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Non-fungible tokens (NFTs) have become increasingly popular more recently. Starting with small blockchain games such as Crypto Kitties in 2017, they have entered public awareness with NBA Top Shot and the Christie’s auction raising USD 70 million for a digital art piece.

Given the recent success and increasing interest of mainstream media, it is time to take a closer look the mechanics and legal classification of NFTs. In many cases it is still unclear what NFTs legally represent, and poor technical implementation may render them worthless despite the buyer spending millions of dollars.

Definition

NFTs are commonly said to represent something unique. It may therefore come as a surprise that the content represented by the NFT can often be downloaded by anyone and duplicated freely. Take ‘Everydays: The First 5000 Days’ which was auctioned off by Christie’s recently. While you cannot simply download the high-resolution picture from Christie’s website directly, it is recorded on the Inter Planetary File System (IPFS) where it can be accessed and downloaded by anyone. The file stored on IPFS is the same file the buyer of the digital artwork will eventually receive.

Beeple (b. 1981), Everydays: The First 5000 Days – Sold for USD 69,346,250 by Christie’s

The high-resolution file is recorded on IPFS and can be accessed and downloaded by anyone. The size file is 326MB. It might therefore take some time to download.

So, if the content is not unique, what is it, then? In fact, it is the token itself. NFTs, unlike other tokens, are not interchangeable. Each NFT has unique features and given these features, a different economic value. While you can easily interchange ten ERC-20 tokens with ten ERC-20 tokens of the same kind, you cannot do this with NFTs as you will end up with tokens that have different features and a different economic value.

Implemented properly, NFTs inextricably link to the content which they represent. Depending on the design, they may represent digital ownership or some other rights and make the otherwise easily duplicable content scarce.

Common use cases

Common use cases of NFTs include digital art, digital collectibles, in-game items and worlds, domain names, event tickets, and fan tokens. The focus of this post will be on digital art.

The anatomy of NFTs and related problems

When dealing with NFTs it is important to understand why an NFT is unique, but more importantly, how it links to the content represented by it and where the content is stored.

On Ethereum, there are different token standards for NFTs – ERC-721 and ERC-1155. In the case of ERC-721, the NFT contains a mapping of unique identifiers with each identifier representing a single asset/content. In addition, it allows to track the owner of the token easily and creates a public trail of ownership. In the case of ERC-1155, the identifiers do not represent single assets but groups of assets. Tracking the provenance of single tokens is only possible if an ERC-721 superset is implemented. Given the possibility to track provenance, digital art typically uses the ERC-721 standard.

The metadata, which makes a token unique may either be on-chain or off-chain. Because of the costs for storing something on-chain, it is typically stored off-chain. In these cases, the NFT only contains a pointer to an external source which is typically an URL.

Once minted the data on the token becomes immutable and cannot be changed.[1] Depending on how the external content is stored the same is not necessarily true for the content. If the pointer in the NFT points to a URL that is controlled by a central entity or the artist himself, the artist may decide to replace the picture stored under the URL or to delete it completely. In addition, the link itself may be removed resulting in the NFT pointing to a 404 website.

Ultimately, this would leave the owner of the NFT in a very bad position as he still owns the NFT pointing to the URL where the digital art was originally stored. To draw attention to this issue, neitherconfirm replaced digital art with pictures showing rugs more recently.

To avoid this from happening and to ensure the data lives on forever, more recent projects including Beeple’s artwork on Christie’s use IPFS. Unlike current URLs, the IPFS creates unique URLs for files stored on the IPFS in a decentralized manner. If the file is changed, a new URL will be produced, meaning that the original file will always sit at the URL referenced in the NFT. Stated differently, the content and the token will become inextricably linked.

Legal issues

As important as the technical implementation is the question of what NFTs legally represent. This is important as it may limit what the creator or the buyer of an artwork can do, which again affects the price – both for primary and secondary sales. Other issues include the legal classification of NFTs under the Payment Services Act (PSA) and the Financial Instruments and Exchange Act (FIEA), their custody, and consumer protection laws.

Copyright and Ownership

Art, in general, involves a number of complex questions revolving around ownership and copyright. When creating an artwork, the creator generally becomes the first copyright owner. Registration at the copyright office is not necessary but may be advisable in some cases as it establishes a record of copyright ownership. For digital artworks, the same result can be achieved by signing the picture digitally, recording the corresponding NFT on the blockchain, and storing the high-resolution file on the IPFS.

But what does the NFT exactly represent? Digital ownership? Copyright? Or both?

This really depends on the artist as well as the platform the artist uses to sell his artworks. At an absolute minimum, an NFT represents digital ownership. The ownership of a digital artwork is transferred when transferring the NFT itself. The copyright, however, remains with the creator unless explicitly agreed otherwise.

As the first copyright owner, the artist has the exclusive right to make copies, sell and distribute the copies, prepare derivative works based on the copyrighted artworks and publicly display the artworks. In case you have been wondering how it is possible that some of the pictures in Beeple’s ‘Everydays: The First 5000 Days’had been sold in other auctions before but are still shown in his latest piece – this is the reason.

The copyright gives creators the following rights/protection:

• moral rights
• reproduction and distribution rights
• right to produce derivative works
• renting and lending rights
• right to communicate the work to the public
• profit rights

Compared to copyright, ownership rights are rather limited and, broadly speaking, restricted to non-commercial use.

If a creator wants to grant the owner the right to use the artwork for commercial purposes (merchandize, display, etc.), he may either transfer the copyright or grant the owner a license to use the artwork commercially.

It should be noted that some platforms require creators to give the platform a license to use the artwork for commercial and non-commercial purposes. In the case of Open Sea, for example, the creator grants the platform a worldwide, non-exclusive, royalty-free license to use the uploaded artworks for non-commercial and commercial purposes.

“By submitting, posting or displaying Content on or through the Services, you grant us a worldwide, non-exclusive, royalty-free license (with the right to sublicense) to use, copy, reproduce, process, adapt, modify, publish, transmit, display and distribute such Content in any and all media or distribution methods (now known or later developed). This license authorizes us to make your Content available to the rest of the world and to let others do the same. You agree that this license includes the right for OpenSea to provide, promote, and improve the Services and to make Content submitted to or through the Services available to other companies, organizations or individuals for the distribution, promotion or publication of such Content on other media and services. Such additional uses by OpenSea, or other companies, organizations or individuals, may be made with no compensation paid to you with respect to the Content that you submit, post, transmit or otherwise make available through the Services.” OpenSea, Section 9 Terms of Service

When selling digital artworks to users, the creator must therefore consider which rights he has already granted to the platform to avoid potential conflicts. If a creator has given the platform a non-exclusive license to use the artwork for commercial purposes, he cannot grant an exclusive license to the buyer anymore.

Hashmasks clearly distinguished between ownership and copyright as well. In its terms and conditions, Hashmasks states that the buyer of the NFT does not only become the owner of the artworks but also that he is granted an unlimited worldwide, exclusive license to use, copy and display the purchased art.

“You Own the NFT. Each Hashmask is a NFT on the Ethereum blockchain. When you purchase a NFT, you own the underlying Hashmask, the Art, completely. Ownership of the NFT is mediated entirely by the Smart Contract and the Ethereum Network”Hashmask, Section 3.A.i. of the Terms and Conditions

“Subject to your continued compliance with these Terms, The Company grants you an unlimited, worldwide, exclusive, license to use, copy, and display the purchased Art for the purpose of creating derivative works based upon the Art (“Commercial Use”). Examples of such Commercial Use would e.g. be the use of the Art to produce and sell merchandise products (T-Shirts etc.) displaying copies of the Art.” Hashmask, Section 3.A.iii. of the Terms and Conditions

Even where the creator and the buyer explicitly agree on the transfer of the copyright or the granting of a license, the token does not necessarily reflect the exact terms. Written in natural language, the terms do not become part of the code. To ensure that all parties are always fully aware of the rights represented by the NFT, it is advisable that the NFT points to the respective terms and to store the terms on the IPFS. In this case, the NFT would not only serve as a track record of ownership but also bring more clarity with respect to the rights represented by it.

Crypto regulations and custody

According to the Japanese Financial Services Agency (FSA), NFTs are generally not considered securities or crypto assets. Trading, intermediary services for the trading, as well as the provision of custody services is therefore not regulated and may be performed without a license.

If a platform accepts BTC, ETH, or some other crypto asset as payment and manages the funds on behalf of the artist, the platform would however have to register as a crypto asset service provider with the FSA as it would engage in regulated activities – here the provision of custodian services.

BTC, ETH, etc. can be used for payment. There are no legal or regulatory limitations.

Consumer protection

Consumer protection laws only apply if the artist sells his artworks as a business. This must be assessed on a case-by-case basis. Where the pictures are sold by a platform, consumer protection laws generally apply.

AML/CFT Regulations

Since art dealers are not regulated, they do not have to comply with AML/CFT regulations.

Tax

Gains from the sale of NFTs are classified as miscellaneous income under Japanese tax law. As such they are subject to a progressive tax rate of up to 45% plus a fixed local inhabitants’ tax of 10%.

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[1] In many cases, it is still possible to change the metadata in the smart contract. It is therefore advisable to analyze each smart contract carefully.

It is one of the basic principles of capital and financial markets regulation that the same rules apply to the same business and the same risk. In the age of DeFi, this does not seem to be the case anymore. A second look shows, however, that nothing has changed but that the results have become far more difficult to predict.

To assess whether regulations apply, it is generally necessary to assess (1) whether the activities are regulated and (2) identify the entity/person engaging in such activities.

Until more recently, it has been relatively easy to identify both the regulated activities as well as the relevant actors. For DeFi protocols, the answer is not always that straight forward. In the absence of legal documents, it is often unclear how the services are structured (e.g. lending vs. investing). And even where it is possible to classify the respective activity, it is still necessary to analyze whether the activity is performed by a person (regulated) or a piece of software (unregulated).

This brings us to the question of when a project is sufficiently decentralized.

While there is no general answer to this question, there is a distinct set of factors that must be considered when answering the question. The most important factor is the degree of control the team retains over the project after it is launched. In many cases, the team retains admin rights to fix bugs or to upgrade the protocol. This alone may, however, not be enough to establish a sufficient link between the team and the regulated activity. In fact, a comparison with the traditional financial and capital markets shows that the regulations do not apply to the technology providers but those using the technology, in other words, banks, exchanges, and other financial intermediaries. Nasdaq, for example, is not only a registered exchange in the United States but also a software company providing its matching technology to more than 70 markets globally. This does, however, not make Nasdaq subject to regulations in all these markets. Instead, the regulated entities are those providing the marketplace.

If financial and capital markets regulations are meant to be interpreted technology-neutral as claimed by regulators around the globe, nothing different can apply to DeFi protocols. Just because the smart contracts are publicly available on the blockchain does not justify different results in the case of DeFi.

Something different applies, of course, if the team does not only develop and maintain the smart contract but also engages in the listing of tokens or provides the GUI for interacting with the protocol. In this case, there is a clear link between the regulated activity and the team, and registration becomes necessary.

If the GUI is provided by someone else, it is likely that this person becomes subject to regulation as this person opens the marketplace and facilitates trading, etc.

As can be seen from these examples, it is not always possible to draw a clear line. To avoid the risk of becoming subject to regulation, the best way is still full decentralization. In other words, the team must deploy smart contracts without admin rights or transfer the protocol’s governance to the community. While still untested, it is highly likely that this provides an effective shield against regulations.

The trade-off of this approach may, however, be a lack of institutional investment/usage. It is, therefore, necessary to consider the implications of a fully decentralized strategy holistically and not solely from a regulatory point of view. What works for one project might not necessarily be ideal for others.

We are proud to announce that So & Sato and Curvegrid are joining forces to deliver next-generation services at the intersection of finance, tech, and regulation.

With this first-of-its-kind partnership, we aim to address the key pain points that plague many businesses in the crypto industry and that have slowed down the development of the Japanese blockchain industry as a whole.

In many cases, these problems are of technical or legal nature. More often than not they are both. This adds further complexities to an already challenging environment which can neither be solved satisfactorily by law firms or tech companies on their own. Yet, many companies still follow this one-dimensional approach, which results in suboptimal solutions, delays, and wrong allocation of resources.

By combining the expertise of one of the leading law firms in the blockchain/crypto space with Curvegrid’s MultiBaas blockchain middleware and extensive technical knowhow, we are not only able to remove these inefficiencies but also to provide a one-stop solution for our clients, streamline communication with the regulators, assist with the launch of new products, and build solutions which are not only meeting the highest technical standards but which are also fully compliant.

Examples

• staking services (PoS)
• integration of DeFi protocols
• listing of new tokens
• communication with the FSA concerning non-custodial nature of wallets

Want to learn more? Feel free to contact us and arrange a meeting.

About Curvegrid

Curvegrid is a blockchain technology company based in Tokyo, Japan. Curvegrid’s MultiBaas blockchain middleware makes it fast, easy, and cost effective for companies to build on multiple blockchain platforms. Turnkey MultiBaas solutions are available for financial services, decentralized finance, online gaming, document management, logistics, and manufacturing that help companies get to market with blockchain faster than otherwise possible.

About So & Sato

So & Sato is a boutique law firm specializing in blockchain and crypto. Our partners are fully bilingual and have worked with leading law firms in the US, Singapore, and Japan for many years. Our firm has been at the forefront of Blockchain and Fintech ever since it was established in 2015. In 2020, our partner So Saito was ranked among the top 3 FinTech lawyers in Japan by Chambers and Best Lawyers. Combining years of experience in the field of capital markets and finance with an in-depth understanding of new technologies, So & Sato is uniquely positioned to develop innovative solutions for our clients in a highly complex and constantly changing legal and regulatory environment.

(1) SEC Chairman Jay ClaytonのICOレター (Dec. 11, 2017)
https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
Statement on Cryptocurrencies and Initial Coin Offerings

(2) Dec. 11, 2017
Company Halts ICO After SEC Raises Registration Concerns
https://www.sec.gov/news/press-release/2017-227

Sample Questions for Investors Considering a Cryptocurrency or ICO Investment Opportunity

1. Who exactly am I contracting with?
2. Who is issuing and sponsoring the product, what are their backgrounds, and have they provided a full and complete description of the product? Do they have a clear written business plan that I understand?
3. Who is promoting or marketing the product, what are their backgrounds, and are they licensed to sell the product? Have they been paid to promote the product?
4. Where is the enterprise located?
5. Where is my money going and what will be it be used for? Is my money going to be used to “cash out” others?
6. What specific rights come with my investment?
7. Are there financial statements? If so, are they audited, and by whom?
8. Is there trading data? If so, is there some way to verify it?
9. How, when, and at what cost can I sell my investment? For example, do I have a right to give the token or coin back to the company or to receive a refund? Can I resell the coin or token, and if so, are there any limitations on my ability to resell?
10. If a digital wallet is involved, what happens if I lose the key? Will I still have access to my investment?
11. If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit?
12. Has the offering been structured to comply with the securities laws and, if not, what implications will that have for the stability of the enterprise and the value of my investment?
13. What legal protections may or may not be available in the event of fraud, a hack, malware, or a downturn in business prospects? Who will be responsible for refunding my investment if something goes wrong?
14. If I do have legal rights, can I effectively enforce them and will there be adequate funds to compensate me if my rights are violated?