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Legal Review: Non-Fungible Tokens

Winston WONG

25 November 2021 – It has been 12 years since the concept of blockchain was conceived and 2 years since Singapore’s legislation governing cryptocurrency and exchanges came into force. It is a good time to take a breather and review how far we have come. Cryptocurrency had gained apparent widespread recognition as Statista, a German company specialising in market and consumer data, reports circa 100 million unique cryptoasset users as at 3Q2020 though by its very nature it is not possible to know how many actual unique users there are and how many wallets are defunct.

The Non-Fungible Token

In this article we would examine some selected matters regarding the recent new asset class, the non-fungible token (NFT).

Some popular questions asked about NFTs are as follows:

  1. Are NFTs legal?
  2. What happens if the server holding my digital artwork is destroyed?
  3. Do I have legal ownership over the underlying asset represented by my NFT?
  4. Can I resell my NFT?
  5. What happens if the seller sells me a fake NFT?

Are NFTs legal?

Firstly, question one: Are NFTs legal? For the majority of countries that choose and feel the need to regulate blockchain-backed assets, the areas of concern are the variations and degrees of the following:

  • Is the blockchain-backed asset a cryptocurrency? The exact definitions vary significantly, but the ballpark distinguishing factor is whether the nature of the stored value is closer to a playground token that you use to purchase rides, or a rewards point, or is it closer to being real money, where you can use to buy anything, or its ability to be exchanged into fiat currencies. The main consideration here is that playground tokens do not need regulation, but cryptocurrencies need to be watched more carefully.
  • What is the volume of transaction per unit time in terms of dollar value? Here, the larger they are, the wider the fallout.
  • Type of operation: Are you operating an exchange, or a wallet, or something else? If you are operating an exchange, do you trade only cryptocurrencies or do you also facilitate exchange with fiat currencies?
  • Capital backing: Depending on the answers above, the governing body may impose capital requirements for accountability.

Jurisdictions that choose to regulate cryptocurrency generally do not regard NFTs as illegal assets. We feel that the regulation of NFTs have not matured and there is scope for expanded regulation though it will not result in NFTs being outlawed. One pre-requisite market development for further substantial legal regulation is for the prevailing underlying asset for an NFT to go beyond the digital art market into regulated assets, like financial derivatives, synthetic instruments, real estate property, medicines, poisons, controlled substances, military weapons, etc, although there is no way of knowing whether these NFTs do in fact exist at this time. We feel that in the absence of a fraud causing wide distress in the international economy, or the knowledge of regulated assets being traded via NFTs, there will not be an impetus to proactively govern NFTs.

This is not to say that existing laws are inadequate to govern NFTs but one of the key challenges in regulating anything blockchain, electronic, or internet-based, is the inherent borderless characteristic of such transactions, as recently popularly illustrated by the case of the Binance exchange. Past experience will tell us that extraterritorial enforceability of any law is created not by the words of the law but materially by the will and influence of a country and relative power of the intended regulated entities.

What are my legal rights?

Technically, questions 2 to 5 are the same two questions: What legal rights do I have? How do I enforce my legal rights, if any?

In order to answer the above, there is a need to answer the question first: What is an NFT? An NFT is an electronic token that a person may own, which purports to evidence ownership of an underlying asset. For example, the NFT may have embedded a hyperlink to a particular digital image. This is the popular form of “digital art NFT”. Another possible application that is explored by various players is the use of the NFT to evidence real property title, and this would in theory allow real property to be traded with ease without the hassle of lawyers and in an instant.

The key technological feature of an NFT is that one is able to trace the chain of ownership back to the creator of the NFT, and that it is generally accepted that it is not impossible to create a counterfeit NFT. One may try to understand the nature of an NFT by likening it to a certificate of ownership that cannot be forged, and this certificate lists all previous owners till the time of conception.

With this we can now discuss the legal rights of an NFT:

What legal rights do I have when I purchase an NFT? You don’t really purchase the NFT. When you do make a purchase of an NFT-backed asset, you pay for one or more of the following:

1. The key characteristic of the NFT that is of value is appending and embedding the detail of your purchase to the blockchain. Hence, you pay for someone indelibly engraving you as purchaser of the token.

2. Legal right to own the underlying asset, assurances as to the economic value of the underlying asset, the right to resell the underlying asset, the assurance of the value of the underlying asset when the time comes to sell.

(a) Seller having ownership of the asset – let us take two examples here:
  • High value item, like a valuable piece of land. Traditionally, because a purchaser parts with a substantial part of his wealth, he will hire consultants like valuers (to ensure the land is worth what is demanded), lawyers (to conduct searches of land register, prepare contracts, babysit the process, and advise on risks), and specialty consultants (where the land is of a certain characteristic, like industrial land, to conduct environment baseline assessment). In the NFT context the key objective of the use of these advisors is to ensure the seller has title to the asset and the asset delivers the value promised by the seller. This could be because the purchaser wishes to exploit the asset or to on-sell the asset. It is prudent to retain the appropriate combination of consultants if the NFT you are considering to purchase fall into this category.
  • Low value item, like a souvenir. In the NFT context this could be low priced digital art that one purchases with a view to price appreciation. The usual considerations for this category are: the NFT may be possibly sold for a much lower price elsewhere, the NFT may be counterfeit, or the owner may sell multiple copies of the same item, or even not have the legal right to sell the asset. The key issue here is that it is not cost effective to do any type of investigation or expend any cost to assure its authenticity or value. Due diligence and asset quality assurance is limited.
  • Somewhere between the above. In the non-digital context, these are items like mechanical watches, a holiday to a faraway destination, or even an expensive medical procedure. These purchases, we typically conduct a fair bit of self-research and due diligence, consult trusted friends, and may take second opinions from professionals, but it is not cost effective yet to retain advisors and consultants, or conduct extensive paid searches. Majority of NFTs fall into this category.

If one wishes to be assured of ownership of an NFT, it is prudent to retain consultants, conduct research and investigations. What degree of assurance is needed for a particular NFT and steps you take to ensure that assurance really depends on which of the above categories a purchase falls into. Naturally, what is of intermediate value to one may be low value to others.

(b) Terms of the sale and purchase contract. In purchasing NFTs, it is common for terms and conditions to be either fixed (by the marketplace it appears on, or by the artists/owners/sellers themselves), or there could be no express terms and conditions. Traditionally, the key terms affecting title is the description in the contract what rights are actually conferred (limited licence, right to resell, obligation to pay commission to previous owners, etc), pre-conditions to passing of title, warranty of ownership.
(c) The underlying asset matching the description of what was promised. If there are written and express terms and conditions, this may be a function of the warranties of the description of the asset, warranty as to the fitness for purpose, obligation to maintain the URL of digital art.

3. The privilege of being able to enforce your legal rights when the need arises.

There are certain purchases do not come with this privilege, typically the purchase of a low value items, although in certain jurisdictions class actions exist. Next, there are purchases that do not come with this privilege because the seller is unknown, untrackable, uncontactable, or simply may become untrackable. Although the blockchain of an NFT contains an definitive list of identities of past owners such description is limited and even if a court of law may compel a marketplace (that itself is not without difficulty) to reveal details of a previous owner, these details may not be very useful if the marketplace is not required by law to effective KYC/AML verification. One of the key attractions of blockchain assets is anonymity. As such, a large majority of NFT assets fall into this category. If a seller is accountable, or reputable, the use of blockchain technology to facilitate the purchase transaction adds an additional layer of cost which may be unnecessary.

Talk to us

We hope the above is a useful primer of NFTs and the nature of the legal structure that surround it to seed thoughts and we hope you have found it of benefit to you. Please contact our team at Flint & Battery LLC if you wish to consult us. Flint & Battery LLC is an international law practice licensed by and registered with the Legal Services Regulatory Authority, and is the Singapore office of the Cicero international law firms.