NFTs: New legal challenges on the horizon

Non-Fungible Tokens (“NFTs”) have recently gained much attention due to their role in the transfer of digital artworks. The market for NFTs grew from USD 13.5m in the first six months of 2020 to USD 2.5bn in the first half of 2021 and is still growing. According to the market tracker DappRadar, NFTs generated nearly USD 11bn in sales in the last quarter. Notwithstanding their increasing popularity in the world of art, NFTs have many potential applications. In this blog we explain what NFTs are and set out some of the regulatory and copyright issues NFTs will bring about.

Setting the stage: what are NFTs?

NFTs fall within the broader trend of tokenisation. Tokenisation describes the development of digitalising assets or rights on a distributed ledger, such as a blockchain. The token itself is a cryptographically encrypted form of the asset or right, and the distributed ledger embodies information regarding its issuance, value and circulation.  The NFT represents a certificate of an asset which can be either tangible or digital.

The main difference between NFTs and other tokens is that NFTs are non-fungible. The most well-known example of a fungible token is a bitcoin. This means that every bitcoin represents the same value and can be replaced by another bitcoin with no loss of value or material change in the owner’s possession. Contrarily, NFTs are non-fungible. This means that every NFT is unique and only one person or entity owns it at the same time. In this regard, the exchange of two NFTs compares to the exchange of two unique artworks; they are not substitutes, and their exchange constitutes a material change in both owner’s possession.

Blockchain technology allows NFTs to remain unique and indivisible regardless of their digital nature. After creating an NFT – a process termed ‘minting’ – the use of a smart contract, which is a piece of software recorded on the blockchain, ensures that the NFT cannot be duplicated or divided. A smart contract is a self-executing instrument that performs acts on a blockchain once all predefined parameters have been fulfilled. As a result, the NFT remains one of a kind, and so does the corresponding asset or right.

Financial regulatory challenges

Pursuant to current legislation in force, NFTs will not qualify as securities (effecten) within the meaning of the Dutch Financial Supervision Act (Wet op het financieel toezicht). In order to qualify as a security, an NFT should be tradeable (verhandelbaar). In order for a security to be tradeable it must be transferrable to a third party. Another important characteristic of a security is the degree of standardisation of the rights attached to the security. To qualify as a security, the object should be highly standardised, and thus be fungible. One of the main characteristics of an NFT is that they are non-fungible and cannot be replaced by another NFT. Therefore, NFTs fall out of scope of the definition of security.

Furthermore, NFTs do not fall under the scope of virtual currencies as introduced by the Fifth Anti-Money Laundering Directive ("AMLD5"), because NFTs do not qualify as a means of exchange due to their lack of fungibility. Hence, issuers do not have to comply with the registration requirement pursuant to the Dutch Money Laundering and Terrorist Financing (Prevention) Act. However, AMLD5 obligations may still apply. NFTs are used in the art world, and AMLD5 introduced an obligation for art dealers with respect to transactions in art works for an amount of EUR 10,000 or more. With respect to such transactions, art dealers must comply with a number of AML-obligations (including client due diligence and transaction monitoring obligations). This applies to the extent that NFTs were to qualify as works of art.

The European legislator is currently preparing a regulation that will also affect NFTs: the Markets in Crypto-assets Regulation ("MiCA"). MICA is expected to enter into force in 2024. The proposal provides for a consistent international approach of all assets that are “a digital representation of value or rights which may be transferred and stored electronically, using distributed ledger or similar technology”. Under the current draft of the MiCA, NFT issuers will fall out of scope of the licensing obligation and will most likely be exempt from the requirement to draft, notify and publish a crypto-asset white paper at the time of an Initial Coin Offering, as this requirement will not apply to non-fungible tokens.

However, certain requirements will most likely apply to NFT issuers. They will be required to be a legal entity (which may be established outside the EU). Additionally, they will have to comply with a number of business conduct and governance requirements. NFT issuers will be required to:

• act honestly, fairly and professionally;
• communicate with the holders of NFTs in a fair, clear and non-misleading manner;
• prevent, identify, manage and disclose any conflicts of interest that may arise; and
• maintain systems and security access protocols to appropriate Union standards, which will be further developed by ESMA and EBA.

GlobalArtMuseum’s NFTs

The rise of NFTs has not only resulted in interesting regulatory challenges; it has also given rise to challenges with regard to copyright law. This can be illustrated with the following example. Earlier this year an independent seller called GlobalArtMuseum (“GAM”) tokenised famous (digitalised) artworks, such as Rembrandt’s Night Watch, currently exhibited in the Rijksmuseum. The Rijksmuseum strongly believes in the public domain and, therefore, digitalised its art collection for the public during the COVID-19 pandemic. GAM took the opportunity to immediately tokenise these digitalised artworks and sell them online as NFTs. The Rijksmuseum, however, declared on Twitter that it had not made any arrangements with GAM for the tokenisation of the Night Watch. This gave rise to a number of allegations on Twitter accusing GAM of fraudulent behaviour, as GAM is not the owner of the artworks, nor does it own the copyrights vested in those artworks. Nevertheless, these allegations do not hold water, as the copyrights on the physical artworks of the Rijksmuseum are most likely largely expired and – as said before – according to the Rijksmuseum, the digital artworks are currently within the public domain. Suppose, however, that the tokenised artworks are protected by copyrights, and the Rijksmuseum is the legal owner of these copyrights vested in the artworks. This would raise an interesting question: is GAM authorised to tokenise the copyright-protected artworks and transfer this token despite not being the legal owner of the copyrights? Note that NFTs exist in different forms: an NFT can represent a digital or a tangible object, and it can be governed by different types and sizes of smart contracts. Consequently, there is no uniform answer to the general question as to whether minting an NFT and transferring an NFT to a third party will constitute in a copyright infringement. The explanation given in this blog will therefore limit itself to the GAM example.

To understand the challenges for copyright law, some explanation on what an NFT represents is necessary. An NFT contains metadata (data that describes the characteristics of other pieces of data) about a certain object. More specifically, the NFT is a certificate that contains information about the underlying object. Hence, the ownership of an NFT indicates the ownership of a certificate, and not necessarily of the object it represents. The value of an NFT also depends on the content of the smart contract that governs it. The smart contract may contain provisions concerning proprietary rights vested in the underlying object and it, therefore, determines the rights the owner of that NFT may have in regard of that underlying object.

Whether GAM – in the hypothetical situation – is authorised to tokenise the digital artworks and transfer the tokens to third parties depends on how GAM obtained the files containing the digital artworks. The first question to be asked in that regard is whether GAM made a copy of the file during the minting process. The answer to this question depends on how GAM obtained and stored the file on the NFT. If, for example, GAM obtained the digitalised Night Watch via the website of the Rijksmuseum and stored a copy of the file on its computer, GAM made a reproduction of that file under Article 2 of the Copyright Directive. This reproduction may, in turn, constitute a copyright infringement when it is published on the blockchain as an NFT.

However, the use of a hyperlink does not automatically qualify as a reproduction in the sense of Article 2 of the Copyright Directive. With regard to the use of a hyperlink, the transfer of the NFT may, depending on the legality of the content that hyperlink refers to, constitute ‘an act of communication to the public’ as meant in Article 3 of Copyright Directive. This, in turn, results in a copyright infringement when done so without permission from the rightful copyright owner. To determine whether the tokenisation process results in a copyright infringement, it is important to make a distinction between hyperlinks that refer to legal and to illegal content (respectively, “legal hyperlinks” and “illegal hyperlinks”).

For legal hyperlinks the Court of Justice of the European Union (“CJEU”) concluded in the Svensson/Retriever case that, “the provision on a website of clickable links to works freely available on another website does not constitute an ‘act of communication to the public’.” However, if that hyperlink refers to a webpage that is only legally accessible to subscribed users, the transfer of the NFT to a third party may constitute in an act of communication to the public. Applying these rules to our case, GAM could infringe the copyright of the Rijksmuseum if:

1. GAM was permitted to legally access the digitalised artwork via a subscription to the Rijksmuseum’s website, and placed the legal hyperlink on an NFT certificate, but
2. after the transfer, the next owner of the NFT (who does not have the same subscription) circumvents the restrictions of the website-owner and gains access to the copyright-protected artwork by clicking on the hyperlink placed on the NFT certificate.
    

In this situation, GAM would be authorised to tokenise the digital artwork, but would not be authorised to transfer that NFT to others. A solution could be to make arrangements with the website-owner and put royalties in place in the smart contract governing the NFT transaction.

An example of an illegal hyperlink is the Pirate Bay website, which links to files that can be illegally downloaded by end-users (e.g. the Stichting Brein/Ziggo case of the CJEU). In the Media/Sanoma case the CJEU concluded that the determination of whether the publication of an illegal link results in a copyright infringement requires an individual assessment. A decisive factor in this determination is whether the user wants to pursue profit through the use of this link. This criterion is easily met in the NFT marketplace, as NFT minters presumably enter the NFT market to earn money. Nevertheless, the contrary was true in the GAM example. Earlier this year, GAM stated in a press release that posting the artwork was a publicity stunt and that they did not intend to profit from the sale of these NFTs.

To conclude, the rising popularity of NFTs unfortunately means the danger of a potential copyright infringement is lurking in the background. Already, several artists have reported that their artworks were tokenised and sold as an NFT without their consent. Minters frequently act under various identities on the blockchain, making it nearly impossible to track them down and enforce any kind of legislation.

Takeaways

It remains to be seen whether the NFT boom of 2021 will continue. If the NFT is here to stay, its use will surely lead to many interesting legal challenges. Therefore, we suggest that NFT issuers and buyers follow these developments closely, as various regulators already have taken note of the rise of NFTs. We also expect interesting copyright-related disputes to arise which will provide further clarity on how to deal with NFTs.