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What you don't know about NFTs could hurt you: non-fungible tokens and the truth about digital asset ownership

Friday 8 October 2021

Lance Koonce

Klaris Law, New York

lance.koonce@klarislaw.com

Sean M Sullivan

Davis Wright Tremaine, Los Angeles

seansullivan@dwt.com

Non-fungible tokens, or NFTs, are currently in the middle of the type of hype-cycle last seen in the blockchain/crypto world when initial coin offerings (ICO) were all the rage. On 11 March 2021, an NFT associated with a piece of digital art sold at auction at Christie’s for US$69m. 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 they buy 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 therefore a piece of digital data containing  certain pre-programmed levers which 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 tangible. 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 I 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 lack of a connection 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 move digital assets around easily in a manner similar to cryptocurrency. In reality, blockchains are great as ledgers for tracking transactions but terrible as storage or distribution systems 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 eBook, 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 catalogue 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 decentralised, permanent fashion, such as the Interplanetary File System (IPFS) – 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, as even two copies of the same book will have at least minor variations in the way they are bound, how the colour 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, therefore, we have copyright’s ‘first sale’ doctrine, which says that a 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 recognise 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, numbers 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 decentralised 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 track items cryptographically, to answer the first sale/double-spend problem a number of years ago. The development of the NFT standard has revitalised this question.

NFTs to the (partial) rescue

Because NFTs are digital tokens, they can be owned and can therefore be bought and sold in the market, just like the cryptocurrencies on which they are modelled. 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’.

Consequently, 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 National Basketball Association’s  Top Shot collectibles programme, which has resulted in over US$400m in sales of NFTs related to specific video moments in NBA history. Users who purchase an NFT obtain a limited licence 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 $69m 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 catalogue 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 unauthorised 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 new 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 making use of 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 (eg, 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 later deemed 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 on in making the purchase.

As a practical matter, most NFT platforms currently provide the sales terms as part of a licence 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 initial 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 improve understanding of the deals they are making in order to ensure a robust, sustainable market for NFTs in future.