Legal Structuring Guide for Issuing NFTs & NFT Distribution

August 11, 2022
TABLE OF CONTENTS

Legal Structuring Guide for Issuing NFTs & NFT Distribution

August 11, 2022

NFTs–Non-Fungible Tokens– are one of the hottest Web3 topics to trend in the last few years. In this article, we explore NFT use cases and examine the criteria for choosing the right jurisdictions and platforms for NFT distribution.

NFTs and their Use Cases

An NFT, or a Non-Fungible Token, is a blockchain-based digital representation of unique real-life objects, such as visual or musical art, videos, or digital in-game items. The idea of NFT tokens is not as new as many may think – it’s been around since 2014 when the first NFT was created. The market for NFTs peaked in 2021 when NFTs were being widely used to sell digital art.

The non-fungible nature of NFTs differentiates them from other virtual assets that are fungible. The “fungibility” attributable to most of the virtual assets is a two-fold characteristic:

  1. First, they can be traded or exchanged into another virtual asset or another asset, such as fiat money; and
  2. Second, they are always equal in value to one another. For example, no matter the exchange rate in a given pair, 1 BTC is always equally valuable to another BTC.
I still think “non fungible” sounds like it means “cannot be turned into a mushroom”6.7k rts 47.2k likes
Credit: Prof. Michael Kinyon (@ProfKinyon)

This is not the case with NFTs, which due to their “non-fungibility” have a unique digital signature, hence they cannot be traded or exchanged. Additionally, NFTs are either one of a kind or one of the very limited run assets, so an NFT to a particular art object is not equally valuable to another NFT to a different object, even if the art was created by the same artist.

Works of art do not exhaust the use of NFTs, albeit it is what made them so popular. For example, gaming NFTs are records of ownership to in-game items, such as unique equipment or avatars, which can actually be transferred outside of their native game’s ecosystem to give them additional liquidity and can have value as a collector’s item. Another NFT use case that is growing in popularity is digital fashion, as unique virtual clothing that can be designed and modeled virtually can also be recorded in a blockchain, essentially wrapping it in an NFT. Some renowned fashion houses have already dabbled into the NFT x digital fashion trend, sometimes promoting it as a sustainable fashion concept, non-harmful to the environment.

NFT vs Tokenized Art

Some uses of NFTs might sound awfully familiar to another hot topic of the Web3 industry, asset tokenization. It can be especially difficult to draw the line between NFT art and tokenized art. There are, however, substantial differences.

Asset tokenization is essentially the process of converting (dividing) rights to a certain object into smaller pieces represented by tokens and recording them in the blockchain. This can be done to both regulated financial assets, such as securities, as well as real-life assets like immovable property, art, and precious stones and metals. The idea is to increase the liquidity of the object by fractionating and trading rights to it, even when rights to an object as a whole cannot be traded yet or that trade is complicated by regulatory requirements. Additionally, it allows to have a further geographical reach and attract smaller buyers than, for example, usual art auctions will.

For NFTs, the situation is drastically different. Despite only one token being issued per asset, holding an NFT does not normally give a person rights to the asset, such as a piece of art. When purchasing an NFT, buyers actually purchase the metadata associated with an object, not the object itself. Essentially, the holder of the NFT token has rights to a piece of code but not copyright to the art and definitely not the physical copy of it. The transfer of copyright rights via an NFT is possible, however, it has to be written in a smart contract and coded into the NFT itself. Otherwise, copyright is retained by the creator of the NFT.

Picking a Platform for NFT Distribution

To issue an NFT, the help of an NFT marketplace is needed. An NFT marketplace is an online platform that will take care of the technical side of issuing the NFTs (also known as minting) and selling them to buyers.

“When we were issuing our NFTs, the main goal was to make the whole process take as little time and resources as possible. We first wanted to accomplish this with our own landing page with a simple functionality with an exchange transaction through a third-party wallet, but this turned out to be not a very fast option. We ultimately decided to proceed with an NFT marketplace that has a lazy minting solution”, says Ilona Maklakova, Associate at Legal Nodes, who has recently launched her own NFT project to help Ukrainian women suffering from the effects of the Russian war.

Before actually interacting with an NFT distribution platform, a person must already have in their possession an object in regards to which the NFT will be issued, access to a cryptocurrency wallet, and have already chosen which blockchain they will use to issue their NFTs, which is most often Ethereum.

“Deciding on the protocol is definitely one of the biggest challenges in issuing NFTs. The platform we picked allowed us to use Ethereum, which has a high gas fee with high volatility, or to use Polygon. The problem with the latter is that it requires payments in MATIC, which is not too popular amongst the buyers”, Ilona explains.

Once a Web3 entrepreneur has finalized the choice for the protocol, consider also the following factors in picking the right marketplace for their needs:

  • How do the Terms and Conditions of the marketplace address the IP rights implications of the NFTs issued on it, their transferability, whether the IP rights are verified by the marketplace side if some person would like to mint the tokens, etc.;
  • For royalty-based business models, whether the marketplace will cut its own commission from each NFT sale or transfer in addition to the royalty that the issuer will receive from each secondary disposal. Either way, the royalties are debited automatically via a smart contract, so it should not trigger any escrow regulation for the marketplace but it is important that all of this is laid down firmly in the platform’s public documents;
  • For auction-related business models, whether the marketplace allows to organize auctions with the help of their technical infrastructure, and if so, whether the marketplace has an e-commerce license to allow the organization of auctions if it is required by the country of registration;The scope of information it provides to prospective buyers;
  • Whether it has a reliable user verification function;
  • Whether insurance is available for transactions to prevent fraud;
  • How convenient its UI/UX is and whether a price discovery function is available, as it can influence the marketability of the NFT; and
  • Whether it only supports multiple projects or if single projects are possible.

It might be a good idea to get in touch with other creators who have minted NFTs to similar objects in the past to learn about their experiences with the platforms they used.

Countries to Issue NFT Tokens

The legal status of NFTs is, perhaps, the least clear of all the different types of virtual assets. When issuing an NFT, consider choosing a jurisdiction that is both crypto- and IT/IP-friendly, as the sale of the NFT might have the transfer of some intellectual property (copyright) rights woven into the smart contract. Note, however, that the rights to the digital object itself will fall under the regulation of the country where it was created, not where the NFTs have been issued. This means that the country where the technical platform which was used for NFT minting is based, should be taken into account when analyzing legal and tax requirements which might be applied to the NFT transactions.

One of the potential candidates is the United States, as it is both home to the largest NFT marketplaces and has a clear testing mechanism that will allow the Web3 entrepreneur to be sure that the NFT is not a regulated asset, the Howey test. The NFT is likely to only be considered a security if it is marketed to users as means to receive a return on investments or if the asset tokenization/fractionalization model will be used. If it is simply a digital representation of the unique collectible item, it is unlikely to satisfy the Howey test, meaning the legal risks to the NFT issuer are quite low. Additionally, the U.S. IP framework allows the transfer of copyright partially or in full in a way that is open to interpretation, meaning it can in principle be done by a smart contract executing the sale of the NFT.

📚 Read more: Token Types, Their Legal Status, and Choosing the Best Jurisdiction For Token Issuance.

Another interesting country is the United Kingdom. It was recently reported that they are planning to issue governmental NFTs, which clearly makes the UK an NFT-friendly jurisdiction. While NFT businesses might need to implement AML requirements as NFTs could be qualified as “crypto assets ” or “works of art” under the AML regulation, there are, for now, no specific requirements that issuers must take care of.

Even in countries with specific VASP regimes, such as the Cayman Islands, NFTs are unlikely to be covered by the special regulatory regime for virtual assets, as they normally do not have payment or investment capabilities and have very limited trading capability other than gaming NFTs. For so long as Web3 entrepreneurs do not market their NFTs as a way to receive future profit, they will not need to obtain a VASP license on the Cayman Islands.

Structuring an NFT Distribution

If you are an artist, a game developer, or a digital fashion designer thinking about issuing and selling NFTs, consider the following:

  1. Whether or not you want to transfer copyright with the issue of NFTs;
  2. Whether the platform you want to issue your NFT on is reputable and its Terms and Conditions are detailed enough to adequately accommodate the business model of the marketplace, such as mentions of commissions, rights granted by an NFT, etc.; and
  3. Consulting a legal professional to make sure that your NFT distribution is not in violation of any law.

To learn more about countries and platforms for NFT distribution, book a Legal Discovery Session with one of the experts at Legal Nodes. During the session, you will get:

  1. An intro to crypto- and NFT-friendly countries;
  2. An intro to NFT legal design to better understand all the implications of issuing NFTs to your pieces of art, in-game items, or digital clothing; and 
  3. A checklist of actions to help you successfully issue and sell an NFT.

Disclaimer: the information in this guide is provided for informational purposes only. You should not construe any such information as legal, tax, investment, trading, financial, or other advice.

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