NFTs: a legal perspective - ownership

It's been hard to avoid talk of non-fungible tokens (NFTs) over this past year, yet there still seems to be a great deal of misunderstanding about them. We commonly find that most people that want to get involved still don't have a clear idea of the legal risks involved, often adhering to the idea of a legal 'wild west'. 
 

Part one – foundations and ownership

We're going to dispel some confusion and common misconceptions by publishing this; the first in our short series of articles addressing NFT ownership, intellectual property infringement, commercial issues, data protection, and regulatory risks.

We've seen a marked increase in the creation ('minting') of NFTs to exploit intellectual property rights in recent months, and we've advised a number of our business and artist clients on alternative ways to increase brand awareness and revenues, or to provide services into this growing market. Recent novel applications include Selfridges becoming the world's first retailer to sell a range of dresses by Spanish designer, Paco Rabanne, in digital form only.

What is an NFT?

In order to understand what an NFT is, let's go back a step. We first need to understand that it is a type of cryptographic token; a digital representation of value described on the blockchain using code. Depending on how they are coded, these tokens can (amongst other things) be a medium of exchange such as a cryptocurrency, or a representation of something unique—a non-fungible token. Non-fungible tokens, or NFTs, are described by code conforming to a particular standard. This is normally the ERC-721 standard on Ethereum, or an equivalent protocol on a different blockchain such as Tezos (e.g., FA2).
It might look a little like this:

interface ERC721 /* is ERC165
event Transfer(address indexed _from, address indexed _to, uint256 indexed _tokenId);
event Approval(address indexed _owner, address indexed _approved, uint256 indexed _tokenId);
event ApprovalForAll(address indexed _owner, address indexed _operator, bool _approved);
function balanceOf(address _owner) external view returns (uint256);
function ownerOf(uint256 _tokenId) external view returns (address);

and so on…

The ERC-721 standard tells us what elements need to be included in the code to describe an NFT, and at its simplest it is just a unique token ID (generated when the NFT is minted) and contract address (which allows it to be found on the blockchain). It will also typically include a token name (in plain text), the creator's wallet address, a link to an original image (similar to cover art for a music album), and a set of metadata.

An important component of an NFT contained in the metadata is the 'smart contract', which is a program built into the token's code that performs certain functions (such as remittance of payment to the creator's wallet) when certain trigger conditions are met; for example upon sale. Smart contracts are notoriously misnamed, as they are neither smart (merely comprising 'if X, then Y' type statements), and do not necessarily constitute contracts (although they can be used to incorporate, and automate, terms into a contract). Smart contracts do give NFTs another interesting property, which is that whilst the code is immutable they can be programmed from the start to evolve over time. Imagine if you will, a digital image of the Mona Lisa whose mood changes with stock market fluctuations; or who ages over time.

Why have they become popular?

The way that blockchain technology operates gives an audit trail to evidence the chain of ownership of each token. For this reason, they are capable of representing ownership of digital and real-world assets. More often than not they don't represent ownership of anything other than the token itself, something we'll go on to cover.
In some cases you may see single unique NFTs being minted and sold, in same way as a unique work of art.

Alternatively, an NFT may be one of a series, in the same way as limited edition numbered prints of a photograph are each unique, but are reproductions of the same original image. The reason they are desirable to many is that the immutable record of provenance they represent generates scarcity. And, just as with real world 'limited editions', this can increase the value of an asset purely by virtue of their rarity. An owner of an NFT will have evidence to demonstrate that she owns that token, and has the benefit of any rights granted in the smart contract. Whilst the NFT may or may not in itself grant valuable rights, this ability to create scarcity has caused a secondary market to develop under which supply and demand principles have seen some NFTs sold for very substantial sums.

Some NFTs correspond to real-world assets, such as artist Damien Hirst's NFT collection, in which each of the 10,000 NFTs correspond to a unique physical piece of art which is locked in a secure secret vault in London (and rights in the physical artwork will only be transferred to the buyers if the buyers "cash in" their NFT with Hirst who will destroy it and give them the physical artwork), and others unlock rewards and free items once purchased. Fans of brands and celebrities are encouraged to get involved to become part of a limited edition 'club' and 'own' a part of the collection.

Who owns an NFT?

The answer to this is less straightforward than many market participants imagine.
With NFTs, just as with any intangible asset, title can be bought and sold. When this is done via an NFT exchange the transfer of ownership will be recorded on the blockchain to provide an immutable record of the transfer.

Of course, transactions transmitting legal title can also occur off-chain, and a private arrangement between buyer and seller can be concluded simply by agreement between the parties—sometimes even verbally. One would then expect the parties to record the transaction on the blockchain by sending the NFT from the seller's wallet to that of the buyer. In fact, some of the most significant NFT sales (e.g., sales though auction houses) are conducted off-chain and then manually recorded afterwards.

However, it is entirely possible to transfer title to an NFT without this being recorded on the blockchain. Whilst buyers would be well-advised to ensure they are recorded on the chain for evidential purposes, there is no legal requirement for this to happen. A further layer of complexity emerges when you consider that legal title is severable from beneficial title, or other forms of security interest that can exist over intangible personal property.

The corollary to this is, whilst of persuasive evidential value, the immutable record of ownership provided by the blockchain isn't necessarily an indefeasible source of truth. In this context, how can a buyer be sure that when they buy an NFT on an exchange, they will actually receive the full legal and beneficial title free of encumbrances?

What about an asset represented by an NFT?

Let's assume for a moment that we're talking about a digital asset such as an image file (e.g., a GIF or JPEG). It's worth noting that you wouldn't ordinarily expect the token to contain the asset itself, as the more data to be stored on the blockchain, the higher the costs (and environmental impact, which we'll discuss later). Normally, you'd expect the digital asset to be stored elsewhere and simply linked to.

Whilst ownership of the NFT can be bought and sold, ownership of the intellectual property rights in the digital asset associated with the NFT will not be transferred from the owner of those rights to the buyer unless this transfer is explicitly set out in the smart contract encoded into the NFT. The validity of any such transfer presupposes:

• that the creator of the NFT was capable of transferring those rights at the outset; and

• that all formalities for the transfer of IP rights are satisfied by the transfer of the NFT.

Basic principles of copyright tell us that any original literary, dramatic, musical or artistic works created are first owned by the author (except in certain specific circumstances), and such works will be automatically afforded copyright protection in the UK upon creation (without the need for registration) if the author of the work is a national of, or the work is first published in, the UK. So whilst for NFTs minted by the artist our first presumption is probably satisfied, it may be difficult for a buyer to satisfy themselves that this is the case, given the anonymity afforded by wallet IDs.

As to formalities, in the UK (as in many jurisdictions) an assignment of IP rights will only be valid if in writing and signed by the assignor. It isn't clear that minting an NFT, or a secondary sale of an NFT, would satisfy those requirements.

Express wording of assignment (or even licence) in the smart contract is relatively unusual however, and more commonly an owner of the NFT will not acquire ownership (or indeed any rights) to the intellectual property in the digital asset. They will therefore not have the right to copy the assets except as permitted by law, and certainly wouldn't have rights to sell copies of the work to others.
 
In future articles, we will address NFTs in the context of the risk of intellectual property infringement, commercial issues, data protection, and regulatory risks.

The issues associated with NFTs, blockchain, distributed ledger technology (DLT), and digital assets are cross discipline—from regulation and technology licensing, to privacy and IP. Our leading technology law team has the expertise and experience to help you achieve your strategic objectives when it comes to emerging technologies.

If you have any questions about NFTs, please contact Chris Eastham at chris.eastham@fieldfisher.com.