Legal challenges of "non-fungible tokens" (NFTs)

Legal challenges of "non-fungible tokens" (NFTs)

NFTs will lay the foundations for a new class of assets. We shed light on the legal framework and provide tips for implementation.

On 11 March 2021 the prestigious auction house Christie's sold a work of art called "Everydays: The first 5000 days" by creator Mike Winkelmann (known professionally as "Beeple") for the equivalent of USD 69,346,250.

The special thing about it was that not one single drop of paint was used for the work and the original only exists as a digital signature in the blockchain as what is known as a non-fungible token or "NFT". And who was the purchaser? What we know so far is that it was an anonymous art lover with the pseudonym "MetaKovan" who, on his Twitter account, refers to himself as a "Crypto Native". What currency was used to pay for the work? Ether, a cryptocurrency based on the Ethereum blockchain.

However, "Everydays" is only the tip of the iceberg of a market for NFTs which has been developing parabolically since the beginning of 2021: other unique items such as short video sequences of NBA basketball games (NBA Top Shot) or digital trading cards are now also sold digitally as NFTs to collectors. While writing this blog, the very first tweet by Twitter founder and CEO Jack Dorsey (content: "just setting up my twttr") was auctioned off as an NFT for USD 2.9 million. The band Kings of Leon is also offering limited NFTs to accompany its new album giving fans VIP rights for the next concert tour (e.g. front row seats) and even virtual real estate in computer games such as Decentraland is currently being sold as NFTs for five to six figure sums.

Reading these headlines, the following questions inevitably arise: what are these non-fungible tokens, how can a digital signature on a blockchain be worth USD 69 million and what legal issues are there in this connection?

The technology behind NFTs: blockchain

Non-fungible tokens, like their counterpart "fungible tokens" (e.g. Bitcoin or other cryptocurrencies), are based on blockchain technology.

It is best to imagine the blockchain as a continuously expanding list of data records in which each new data record (block) is linked to the respective preceding block by mathematical-cryptographic functions. This linking ensures that all earlier blocks in the chain are immutable, i.e. tamper-proof.

The blockchain is not stored in a central data centre or "in the cloud" like traditional data hosting but decentrally on distributed computers (nodes). The fact that all nodes always store the same data is achieved through incentive mechanisms based on game theory: only those who join the majority and follow the rules are rewarded. The stability of the blockchain and the addition of new blocks are ensured by what are referred to as "miners" who provide computing power and are remunerated with "coins", i.e. digital money in the currency unit of the respective blockchain. This decentralised storage and verification of information is not actually an invention of the crypto world but existed in the analogue world as what is referred to as distributed ledger technology long before blockchain technology existed.

The tamper-proof storage of information, which is also fail-safe due to decentralisation, in the blockchain is known to the general public mainly through the cryptocurrency "Bitcoin" which is used for storing payment transactions in the blockchain (in the sense of: which participant is transferring how many Bitcoins to which recipient?). In the meantime, however, there are numerous other blockchains, such as Solana, Ethereum or Polkadot, which differ significantly from the Bitcoin blockchain in technical terms and are much more suitable for a wide range of different purposes.

Tokens: fungible and non-fungible

The digital units stored on blockchains are called tokens; the legislator usually uses the term crypto value for this (section 1 (11) sentence 4 German Banking Act (KWG)). Cryptocurrencies such as Bitcoins or Ether are an example. Tokens can be used by anyone who has what is known as a "private key" (comparable to your online banking PIN/TAN). This corresponds to the public key (comparable to an IBAN). Since the private key is highly confidential, it is usually stored in what are known as a "wallet" which facilitates user-friendly access.

Anyone who overcomes the obstacle of embodying rights in such tokens, similar to the act of documenting a deed, has succeeded in making such rights "tangible" and tradable. This is referred to as "tokenisation": a particular right is owned only by the holder of the corresponding token. This concept is the basis of the much-discussed security tokens as well as of the German Act on the Introduction of Electronic Securities and Crypto Securities (eWpG) and, of course, of NFTs.

A distinction must be made between fungible and non-fungible tokens:

• Fungible means "interchangeable" and refers to tokens which exist in indeterminate or at least in larger numbers in the same form, i.e. do not differ in content from other fungible tokens of the same kind. The most prominent example of fungible tokens are Bitcoins: 1 Bitcoin belonging to user A is equal to the Bitcoin of user B: the two are freely interchangeable. Euro coins, for example, would also be fungible in this respect (even if collectors would probably object that some rare years or minting errors make inpidual coins non-fungible). Fungible tokens can therefore ultimately also be defined as "replaceable" tokens, based on section 91 German Civil Code (BGB), with the exception, of course, of the fact that section 91 German Civil Code (BGB) requires the "object" to be a "physical object" in accordance with section 90 German Civil Code (BGB).
• Conversely, non-fungible tokens are tokens which are not freely interchangeable because they are unique, i.e. they only exist once within a blockchain. The first non-fungible tokens appeared as early as 2012 when what are referred to as "coloured coins" were introduced into the Bitcoin blockchain and other assets could be exchanged between users for the first time. In the ensuing period NFTs were mainly used in crypto-based computer games, for example in the game "CryptoKitties", in which players could breed digital cats – unique ones, of course, like in the real world – and exchange them with other players or sell them.

Non-fungible tokens: hype or revolution?

Are NFTs only something for crypto nerds? Who else would spend several hundreds of thousands of dollars on a virtual country in a computer game?

Tokenising digital works actually makes perfect sense: while with physical works of art there is always one original and this can be distinguished from reproductions at all times, in the digital sphere there is, as yet, no counterpart in the sense of a "digital original". Digital works are freely reproducible as a matter of principle and copies always resemble the original 1:1. This is a problem which people have been attempting to resolve for decades through complex "digital rights management" (DRM). With NFTs "digital originals" can now be created and traded for the first time. In view of this, the impressive sum of 69 million still seems unbelievably high but, compared to the prices paid for physical works of art, it no longer seems quite so absurd. Although "tokenising" a work of art as an NFT cannot prevent numerous copies of the artwork from existing on the internet and being downloaded, it can still ensure that there is only one original and that it is assigned to one inpidual person.

The scope of NFTs is not limited to virtual worlds either, however. In principle, all assets in the real world can be "tokenised", either as fungible tokens (where one asset is pided into several tokens of the same kind) or as non-fungible tokens (either where there is only precisely one token for a certain asset or where an asset is parcelled into several different tokens). It is therefore not surprising that numerous crypto start-ups are currently in the starting blocks waiting to do just that: from tokenising football stadium season tickets or concert tickets to tokenising real estate, classic cars or other high-value assets or rarities.

The legal issues surrounding the use of non-fungible tokens are perse

Legal disputes with NFTs are currently only taking place in specialist circles. Nevertheless, there are numerous legal questions, e.g. regarding financial law obligations, copyright law classification as well as challenges posed by civil, criminal and data protection law. The following merely provides an initial overview.

Prospectus and licensing obligations under financial law

One of the decisive questions when trading in crypto-assets is whether prospectus or licensing obligations under financial law must be observed. In the past, the German Federal Financial Supervisory Authority (BaFin) has frequently issued information letters on the classification of "Initial Coin Offerings" (ICOs). However, as yet, there are no statements on NFTs.

1. Prospectus obligations under the Prospectus Regulation

There are prospectus obligations under the European Prospectus Regulation (REGULATION 2017/1129) if tokens must be classified as securities. A prospectus obligation means that a securities prospectus must be published before the security is offered to the public for the first time in order to transparently inform investors about content and risks and to enable them to make informed decisions. However, there are numerous exceptions to the prospectus obligation which are particularly interesting for young start-ups.

Art. 2 (a) Prospectus Regulation in conjunction with Art. 4 (1) (44) Directive 2014/65/EU (MiFID II) defines securities on the basis of various examples, none of which seem to cover NFTs, however, as NFTs are often structured in such a way that they are neither shares nor bonds and most certainly do not embody membership rights or promise pidends.

The definition also establishes that transferable securities are only

those which are tradable on the capital market, with the exception of instruments of payment.

The fact that "tradability" requires a minimum degree of standardisation, i.e. that several tokens with identical properties and rights exist which (according to the German Federal Financial Supervisory Authority (BaFin)) are

comparable with one other in the sense of a "class"

would initially seem to argue against the Prospectus Regulation applying to NFTs. The explanatory memorandum on the German law implementing the former European Prospectus Directive has already emphasised in this respect that fungibility is the decisive factor for the term "securities". However, one will also have to take into account in this respect that "the inpidual NFT" is indeed tradable.

In practice, however, sales of NFTs are often not subject to the prospectus obligation because they are expected to have a very high sales price and are therefore not offered for less than EUR 100,000 (Art. 1 (4) (c), (d) Prospectus Regulation).

2. Investments under the German Investment Products Act (VermAnlG)

Similar arguments apply to qualifying NFTs as an investment within the meaning of the German Investment Products Act (VermAnlG), even though the minimum threshold under this Act is not EUR 100,000 but EUR 200,000. In addition, however, investments under the German Investment Products Act are also not tradable, which is typically the case with crypto-assets, as tradability is indicated here by the fact that they are transferable.

3. Licensing obligations under the German Banking Act (KWG)

There may also be licensing obligations for services related to NFTs as NFTs can be qualified as financial instruments in terms of section 1 (11) German Banking Act (KWG) if they are transferable and tradable. Besides, an acceptance as a "means of exchange or payment" is required as the decisive criterion for crypto assets, and the German legislator also considers tokens which are only held for "investment purposes" to be financial instruments. It remains a case-by-case decision whether NFTs fall under the term “financial instrument”. In particular if they are unique and thus non-fungible, there are reasons to argue that the statutory requirements are not met. NFTs can therefore be unregulated.

The most important implication would be that anyone brokering investments in NFTs requires a licence for investment brokering (section 1 (1a) sentence 2 no. 1 German Banking Act (KWG)). Proprietary trading in NFTs or acting as a custodian would also require a licence.

Copyright: is there a right in and to create an NFT?

There are also a number of copyright questions which need to be answered in the contracts. For example, questions concerning how NFTs are to be classified in the catalogue of types of use and which rights are to be transferred to a buyer when an NFT is sold.

One possibility would be that creating an NFT of a work protected by copyright and putting it on the market requires an (as yet) unknown right of communication to the public within the meaning of section 15 (2) German Copyright Act (UrhG). However, this classification is by no means mandatory; it is just as conceivable that NFTs have no copyright relevance at all, but that the (possibly ownership-like) proprietorship of the "digital original" must be considered in isolation of any copyrights. In this respect buyers of physical paintings also only acquire the right to freely enjoy the work. If one follows this view, however, the question arises as to how an author can then take action against an unauthorised third party presuming to create and put into circulation an NFT of a copyrighted work.

If one follows the view that NFTs constitute an unknown right of communication to the public within the meaning of section 15 (2) German Copyright Act (UrhG), the follow-up question arises of who is entitled to this right. It is clear that such a right initially lies with the author but what about works with respect to which the exclusive rights of use have already been assigned to publishers or music labels? In such cases it is important to check whether the right to create NFTs has also been transferred, for example on the basis of wording providing that rights "in all known and as yet unknown types of use" are transferred (caution: written form requirement, section 31a (1), sentence 1 German Copyright Act (UrhG)).

Creators and buyers of an NFT must think about the rights to the digital original

Of particular interest to the buyer of an NFT is the question of what rights he actually receives to the "digital original". Property rights only exist for (physical) objects and therefore not for digital works. The only possible rights in this respect are rights of use but they must be granted inpidually.

The rights most similar to property rights are "exclusive rights of use, unrestricted in terms of time, territory and content, which can be sub-licensed and leased". These could be supplemented by editing rights or various types of use, such as the right to print on paper.

It is to be expected that the NFT industry will soon come up with standards here so that it is clear to all buyers at a glance what they are actually buying. Finally, from the investor's point of view, a third party suddenly acquiring "the same original" but with different rights of use (delimitation would be possible, for example, on the basis of territory) needs to be avoided.

A further facet of NFT: copyright law generally provides that authors may participate in any subsequent increase in the value of their works (section 32a German Copyright Act (UrhG)). In the case of traded NFTs, this is highly likely. It would be necessary, for example, to allow authors to automatically participate in increases in the value of their works when NFTs are resold, by automatically transferring a portion of the sales proceeds or the increase in value to the author through smart contracts.

Civil law and criminal law: NFTs revisit question of data ownership

In terms of civil law NFTs will once again lead to a new discussion about "data ownership". Even if objects in the sense of section 90 German Civil Code (BGB) can still only be physical objects and actual "data ownership" is therefore not possible, even in the case of NFTs (this will only change after the German Act on the Introduction of Electronic Securities and Crypto Securities (eWpG) comes into force, section 2 (3) of which defines tokens with bearer bonds as objects), the question still arises of whether NFTs could not at least be classified as "other rights" under section 823 (1) German Civil Code (BGB). This would be particularly helpful if one follows the view that, even though NFTs do not enjoy copyright protection, owners of NFTs still want to defend themselves against the unauthorised creation of another, identical NFT or against any other interference with their rights in the NFT.

Recognition as "other rights" under section 823 (1) German Civil Code (BGB) requires a legal interest to have at least ownership-like status, i.e. it must especially satisfy the "allocation and exclusion function" of property. This is the case when a legal interest can be assigned to a clear inpidual person simultaneously excluding all other persons from using the legal interest. For ordinary computer data this has so far been negated, among other things, on the grounds that data stored on a computer are freely reproducible as a matter of principle and a copy cannot be distinguished from the original. This led to data not being considered to have an exclusion function, at least. The situation for NFTs could now be different if, as unique digital objects, they only exist once and can also be clearly allocated to a holder/wallet.

This discussion must also be continued in criminal law from the perspective of section 303a German Criminal Code (StGB) and it must be clarified whether NFTs constitute "data" within the meaning of this norm and who is then considered to have the power of disposal over these data.

Data protection law also an issue for NFTs

Most blockchains are publicly visible, i.e. transactions can be tracked by anyone. The participants are only pseudonymised, not anonymised, which means that the GDPR can apply in principle.

Especially because there are already numerous analytics services which evaluate blockchain and especially Bitcoin transactions and can therefore even create profiles of investor behaviour, data processing on a blockchain should not be neglected from a legal perspective. However, most of the problems can be overcome through appropriate contractual provisions and additional technical measures.

NFTs are the future but legal regulations must be kept in mind

We will encounter NFTs in many forms in the coming years and they will raise numerous legal questions. In order to protect investors, in particular, from there being "multiple originals" of a work, it is important to supplement the contracts with investors with suitable clauses specifically drafted for NFTs. Financial regulations must also be kept in mind so that service providers do not fall into the trap of incurring a fine.

NFTs are undoubtedly laying the foundations for a new class of assets.