any depicted individual’s publicity rights, or name, image, and likeness rights. If an NFT is minted by an infringer, the underlying artwork may be removed from the IPFS if the owner of the underlying artwork sends a DMCA takedown notice, potentially resulting in a major loss of value to the NFT.

Intellectual Property Infringement by an NFT Purchaser

Because an NFT purchaser is only purchasing an NFT and a right to use the underlying artwork, not copyright ownership in the underlying artwork, an NFT purchaser should not take any actions that would constitute copyright infringement of the underlying work, such as making and selling copies of the underlying artwork.

Data Privacy

As countries across the world and states across America pass stronger data protection laws, it is important to consider the implication of data privacy concerns and the blockchain. Because of its immutable nature, certain rights protected by these new laws, including the right to correct or delete personal data, may be difficult to recognize on the blockchain. An NFT which contains personal information may indeed violate these laws. This is an area where the law has not kept pace with technology, resulting in uncertainty.

Regulatory Concerns

While U.S. regulators have yet to provide official guidance on NFTs, the Commodity Futures Trading Commission has stated that cryptocurrencies are “commodities” under the Commodity Exchange Act (“CEA”). As such, some legal scholars believe NFTs could be regulated under federal law in the near future, due to the similarities between cryptocurrencies and NFTs. If it is determined that the CEA applies to NFTs, requirements could be imposed to prohibit deceptive or manipulative trading practices, or to mandate trading only on registered derivative exchanges.

The Financial Crimes Enforcement Network (“FinCEN”) has not issued guidance on NFTs but has published general guidelines on how the Bank Secrecy Act and the agency regulations impact cryptocurrencies. Some legal commentators find this unlikely because NFTs are not considered to be a “value that substitutes for currency” in the same way that a Bitcoin does.

Many other federal laws and regulations may also be implicated. For example, anti-money laundering laws may be triggered if NFTs are deemed an “antiquity,” and security laws may be implicated if NFTs are deemed a “security.” In fact, a class-action lawsuit has been filed alleging that recent NFTs created by the NBA called Top Shop Moments constitute securities. Further, considering NFT transactions can occur across borders, the Office of Foreign Assets and Controls could seek to sanction an NFT marketplace in the same way it has pursued enforcement actions involving other blockchain technologies in the past. Of similar concern is guidance from the Financial Action Task Force which regulates any service provider related to “virtual assets” which it broadly defines as any “digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes.”

Finally, while no state has done so to date, it is possible that individual states could seek to exert regulatory oversight over NFTs as money transmissions. For example, New York and Louisiana have both passed laws to address the operation of cryptocurrency businesses, and Florida courts have held that being in the business of selling Bitcoin is a regulated activity under the state’s money transmitter law.

Cyber Security

Due to the unchangeable nature of transactions on the blockchain, NFTs are not easily returnable if a malicious actor gains unauthorized access to an account and trades an NFT without the rightful owner’s authorization. In fact, at least three NFT owners have reported that their accounts were hacked and their NFTs were stolen, though the NFT marketplace in question released a statement that there is no indication of a compromise on their platform.

Adult NFTs

The adult entertainment industry is also finding a way to cash in on the NFT trend. In March 2021, rapper Azealia Banks and her boyfriend sold their audio sex tape NFT for $17,240. And many NFT marketplaces are beginning to explore additional pornographic offerings.

NFT artists, purchasers, and marketplace operators should understand the patch work of federal and state laws as well as banking and payment processing requirements that are imposed on the sale of adult NFT content.

Federal law prohibits the production and distribution of child pornography, imposes reporting obligations in certain scenarios, and requires producers of adult material to collect and maintain identity and age verification documents from all performers. Recent actions by Mastercard require specific compliance obligations to document consent of adult performers, as well as implement strict procedures for reporting and removal of nonconsensual content. Special consideration should also be paid to federal criminal laws on prostitution and sex trafficking which can be imposed against online platform operators based on user-submitted content.

In the case of online marketplaces, these issues are typically addressed by employing experienced legal guidance on issues such as user terms, age and consent verification, and development of prohibited content and acceptable use policies. Given the growing data privacy requirements under both U.S. and international laws, it is also important to implement robust privacy policies.

Building an NFT Marketplace or Auction Platform

For those considering starting an online marketplace or auction platform for NFTs, there are significant legal matters to consider. Some of these issues are faced by all businesses, such as deciding on a corporate structure or settling on a brand name. In other cases, the legal issues are more specific to the NFT business model. For example, what depictions will be prohibited in NFT artwork? Will you allow listers to sell NFTs for a set price, or will you allow listers to post NFTs at auction? Will the auction have a minimum starting bid, and how long will bids be accepted for? Will you charge a flat fee to list the NFT, or will you collect a portion of the sale price? Will you allow artists to collect royalties on resales, and if so, will you receive a portion of those resales? Will you allow users to gift NFTs free of charge, and if so, will you charge a fee for such transfers? All of these questions should be considered before launching a platform or marketplace, and the answers to these questions should be detailed in the platform’s Terms of Use Agreement.

Some legal efforts will also be required for risk mitigation, such as implementation of DMCA safe harbor policies to avoid copyright infringement claims, and development of robust age and identity verification systems to avoid underage content concerns. Certain federal laws provide immunity or other legal protection to online platform operators, and consideration should be paid to these legal benefits when developing your business model.

Conclusion

Given the significant business opportunities present in the creation and sale of NFTs, early adopters stand to earn substantial profits if they understand and are able to limit the inherent and unique legal risks associated with the NFT business model. Those considering these cutting-edge business opportunities stand to benefit from careful legal planning from inception.

This article is not intended as legal advice. Walters Law Group has represented adult industry clients for over 30 years. Lawrence Walters and Bobby Desmond can be reached at www.firstamendment.com, or on social media @walterslawgroup.