What are NFTs and why are they so popular?
Whether NFTs are the future of the art market or a bubble, the continued growth of the phenomenon of minting and selling digital artworks as NFTs means they cannot be ignored. The rise of NFTs has been staggering. It has been reported by NonFungible.com that more than $2 billion was spent on them during the first quarter of 2021 alone.
Moreover, NFTs have gate-crashed the mainstream art world. In March 2021, perhaps demonstrating how frothy the market is, Christie’s sold Beeple’s ‘Everydays: The First 5000 Days’ (a purely digital NFT-based artwork) for $69,346,250, leading many to speculate that NFTs represent the future of art. It should be noted, however that the vast majority of NFT transactions are at a low level, with more than 50% of sales under the $200 mark as reported by Artnet.
This all begs the question of what an NFT actually is. NFTs are unique cryptographic tokens stored on a decentralized blockchain that are capable of representing ownership of goods (most commonly digital artworks, on which this article will focus). As blockchains are digital ledgers that permanently record and timestamp transactions, an NFT is an undisputable record of authenticity and ownership of the token. Each NFT is unique and cannot be deleted or counterfeited (notwithstanding another NFT could be created by copying and re-minting the same underlying artwork).
The popularity of NFTs stems from the scarcity they create. Digital works by their very nature can be copied, recreated and replicated infinitely. An NFT does not change that. Rather, an NFT creates scarcity by generating a digitally unique record authenticating ownership of a particular version of a digital work (usually one the creator themselves holds out as being the true version). Therefore, they represent the ultimate example of an artwork deriving value from its provenance rather than the quality of the work itself. Anyone can view Beeple’s ‘Everydays: The First 5000 Days’ online for free and a number of copies of the artwork exist; but only one person can claim ownership of the version authenticated by the artist himself.
Legal issues surrounding NFTs:
The creation, distribution, ownership and trading of NFTs are new phenomena which raise a plethora of legal issues, many of which are ambiguous or unresolved. Discussed below are some of the more prevalent legal issues about which anyone involved in the minting, sale or acquisition of an NFT should be aware.
When you buy an NFT you are not buying the digital work itself. What you are buying is merely a collection of code known as metadata, which links to the ‘true’ version of that work. This metadata is written into the blockchain and contains information about where the original work is located and who owns that particular version of the work. This does not prevent anyone else from downloading and viewing the digital artwork.
A common misconception is that when you buy an NFT you are acquiring the copyright in the digital artwork. This is not the case. In fact, the situation is essentially the same as if you were buying a painting. When you buy a painting, you are buying only the physical artwork itself and not the ability to make and sell copies or create new works which wholly or substantially reproduce the original. The same is true of NFTs: no copyright is automatically acquired. The rights of NFT holders are, generally, simply to own, sell, lend or transfer the NFT itself depending on the particular terms of the market place where you make your purchase. Each marketplace and even each individual product may have different terms, so these must always be thoroughly checked prior to a sale so the buyer knows exactly what they are purchasing.
More complex issues arise where someone creates and sells an NFT of an existing work in which they have no rights of ownership, either in the work itself or the copyright in it. For instance, in March 2021, a twitter account named “Global Art Museum” tweeted that they were selling NFTs of public domain works without informing the museums which housed these pieces (this later turned out to be a publicity stunt). While undoubtedly ethically questionable, such activity is not inherently illegal.
As a matter of copyright law, once copyright has expired and a work has fallen into the public domain (which in the UK happens 70 years after the artist’s death) there is nothing to stop anyone making a copy (for example, a photograph) of the work then marketing that copy (whether as an NFT or otherwise). Indeed, the digitisation and subsequent licensing of artworks by the museums and galleries which hold them has been common practice for over two decades (though is a topic not without controversy itself). Nonetheless, the notion of an unconnected third party monetising such copies is a rather different scenario and might look a little like too flagrant an assault on the public domain to be considered acceptable. It might also violate contractual terms and conditions imposed by many museums and galleries.
Arguably even more complex is the situation where a third party opportunist targets a work which is not in the public domain but still in copyright, say a contemporary digital work, and mints that as an NFT. On the one hand, this might initially look like a clear-cut case of copyright infringement – and could well be so, if the process of minting and selling the NFT involves making a copy of the underlying digital work. On the other hand, however, if it does not, there might be an argument that since the NFT itself is only a cryptographic token linked to the digital asset, no infringement has occurred. That is not to say such exploits would not raise other potential legal claims based on fraud in some circumstances, or passing off, for example. In either case, it would be very dependent on the facts and what the creator of the NFT is claiming about the underlying work.
Another possible challenge in this scenario might relate to an artist’s moral rights – both the right to have his work attributed to him and to object to its derogatory treatment. Even in the mainstream art market, there is very little case law in these areas so quite how such cases might play out in the digital world is currently a matter of mere speculation.
Given the many uncertainties, a buyer would be best advised to conduct rigorous due diligence. Specifically, one would want ascertain whether the seller really is the creator of the work, has good title to it and has obtained the permission of any third party whose IP is present in the digital work. The terms of any platform should be checked to ensure it is clear what is actually available to buy. Just as importantly, due diligence is always required to check that both the artist and the site on which the digital asset is hosted are reputable. The digital artwork itself, which is attached to the NFT, may be hosted on the servers of a third party website and not secured on the blockchain. This means that if the website were to stop running for any reason, the NFT would end up being linked to nothing and would likely become worthless and redundant as a result.
ii.) SMART contracts
Smart contracts govern NFT sales. These are digital contracts where the terms of the agreement are written in the code and are embedded within the purchase tokens. SMART contracts are usually programmed to operate automatically when a pre-defined set of conditions are fulfilled. For instance, the code of the SMART contract could automatically make royalty payments to the creator upon resale of the NFT. The code itself is permanently minted into a token on the blockchain so it cannot be replaced, deleted or amended. The programmed nature of SMART contracts reduces the level of trust required between contracting parties as the contractual terms will be performed automatically upon a triggering event, such as payment being made.
Because the contractual obligations of smart contracts are performed automatically, it follows that, in theory, fewer legal disputes should arise over the terms and performance of the contract. However, there is practically no case law, legislation or regulation addressing SMART contracts. This creates questions as to whether SMART contracts are actually legally binding. On 17 December 2020, the Law Commission called for evidence to inform its scoping study analysing the current law as it applies to SMART contracts. Until this report is published later this year, the legal status of SMART contracts in the UK is uncertain. However, on the face of it, there is no reason why a SMART contract should not be legally binding so long as the terms of the contract are sufficiently clear, both parties intend to be legally bound and both parties have given consideration. What may complicate matters, however, is that SMART contracts will generally operate in tandem with the text-based terms and conditions of the relevant marketplace. This leaves room for potential confusion and uncertainty if the two fail to match up in any particular respect.
iii.) Money laundering
Given the exorbitant sums which are being spent in the NFT market, and the widespread use of cryptocurrency, concerns have been raised about whether these transactions are being used to circumvent the increasingly robust anti-money laundering regulations being implemented around the world. After all, it can be difficult to understand why collectors are spending so many millions on what some might say are essentially just digital autographs. The more cynical commentators may also point to the timing of the rise in popularity of NFTs, which has coincided with the mainstream art market being made subject to anti-money laundering regulations for the first time (in Europe at least). David Hockney, for example, labelled NFTs as the preserve of ‘crooks and swindlers’ when speaking on an art podcast.
The EU’s Fifth Anti-Money Laundering Directive (5AMLD), which came into effect in the UK on 10 January 2020, subjects all “Art Market Participants” (i.e. anyone who acts in the sale or purchase of works of art in excess of €10,000) to a plethora of new duties. Most notable among these is the requirement to carry out Client Due Diligence (CDD) to verify a purchaser’s identity and their source of funds in advance of any transaction.
Interestingly, it is far from clear whether NFTs fall within the scope of the UK regulation. This defines a “work of art” by reference to the 1994 Value Added Tax Act, which is anachronistic in the context of internet-based digital art. There is no reference to NFTs or other digital art forms in the 5AMLD and no direct guidance on the subject in the British Art Market Federation’s 2020 Guidance on Anti-Money Laundering for Art Market Participants.
This seems to leave NFTs in something of a regulatory blind-spot, which may increase the risk of high-value NFT transactions being used as a means of circumventing the anti-money laundering regulations. After all, they are easy to trade discreetly as there is no physical artwork to transport. Furthermore, they are often tied to a decentralised currency which allows for a high level of anonymity in transactions. It is worth noting, however, that in the UK criminals using ill-gotten gains to acquire NFTs as part of an attempt to clean those funds might still be caught under the Proceeds of Crime Act 2002.
Now that NFTs are undoubtedly part of the mainstream art market and the legitimacy of the art-form is becoming more widely accepted, it seems only a matter of time until these digital artworks are brought within the scope of the UK’s anti-money laundering regulations. If this were to happen, then art market participants in the digital art industry would have to register with HMRC, conduct thorough CDD and carry out other obligations. This would significantly change the nature of NFT transactions and probably the market as a whole.
iv.) Estate and succession planning
One question which investors of these thriving assets may not have considered yet (and in particular those Gen-Z investors) is how the UK’s legal framework deals with digital collectables on the owner’s death. This is an increasingly important question given the number of estates which now have a digital footprint. This has emphasised the need for thorough estate planning when it comes to assets like NFTs.
One of the key issues is dealing with access to NFTs on death, since (like crypto assets) they can only be accessed by a unique personal key and password. Given the very real risks of these potentially money-spinning assets being lost forever (and there are a frightening number of well-known examples of private keys and passwords to digital assets being forgotten or misplaced), investors should at the very least take a few simple steps to mitigate these risks.
In most cases the first step is often to make these assets known to personal representatives (and to professional advisers). Preparing an inventory which gives details of the asset(s) and how to access them (and ensuring it is regularly updated and kept securely) will assist with the administration of the estate. In turn, this will make it more likely that those people who the investor wanted to benefit from these assets (if any) will do so. If NFTs are not included as part of an estate plan to pass on to beneficiaries, there is a chance that they will be sold or liquidated, which may not be the owner’s intentions.
A Will becomes available to the public following the grant of probate, and so it is recommended that any sensitive information such as instructions as to how to access a testator’s NFTs should be kept in separate document/memorandum which is stored safely. This will help to create a more robust ‘digital legacy’ plan.
The rise in NFTs and crypto assets has inevitably accelerated the development of technology in this area, and so not only is it possible for these digital legacy plans to be backed up using cloud data storage providers, but there are now sophisticated products in the industry which are created specifically for these assets. In relation to crypto assets, for example, ‘multi-sig wallets’ enable users to assign to a third-party a ‘back-up key’ in the case of an emergency. This technology is intended to allow the owner’s personal representatives to retrieve funds on the owner’s death on behalf of the owner’s beneficiaries. Owing partly to the fast pace of development in NFT technology and evolving law in this area, investors should be wary of the security threats posed by cyber-hacking.
While we have touched on how these assets might be dealt with on death, we can also expect more people wanting to include specific authority relating to digital assets, for example in a lasting power of attorney in the event of mental incapacity.
The use of trusts:
Trusts are often used as an estate planning mechanism in order to circumvent the need for assets to go through probate. Whilst on the face of it this may seem attractive to investors (also for reasons relating to confidentiality), trustees need to carefully consider their approach to investment and fiduciary duties when it comes to holding digital collectables like NFTs. Given the speculative and volatile nature of these assets, trustees need to be mindful of any limits on their powers of investment including their powers of diversification etc. Where trusts are used to hold such assets, consideration should also be given to including additional provisions relating to NFTs (i.e. concerning liability, management or delegation).
Another area where the law has not yet caught up with the increase in popularity of NFTs is in the field of taxation. There is a dearth of legislation and guidance dealing specifically with NFTs, both in the UK and globally. In the UK, HMRC’s recently updated ‘Crypto-assets Manual’ deals principally with cryptocurrencies. NFTs fall into a slightly different category of digital asset and the manual states that NFTs are separately identifiable and so are not ‘pooled’ for Capital Gains Tax (CGT) purposes. It seems clear that CGT can clearly apply to gains or losses on disposals of NFTs and they are doubtless within the scope of Inheritance Tax and other UK taxes, although the precise tax position is far from clear.
One particularly difficult issue is determining where NFTs are situated for tax purposes. This is a key issue for owners with a foreign domicile whose assets abroad may fall outside the scope of UK tax. HMRC’s view is that cryptocurrencies are taxed in the place where the beneficial owner is resident and they may take the same approach with NFTs, especially where the underlying artwork is in digital form, although the law is unclear on this point.
The seemingly inexorable and rapid rise of NFTs over the last few months means that the law has not yet fully caught up with the phenomenon. The legal ambiguity surrounding so many different aspects of buying and selling digital artworks via NFTs extends not only to the examples considered above, but to other areas of law too: data protection and privacy law to name but two. It could be a matter of time before legal disputes centred on NFTs and digital art start to arise. It remains to be seen whether NFTs will become established as a legitimate art form or whether they represent a bubble which may burst. Either way, complex legal issues will continue to surround the commercialisation and ownership of digital art and NFTs. Regulatory bodies and governments will have to move quickly to keep up.