NFTs Are All the Rage. They May Also Raise Some Legal Red Flags

Got some spare cash burning a hole in your pocket? Then perhaps you’d like to get in on the NFT craze. Now’s your chance to own a bit of history or, at the very least, a collectible cryptocurrency token that’s one of a kind (well, in a way).

Non-Fungible Tokens: What the Funge Are They?

NFTs, or non-fungible tokens, are unique digital assets that can’t ever be replaced. Take, for example, the first ever tweet sent by Twitter founder Jack Dorsey. That message, "just setting up my twttr," published back in March 2006, can be viewed, free of charge, by anyone on the planet with internet access. But with the advent of the Ethereum blockchain, actual ownership of those five words in their original tweet form became a real possibility. In fact, it was purchased earlier this year for 1,630.58 ether, a cryptocurrency (like Bitcoin) that, at the time of the transaction, was worth $2.9 million.

As of this writing, those 1630.58 ether are valued at . . . (you may want to sit down for this) . . . just south of $450 million. And the examples of seemingly outrageous NFT sales continue to pile up faster than our national debt. Last month, an Instagram-famous digital artist named Beeple (née Mike Winkelmann) auctioned off a JPEG collage through Christie’s for the equivalent of a cool $69.3 million. A yearbook photo that was fodder for a series of hilarious “Bad Luck Brian” memes traded as an NFT a few weeks ago for what was then $36,000 in ether (the value of the cryptocurrency has subsequently spiked). And the ultimate irony: an article in the New York Times about NFTs just sold as an NFT for 350 ether, or about $975,000 if converted into dollars today.

Unlike tangible assets such as an original Picasso, a LeBron James rookie card (which recently sold for $5.2 million), or even a piece of real property, buyers of NFTs are essentially purchasing non-physical certificates of authenticity in code form that can never be changed. Sure, anyone can hop online and see an image of that Beeple collage, have a laugh at the expense of Brian, or read the NYT piece by Kevin Roose, but only one person or entity can actually boast ownership of the unique characters (read: stored information) living on the Etherium blockchain that represent the genesis of each creation being acquired.

It’s this uniqueness that makes an NFT non-fungible. While one bitcoin can be traded for another, leaving the owner with the very same thing (meaning a bitcoin is fungible), a one-off digital asset (say, that first Jack Dorsey tweet) is like a piece of art. Sure, it can be copied or replicated, and even viewed by millions, but there’ll only ever be one original. To collectors, there’s considerable value to that, and the data NFTs contain can be used to prove ownership rights over these digital assets.

But is this new(ish) digital asset class destined for mass adaptation? Maybe yes, maybe no. Whatever the case may be, it's clear that NFTs are attracting a lot of attention these days. And with the buzz come potential legal pitfalls. Here are three to consider.

NFTs and the SEC

For many, NFTs are speculative assets, purchased as investments assuming their values will increase over time, in which case they can be sold at a profit. As such, despite their digital characteristics, NFTs run the risk of being considered “securities” for purposes of their treatment under the law.

Under the Securities Act of 1933, a security is essentially any type of negotiable instrument that represents some type of financial value. Some that immediately come to mind include fungible investments like stocks and bonds. But the definition of securities as set forth by the U.S. Supreme Court also includes “investment contracts,” meaning an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others." This so-called Howey Test begs the question: could release of an NFT implicate federal securities law?

The short answer is: it depends. For many NFTs, like Jack Dorsey’s inaugural tweet or Beeple’s aforementioned digital masterpiece, token purchases involve the investment of money, but do not contemplate a common enterprise or any further effort of others to produce profits. Instead, as is the case of an investor buying a Monet or other valuable work of art, those acquiring NFTs hope that the marketplace will dictate their appreciation over time. Bottom line: neither Dorsey- or Beeple-type exchanges trigger securities concerns.

However, should an NFT be sold to fund a company’s business or—say—the development of its blockchain, it’s pretty clear such a transaction would meet all elements of the three-pronged Howey Test and, therefore, the token would be considered a security. Likewise, if an NFT is purchased with the intent of licensing the underlying asset, or reselling copies for profit, then the analysis changes and securities laws could potentially come into play.

If characterized as a security after satisfying the Howey analysis, any given NFT would be subject to heavy duty scrutiny and regulation by the Securities and Exchange Commission, particularly when it comes time to sell. In that instance, sale of the token would require registration with the SEC, unless an exemption under federal securities law applied, and the NFT would fall under state “blue sky” laws. And there is more. Platforms facilitating any NFT transaction would also have to register as a securities exchange, alternative trading system, and/or as a broker-dealer.

For these reasons, NFTs and their relation to the Securities Act should be on the minds of all buyers, creators, and operators of NFT exchanges.

Says the NFT Philosopher: IP Therefore I Am

Intellectual property interests, namely copyrights, should be another topic flashing brightly on the radar screens of anyone dabbling in the NFT marketplace. Indeed, parties to an NFT
transaction must understand the importance of obtaining appropriate IP rights prior to consummating a purchase or sale.

To be clear, NFT creators have to tread lightly when leveraging the work of others. More specifically, permission must be obtained from the owner of a copyright before a third-party creation is incorporated into an NFT, especially one positioned for sale. The failure to do so could subject the originator of an NFT to legal action and financial exposure in the form of copyright infringement litigation. This is particularly true in the absence of a defense premised on the doctrine of fair use.

By way of background, copyright law encompasses a “bundle of rights” that are exclusive to copyright owners in their original works. These rights include copying, performing, distributing, adapting or modifying the work, and displaying or performing it in public. That being said, anyone creating an NFT should nail down the legal right to use and sell any and all of its embedded elements. For instance, where an NFT includes a soundtrack, consent from the relevant music publisher or record company should be obtained prior to upload.

The Tax Man

Tax implications follow most every transaction, and that includes the exchange of NFTs. When selling these digital tokens, tax laws apply and need to be followed to avoid any discrepancies with the IRS.

NFT deals are typically considered to be barter transactions for tax purposes, as tokens are generally characterized as property, as opposed to currency, by the IRS. This means that the fair market value of these assets must be reported on tax returns as income, and sales are to be set forth as capital gains.

For creators, tax repercussions may be ongoing. Another extraordinary aspect of NFTs is a feature that allows digital artists and other originators to be paid a percentage whenever the tokens they created are resold. Thus, NFTs can function as an annuity for their creators, who may participate in financial gains over time, thus triggering the potential of future taxation.

A Final Word

For would-be Beeples looking to ride the wave of NFT mania, it's vital to be aware of the legal issues tied to these headline-making digital tokens. That means remaining mindful of the IP, securities, and tax law concerns that come with the territory when dipping a toe or jumping head first into this increasingly popular digital asset class.

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.