What you need to know before purchasing or selling an NFT in the United States

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If more people strive to build and participate in NFTs, here is what you should know about them.

Nonfungible tokens tend to be a feasible term. NFTs, which were originally designed for use in collectable trading card games, can now represent virtually any one-of-a-kind asset. Outside of the gaming sense, CryptoKitties, which was launched in 2017, was most likely the first NFT to achieve mainstream attention.

CryptoKitties became so popular that at one time, CryptoKitty trading clogged the Ethereum network, setting records for transaction volume. NFTs have only grown in popularity since then, and have now been developed for a range of in-game assets, digital collectibles, unique artworks and more.

The “Non-Fungible Yearly Report 2020” demonstrates the phenomenal growth of NFT transactions, showing an increase in market capitalization of NFTs from $141.5 million in 2019 to $338 million in 2020.

This comment focuses on NFTs associated with creative works of art. At this point in time, by far the most famous of these is “Everydays: The First 5000 Days,” a work created by the digital artist known as Beeple. That work was auctioned off by Christie’s in the form of an NFT for an astonishing $69.3 million on March 11, 2020.

However, more affordable NFTs in images, paintings, photographs, songs, videos and other creative works are also being made available. For a recent example somewhat less eye-catching than Beeple’s sale, popular artist Grimes raised about $6 million selling NFTs based on 10 pieces, some of which have thousands of copies available. The sale included NFTs for 700 copies of two pieces consisting of a short video and original music for $7,500 each, as well as a single NFT for a unique video and accompanying original song that sold for approximately $389,000.

However, before anyone decides to get in on the action and start selling or buying art in the form of NFTs, it is important to have a basic understanding of what these transactions actually involve.

The information presented here is very general in nature, and this comment relies on United States federal law. The laws in other nations and some states (most notably California) may be more or less restrictive on what the purchaser of an NFT might be acquiring and the relative rights and obligations of the buyer and seller. It should, of course, be understood that this general information is no substitute for individualized legal advice, which is still a good idea.

What is an NFT?

First and foremost, it is likely that the parties to any agreement concerning an NFT have a basic understanding of what they are dealing with. To begin, an NFT is a crypto asset, but it is not the same as Bitcoin (BTC), where each BTC is interchangeable with any other BTC. The term “nonfungible” refers to the fact that each NFT is distinct, encoded into the underlying blockchain with special metadata that separates it from any other token, even though the underlying work of art is the same. Each NFT’s ownership is already monitored on the blockchain, and the programming code specifies how ownership is checked and if transfer conditions have been met. However, no two NFTs are similar.

As is the case for other kinds of crypto assets, NFTs can be supported on a number of different blockchains, including Ethereum, Flow and Wax. However, certain NFT markets are compatible only with specific blockchains, which can have commercial implications for the seller and anyone who is buying with an eye toward the possibility of appreciation in value over time.

This comment is focused on NFTs based on an underlying work of art, and so the obvious question is what a seller is actually conveying or a purchaser is actually acquiring along with the NFT.

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Sales of art in conventional transactions

Consider what happens when a person purchases a one-of-a-kind work of art, such as a painting, from the artist outside of the digital context. When an artwork is purchased, ownership of the actual object is usually transferred. The buyer can then own and exhibit the artwork, however his or her rights are restricted. The customer retains the artwork but not the “intellectual property” connected with it.

Although this may surprise some people, absent agreement from the artist either at the time of acquisition or later, purchasers cannot make and display or distribute copies of the painting; they cannot make derivative works from it; and in many cases, they cannot materially alter or destroy the painting. Section 106 of the U.S. Copyright Act limits purchasers’ ability to reproduce and distribute or to make derivative works based on their purchase, and the Visual Artists Rights Act protects an artist’s “moral rights” in certain visual art that is released as a single original or with fewer than 201 signed and consecutively numbered copies.

As is always the case when it comes to the law, the direct execution of these laws is much more difficult. In certain cases, the underlying copyright is not retained by the artist. This would be the case, for example, if the job was done for hire or if the artist expressly signs away their copyright or “religious rights” to the customer. Furthermore, copyright immunity expires (albeit not until 70 years after the death of the artist).

Finally, not all “visual art” is covered by the federal Visual Artists Rights Act, and the only rights that the artist can sue to enforce under that act are the moral rights of attribution and integrity, as explained in the legislation and interpretation judicial opinions. Creative arts that are not visual in nature, such as songs, are not covered by the act at all.

Remember that this discussion applies only to the U.S., as rights in other countries may be significantly different.

What does an NFT based on an underlying work of art include?

How does all of this apply in the case of an NFT based on an underlying work of art? Of course, the purchaser of an NFT would own the unique token associated with the underlying creative work. Depending on a variety of factors, that might or might not give the purchaser rights in the underlying artistic content.

In general, underlying copyright moves only if the owner gives written proof of intent to transfer those rights. This means that the NFT purchaser must seek authorisation from the vendor to take photos or make copies of the underlying piece of art, or to produce derivative works from it. A customer acquires only a non-exclusive licence to view the associated media in their token wallet for personal uses in the absence of sufficient facts to the contrary. There is no right, for example, to use the media in other items, websites, or digital channels.

This is all subject to contrary agreement. For example, with regard to the $69-million auction of Beeple’s NFT for “Everydays: The First 5000 Days,” the purchase reportedly included some display rights in the image, but the artist retained the copyright. There is no public evidence that the artist agreed not to retain or make additional copies of the digital image or its component parts.

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How to make sure the transaction works as the parties expect?

The only way to insure that the parties to an NFT purchase transaction express and receive the protection that they demand is for everyone to do their homework. The purchaser should conduct research and be confident in the authenticity of the NFT’s developer and the network by which the NFT is being transferred. Both sides must negotiate on, create, and review relevant documents detailing just what the author has kept, what has been moved, and any current obligations related to the underlying artistic work.

From the purchaser’s view, it is vital to examine the NFT’s maker or vendor because it is completely plausible for sham firms to post that they have produced NFTs for sale when they do not have the legitimate right to do so. It is conceivable that they are misleading about the nature of the NFT (instead relying on a digital image unrelated to any blockchain), that the NFT is attached to a separate blockchain that they do not control and cannot pass, or that the art on which the NFT is based does not legitimately belong to them and instead infringes on the copyright of another party.

In these cases, a buyer will want to know that there is a viable company on the other side of the transaction from whom rescission or damages can be sought. In addition, buyers might want to be sure that the party on the other side of the transaction is not selling NFTs to support illegal activities such as terrorism or human trafficking, and the way to do that is to investigate the seller of the NFT and the platform on which it is hosted.

Concerning the remaining concerns raised above, the safest way forwards is for the parties to enter into a formal arrangement outlining each party’s understandings and responsibilities. Dapper Labs has developed a public blueprint for an NFT License as a starting point, and currently requires version 2.0 of a manual for consideration by artists interested in selling NFTs. The Dapper Labs prototype provides vocabulary that sellers can use to outline the rights they plan to pass or licence to the NFT buyer. The sample form offered by Dapper Labs specifically distinguishes between the token and the underlying creative material.

The suggested language gives the purchaser of an NFT two things: (1) a personal license permitting the purchaser to display or use the underlying art, and (2) a limited license permitting commercialization of the underlying art in merchandise created by the purchaser, so long as the purchaser does not exceed $100,000 in gross revenues per year as a result of such commercialization.

The prototype offered by Dapper Labs only includes recommended words, and the agreement can be tailored to fit the needs of both the seller of the NFT and the buyer. It is critical to precisely express which privileges are being passed as well as the restrictions of any licences issued. One possible starting point is the Dapper Labs variant. A quest for NFT sample contracts or NFT sample models on the internet can have links to alternate vocabulary for consideration.

This is not, of course, a substitute for legal representation. Particularly, if a sizable purchase is contemplated, or the buyer is anticipating sizable revenue from commercialization of the underlying artistic content, personalized legal advice is highly advisable.

Can this be solved by the NFT’s smart contracts?

To be connected to creative content, an NFT must hold specific knowledge about the interactive work within its programming. In theory, the entire creative production, whether it be a visual picture, animation, poem, or any kind of work, should be used as part of the programming code that makes up the NFT. Unfortunately, this will necessitate holding a large volume of data “on-chain.” Because of the expense and time involved in moving assets of that scale, this is inefficient on most blockchains.

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Since on-chain storage is impractical, this means that the creative work must be stored elsewhere, such as on a web server. The NFT’s code would then refer to the online web address, but this also means that the underlying digital assets are not safely stored on the blockchain, but rather off-chain.

Of course, other words may be used in the programming code, specifying, for example, what privileges are to be exchanged and when extra payments will be needed. At the moment, though, there is no means for these to be self-executing, and most purchasers will be unable to be able to validate the contents of encoded clauses. As a result, the need for a paper like the Dapper Labs prototype remains unchanged.

It can also be remembered that, since the underlying creative material is unlikely to be embedded in the NFT programming, there are certain unanswered issues, such as how to guarantee that the multimedia content is properly and consistently hosted in a retrievable manner by the purchaser. There is no way to defend against the possibility that the digital art will become unavailable if the domain address is updated or the server goes offline unless there is a constitutionally enforceable requirement.

Again, the most possible option is to provide sufficient paperwork guaranteeing that the NFT’s original vendor either assumes a legal duty to host the digitised artwork so that it remains intact and available to the purchaser or passes the domain name and the obligation to retain access to the purchaser. If the creator holds the duty to run a website, the obligation must be binding in order for future purchasers to impose it against the original seller.

Technological advances are likely to offer additional solutions to these kinds of issues at some point in the future, but if those alternatives are being relied upon, that should also be in the agreement transferring ownership of the NFT in question.

Conclusion

This statement does not purport to include an exhaustive list of possible concerns to consider before selling or investing in an NFT. For eg, there would be federal and potentially state income tax concerns to remember, as well as sales or use tax ramifications in many American states.

Furthermore, purchasers must consider the significance of taking appropriate security measures after buying an NFT.

If NFTs become more common, it is likely that more people will want to build and invest in them. Given the popularity of NFTs focused on creative works, it is possible that many NFTs will have this kind of underlying asset. This statement is intended to provide additional insight for both sellers and buyers in the NFT industry, since they all need to know what they are getting themselves into.

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