Non-fungible tokens, or NFTs, are currently in the midst of the
type of hype-cycle last seen in the blockchain/crypto world when
Initial Coin Offerings were all the rage. On March 11, 2021, an NFT
associated with a piece of digital art sold at
auction at Christie’s for $69 million. Other NFTs,
such as one based on Jack Dorsey’s first Tweet, are selling for
millions as well, and there is an active secondary market for some
NFTs, which can drive prices up quickly after the initial sale.
Just as with any other white-hot tech innovation, when the dust
settles there will be aspects of NFTs that become ubiquitous as we
move forward, but some promises around this new form of digital
collectible will prove to have been illusionary.
One of the key questions, especially for anyone focused on the
legal issues raised by NFTs, can be posed in simple terms: What
does a purchaser really own when he or she buys an NFT?
The answer is far from simple.
What Is an NFT?
A number of public blockchains, starting with Ethereum in late
2017 but now including other blockchains (notably, Flow), have
promulgated a standard for creating tokens on the respective chain
that by contrast with standard cryptocurrencies are non-fungible.
Whereas every bitcoin or ether is interchangeable with another,
NFTs are unique.
To back up a step, tokens on a blockchain are just a piece of
software code with specific functionality and identified by a
unique identifier—essentially a long string of numbers and
letters known as a “hash.” A token is thus a piece of
digital data that contains certain preprogrammed levers that can be
pushed and pulled.
For cryptocurrencies, these digital units can be exchanged with
each other in the manner of real paper currency—each unit has
a serial number, but one bitcoin otherwise is the same as another
bitcoin if you want to trade it.
Because NFTs are not fungible, they can be used to represent
other, unique assets that are either online or in the physical
world. For instance, an NFT could be used to represent an oil
painting hanging on an art gallery wall. More commonly at present,
NFTs can be tied to a digital
asset by cryptographically associating the token with that
other asset.
The Problems With Digital Ownership
When we first started
writing and advising clients about using blockchain
technology in media and entertainment in early 2016, one issue
stood out above all others: the disconnect between how
people thought the technology worked and how
it really worked.
For instance, at the time, many people assumed that when applied
to media assets a blockchain could act as a delivery device, to
easily move digital assets around in a manner similar to
cryptocurrency. In reality, blockchains are great as ledgers
for tracking transactions but terrible as a
storage or distribution system for digital assets of any size. The
files for media assets, in particular, are just too large.
What this means is that for digital media assets, the file
itself—whether a photo, a video, an e-book, or anything
else—must “live” somewhere else. You can create a
permanent, secured record of the asset on a blockchain, and that
record can be “tied” cryptographically to the asset
wherever it lives off-chain, but they do not reside together. Think
of it like a library: There is a card catalog that tells you where
books are located and when they are borrowed, but the books reside
separately on shelves.
This can potentially create issues when the underlying digital
asset is deleted or changed on the platform on which it is hosted.
(To address this, separate global networks have been created to
store digital assets in a decentralized, permanent fashion, such as
the Interplanetary File System—these files can then be linked
to a blockchain record with more persistence.) So when looking at
any blockchain-based system involving media content, including
NFTs, it’s important to always ask: Where is the underlying
content housed?
First Sale and the “Double Spend”
Another complicating factor for digital assets is that although
physical objects are not fungible—even two copies of the same
book will have at least minor variations in the way they are bound,
how the color appears, the quality of the printing. By contrast,
digital media theoretically can be reproduced infinitely and not
vary in any meaningful way.
In the physical world we therefore have copyright’s
“first sale” doctrine, which says that copy of a work
that has been embodied in a physical object (a book, a baseball
trading card, a limited-edition print of a painting) can be bought
and sold in a secondary market without the original author
retaining any control over the secondary sales. The owner of the
physical copy, however, gains no interest in the underlying
copyright for the work—in other words, we separate out the
intangible work of art or authorship which is protected by
copyright law from the tangible copy.
Because digital files can be so readily reproduced, courts in
the United States have refused to
recognize a “digital first sale”
doctrine—under copyright law, there is no such thing as a
unique digital media asset that can be bought and sold on a
secondary market, because media files are essentially treated as
fungible.
There’s a name for the issue of infinite reproductions of
digital assets in the world of digital currency: the
“double-spend” problem. How do we ensure that a unit of
digital currency one person sends to another person is not being
sent to another person as well? After all, a digital dollar is just
a unique identifier (a string of letters, number, or symbols), so
nothing stops someone from just copying that identifier and sending
it to more than one party.
Bitcoin solved this problem by creating a third transaction
ledger beyond the accounts held by each of the parties to a
transaction (or their banks)—a blockchain ledger shared in a
decentralized way among computers around the globe but controlled
by no one. By creating this public ledger, Bitcoin prevents
double-spending of currency.
We first
wrote about the potential for blockchain technology, with
its ability to cryptographically track items, to answer the first
sale/double-spend problem a number of years ago. The
development of the NFT standard has revitalized this question.
NFTs to the (Partial) Rescue
Because NFTs are digital tokens, they can be owned and, thus,
can be bought and sold in the market, just like the
cryptocurrencies on which they are modeled. One of the reasons NFTs
have become a hot topic in recent months, beyond some of the
staggering initial sale prices we’ve seen, is that many NFTs
have then gone on to trade upward in value in secondary sales.
However, it is important to recall that nothing about NFTs
changes the fact that just as books in a library are found on the
shelves, not attached to their library cards, the underlying asset
for NFTs always exists somewhere else “off-chain.”
Thus, when a user buys the NFT, they are purchasing the token
itself, not the digital asset that is linked to the token. The
cryptographic link between the token and the asset does not
automatically result in the transfer of any rights or obligations
as to the asset—that occurs as a matter of contract between
the buyer and seller.
The purchase of the token may include, as a
matter of contract, other associated rights, and might even include
transfer of possession of a digital file of the digital asset, but
that depends entirely on the terms of sale for any particular NFT.
The range of rights that could flow with the NFT
are virtually unlimited.
For instance, one of the current hottest uses of NFTs is the
NBA’s Top Shot collectibles program, which has resulted in over
$400 million in sales of NFTs related to specific video moments in
NBA history. Users who purchase an NFT obtain a limited license to
use, copy, and display the images and/or video associated with the
NFT for personal, non-commercial use only.
The NFT that sold for $69 million in Christie’s recent
auction reportedly included some display
rights in the image, and the artist reportedly has said he will
work with the purchaser to effectuate a physical display of the
piece. But the artist retains copyright in the image and,
presumably, may retain a copy of the digital file as well.
And it’s not just the artist or original seller who might
have a copy of the underlying digital asset. Most such assets are
displayed to the public on the NFT sales platforms, so anyone can
grab a screenshot or possibly make a copy. Just as the existence of
a card catalog does not stop other people from reading the book
that’s on the shelf or prevent someone from even stealing a
book from the stacks, ownership of an NFT does not prevent a third
party from making a copy of a digital asset that is linked to an
NFT if they have access to it (although NFTs may eventually make
tracking unauthorized uses more effective).
Information Asymmetry
Just as many people did not understand how blockchain worked for
media content in the early days, many people purchasing NFTs today
may not understand that they could be purchasing less than they
think. There may be misconceptions among purchasers that by buying
an NFT associated with underlying digital assets, they are
purchasing the asset itself rather than just the token.
Indeed, as of the time of this writing, the Wikipedia entry for
Non-fungible token states that “[a]n NFT is created
by uploading a file, such as an artwork, to an NFT auction market.
. . . This creates a copy of the file recorded on the digital
ledger as an NFT, which can be bought with cryptocurrency and
resold.” This is simply wrong: A copy of the file
is not typically recorded on the blockchain but,
rather, in most cases only a cryptographic “hash”
(identifier) will be associated with the token, and the files stay
off-chain on the platform.
While it may be clear to most buyers that when they purchase a
copy of a book they do not gain ownership of copyright in the
underlying novel, it is possible that with this novel technology
some buyers, in fact, do believe they are gaining a controlling
right in the underlying work. Even if they do not believe this,
they may believe that they are gaining more extensive rights to
exploit the work than they are. Or they may believe they are
purchasing a unique digital file when they are not. User review and
understanding of the terms of sale becomes critical.
Another key misconception permeating the NFT space is that the
terms of sale are essentially encoded by means of “smart
contracts.” To a limited degree, this is true: The smart
contract for a given NFT defines the basic terms of sale in terms
of who gets paid what. This can include, for instance, a
requirement that the original artist or seller makes a percentage
of any subsequent sales, a unique feature of NFTs that could prove
to be revolutionary.
NFTs can include in their metadata a link to off-chain
information about the token, which could potentially include
information about what rights flow with the token (although
it’s not clear how many NFT sellers are utilizing this option).
But this does not mean, for instance, that all of the sale terms
are coded functionally into the token.
For instance, if the seller were to include a term that
precludes buyers from using the underlying digital art for
commercial purposes, the restriction would presumably have legal
effect so long as the buyer and seller had a meeting of the minds
as to the governing terms. But the NFT smart contract itself
cannot enforce that provision—a seller
would have to resort to traditional methods of enforcement (e.g.,
demand letters, litigation).
Caveat Emptor or a Long Chain of Liability?
It’s not at all clear that just because a user purchases an
NFT, that user will be deemed later to have been bound by whatever
terms of sale are initially associated with the NFT. It may well
depend on what the user has seen and agreed upon in making the
purchase.
As a practical matter, most NFT platforms currently provide the
sales terms as part of a license agreement located on the platform
itself. This should be sufficient in terms of making sure that
there is that initial meeting of the minds as between the original
seller and first purchaser. But if NFTs are then traded
off-platform in a secondary market, will the terms be properly
conveyed to subsequent purchasers? If not, is there a meeting of
the minds on the terms?
Some original sellers (and NFT platforms) may take the position
that all subsequent sales are beyond the seller’s control, and
that it is up to downstream sellers to communicate the sales terms
to new buyers. However, it is not certain that if, for instance,
each subsequent sale includes payment of a percentage back to the
original seller, the original seller can just claim that the
enforcement of terms is not the original seller’s problem.
Despite the lack of clarity around these issues, the volume and
value of NFT sales continue to soar. Both sellers and buyers owe it
to themselves to better understand the deals they are making in
order to ensure a robust, sustainable market for NFTs in the
future.
Originally published 26 May, 2021
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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