NFTs: What is an NFT and the legal issues around it?

What is an NFT?

NFTs, or “non-fungible tokens”, are unique crypto assets on a blockchain that cannot be interchangeable like a regular dollar bill. It’s ability to authenticate ownership over digital assets such as virtual real estate, artworks, and collectibles differentiates NFTs from fungible assets like Bitcoin.

What does “non-fungible” mean?

The term “fungibility” refers to goods or assets that are interchangeable and thus hold equal value. An example of a non-fungible good are baseball cards. Due to the unique aspects of that baseball card such as player, team, and game statistics, these cards hold different values and cannot be interchanged with any other baseball card.

Why are NFTs valuable?

An NFT itself is not the digital asset but rather represents an asset. Its representation is where the value of NFTs come from. The NFT guides you to the digital location.

NFTs reflect the authenticity of digital assets. It incorporate smart contract technology to be able to earn money from NFT creations and sales, as well as track exchanges on the open blockchain.

What rights do you have on an NFT?

In theory, an NFT establishes ownership or authenticity on the blockchain. What many people might not know however is that, when you purchase an NFT you are not actually receiving the intellectual property (IP) rights associated to the underlying digital asset it is linked to, but rather to the token itself.

It is thus important to do your diligence, analyze your purchaser rights, review the smart contract to that NFT, and check the source. To acquire copyrights to the work, it would be wise to speak with an expert on drafting licenses for both IP and copyright.

An individual can obtain a right to a copy of that digital asset, obtain an access right to the digital asset linked to the token, or can obtain an IP or copyright license. Most of the time, a purchase is only buying a license that grants only limited rights to use that digital asset.[1] You are not purchasing title.

How do NFTs work?

The NFT certifies ownership and authentication for exchanges. Most NFTs use ERC-721 and ERC-1155 standards to issue digital assets using smart contracts. A record begins at creation of the token and incorporates each future sale. Smart contracts can also be used to ensure the creator continues to profit from each sale as the token is bought and sold. Being able to purchase and resell an NFT for profit or gain royalties off of the sale can be seen as an investment.

How do NFTs relate to cryptocurrency?

Cryptocurrencies are different than NFTs. Because NFTs are build using similar technology such as Ethereum and because NFTs exist on an open blockchain, people get confused.

How do I buy and sell NFTs?

First, you will need to sign up to a crypto exchange such as Binance or Bitbuy. Once you have an account, you can buy crypto or Ethereum.

Second, you will need to obtain a crypto wallet. Consider installing Metamask wallet as well as a hardware crypto wallet if you will be making large purchases. Connect your hardware wallet to the Metamask wallet and then you will be able to send your Ethereum or another cryptocurrency to the wallet.

Third, you need to connect your Metamask wallet to an NFT marketplace such as Binance or Opensea to begin buying, selling, and trading NFTs.

Some platforms will allow payment of credit card or crypto. It is important you look into the currency accepted and well as the method of payment.

Popular digital-artwork NFTs can be found on marketplaces such as Rarible, NiftyGateway, or NBA Top Shot.

Are there any issues to be aware of when minting an artwork?

One facet of Intellectual Property that is most implicated with NFTs are copyrights for aspects such as rights, personality rights, moral rights, logos, and trademarks, etc.[2]

As an artist, to be able to mint one of your works, you may need a license or validate that you are the copyright owner. Considering many NFTs have licenses associated to them, an individual breaching that license by making a copy, trade distributing, or selling that digital asset may infringe copyrights.[3]

Is there risk of fraud?

Purchasers of NFTs may not know exactly what they are buying and thus resell that NFT with inaccurate information (for example, information on IP ownership).[4] This may pose a risk for fraud or obtaining counterfeits.

As anonymity can be upheld in the blockchain, there is risk of fraud that purchasers of NFTs should be aware of.[5]

A fraudster may mint an NFT that is not their own work and without permission from the original creator. An individual may also lie or misinform that they own copyright to the underlying digital asset when in fact they do not.

It is beneficial to conduct your due diligence and read the marketplace’s terms of use to see if there are any provisions to buyers and if you are subject to limitations of liability. Additionally, one should consider only buying NFTs from reputable sources or creators to help mitigate the risk of fraud.

What legal or regulatory framework applies?

NFT marketplaces allow for individuals to trade, buy, and sell globally. Consequently, it is important to look into the regulatory or legal framework of different jurisdictions on the treatment of NFTs. The growing popularity of NFTs will require further development of regulations as our current frameworks may be insufficient. 

There are unknowns of whether our current legal framework can sufficiently protect consumers and whether cryptocurrency can be classified as a good to be sold or imply conditions of title.

How do I know if I am dealing with a security?

The Canadian Securities Administration (CSA) released Staff Notice 46-308 which covers the Securities Law Implications for Offering Tokens. The Notice highlights when the offering of tokens can be constituted as a distribution of securities and urges businesses to assess the economic realities of that offering and whether the transaction is considered an investment contract. It becomes especially important when investors obtain a high risk of loss with such an investment in the NFT.

The offering of tokens may involve a distribution of securities if:

• The offering involves delivery of an investment contract.
• The offering of tokens being issued are securities under one or more of the enumerated branches of the security definition or not covered by the non-exclusive list of enumerated categories.[6]

To determine whether an investment contract exists, ask the following questions about the offering:

1. Is there an investment of money?
2. Is it in a common enterprise?
3. Is there an expectation for profit?
4. Is the profit coming significantly from the efforts of others?[7]

An offering of tokens can be done in multiple steps. The OSC staff have generally seen the following two steps.

Step 1: The purchaser agrees to provide money for the right to receive tokens at a future date (There would be no token provided at the time of purchase).

Step 2: The token is delivered to the purchaser and the issuer is agreeing that the token is now functional.

At Step 1, there is generally a distribution of a security because there is a right to a token in the future. In Step 2, the OSC states that the token is still a security despite it having some form of utility. This may be because it holds security-like attributes (e.g., profit-sharing interest) or involved an investment contract.[8]

What do I need to know if it is a security?

1. Prospectus requirements are involved in the distribution of a security. However, an issuer may meet the conditions for a prospectus exemption.
2. You may encounter resale restrictions is the security is subject to capital-raising prospectus exemptions.
3. You may be subject to dealer registration requirements if you are trading securities.[9]  

It is important that individuals are businesses consult with securities representatives of their jurisdiction before partaking in the offering of tokens to ensure compliance with Securities Legislation.

A special thank you to Maria Kavanagh for her help and contributions to this article!

The content of this article is written for general information purposes only and does not constitute specific legal advice. This article should not be used as a substitute for competent legal advice from a licensed lawyer. Please contact us at 416-238-5527 if you’d like to speak to an Emerge Law lawyer.

Citations

[1] Sackman, N. (2021, August 12). NFTs and intellectual property. NH Business Review. https://www.nhbr.com/nfts-and-intellectual-property/

[2] Copyright Act, R.S.C 1985, c.C-42, s 14(1), 14.1(1).

[3] Copyright Act, R.S.C 1985, c.C-42, s 27.2.

[4] Chugani, S. & Levine, T. (2021, April 15). The Notorious NFT: Consumer Protection Issues Raised by Non-Fungible Tokens (NFTs). Practical Law Finance. https://ca.practicallaw.thomsonreuters.com/w-030-4989?transitionType=Default&contextData=(sc.Default)

[5] Roe, K., Whittaker, C., Jewell, D., & Thiel, S. (2021, October 18). Non-fungible tokens: What are the legal risks? DLA Piper. https://www.dlapiper.com/en/us/insights/publications/2021/09/non-fungible-tokens-what-are-the-legal-risks/

[6] Canadian Securities Administrators, “Staff Notice 46-308: Security Law Implications for Offerings of Tokens” (June 11, 2018).

[7] Canadian Securities Administrators, “Staff Notice 46-308: Security Law Implications for Offerings of Tokens” (June 11, 2018).

[8] Canadian Securities Administrators, “Staff Notice 46-308: Security Law Implications for Offerings of Tokens” (June 11, 2018).

[9] Canadian Securities Administrators, “Staff Notice 46-308: Security Law Implications for Offerings of Tokens” (June 11, 2018).