Hand touching virtual globe

Anatomy of an NFT

United States Publication April 2021

Once relegated to the fringe of the crypto/FinTech communities, non-fungible tokens (NFTs) have recently exploded to the forefront of modern pop culture and are taking on an ever increasing number of forms—from collectible digital kittens, to sport highlights, to music albums, to pieces of art auctioned off by Christie's for US$69.3 million. But what, exactly, is a non-fungible token and how is it different from a fungible, or any other, token? How can the ownership of a tangible item be represented by an intangible token? What if the NFT is the asset and doesn't represent anything separate? If I own an NFT, do I really own the object it represents? Could I really turn this article into an NFT? Are NFTs regulated and, if so, how? These sorts of questions are extremely important for consumers, industry and attorneys alike—and, unfortunately, the answers to many of them are unclear and still being clarified.

What is an NFT, anyway?

NFT stands for non-fungible token. Fungible items, like a dollar bill or shares of Disney common stock, can be readily exchanged for other dollar bills or other shares of Disney common stock and you continue to own the same thing. The item's value defines it rather than its unique properties. Non-fungible items, on the other hand, are not interchangeable due to their unique properties. You cannot readily exchange one plot of land for another or one unique piece of artwork for another without owning something fundamentally different.

Like traditional cryptocurrencies, NFTs are created—or "minted"—on a blockchain using cryptography and can be bought and sold or otherwise exchanged on any NFT market based on the same blockchain. Smart contracts on the blockchain govern the terms of the NFT—who owns it, how it can be transferred and what exactly the NFT represents—making sure no two NFTs are exactly alike. Sometimes, the NFT exists on a platform that is governed by additional terms in a traditional contract. As with other tokens created on a blockchain, the blockchain tracks the transaction history of the NFT from issuance to any number of subsequent transfers and that record is immutable. This record, in turn, creates "provable" uniqueness and scarcity, and these concepts are what ultimately leads to value. NFTs, then, are essentially unique digital representations with blockchain based transferability, authenticity, and ownership properties.

Currently, much of the NFT market is created and exists on the Ethereum blockchain using one of two main standards—ERC 721 or ERC 1155. However, other projects are underway for developers to be able to create and issue NFTs on other blockchains such as Polkadot, Cosmos, and Flow, among others. Developers and consumers should keep in mind which blockchain is used to mint the NFT as many marketplaces will only work with certain blockchains, and once an NFT is minted on one blockchain, it likely won't be able to be moved to another blockchain.

Use cases

Sports

While NBA Top Shots has exploded recently selling millions of dollars' worth of digital basketball trading cards or "moments", NFTs have just scratched the surface of the sports world. Imagine an NFT that is linked to a ticket (or is the ticket) that provides access to a sporting event. Fans can be confident that they are buying a legitimate ticket to the event as all transactions related to that specific ticket will be verifiable on the blockchain. Even after attending the event, the holder of the NFT can continue to hold it as a collectible—you'll be able to say to your friends, with verifiable proof, "Hey look, I was there when the Eagles won the Superbowl!" Instead of hanging the original paper ticket on your wall, the NFT will be accessible digitally via an app on your phone or other device.

Taking it one step further, NFTs have the ability to effectively eliminate the illegal scalping market or at a minimum allow sports teams to accurately track sale prices and profit from secondary sales. An automatic royalty payment function can be built into the NFT. Whenever the NFT changes hands (i.e. whenever the ticket gets resold) the creator of the NFT (the sports team) receives a royalty payment automatically via a smart contract. This applies equally to concert tickets and really any ticketed event.

Fashion

In a similar vein, not only can NFTs be tied to tickets, but an NFT could be tied to an actual physical good. Take the collectible sneaker market for example. Today, consumers will wait in line outside a store for hours for a small chance at the opportunity to buy a new limited edition sneaker where only a handful have been created. These consumers then resell those shoes in the secondary market often for 10x or more times than what they paid to the manufacturer. An NFT tied to the shoe could not only prove authenticity, but again a royalty could be incorporated into the smart contract that pays the manufacturer a certain percentage of any secondary sale.

Real estate and automobiles

NFTs are also knocking at the door of the real estate market. A digital piece of real estate known as "Mars House" recently sold for US$500,000. Mars House can be experienced in virtual reality or augmented reality, but no house actually exists in the physical world. While there are many proponents in the space who believe augmented reality and "metaverses" are the future, NFTs also have their place in today's "real world" real estate. A plot of land can be tokenized by creating an NFT that represents the ownership of the land. All records associated with such parcel will be coded into the blockchain, and any subsequent purchaser will be able to easily see and verify the property records. As anyone who is familiar with land records knows, the current method for maintaining land titles on paper or scanned documents in a local office is extremely inefficient, difficult to search and fraught with opportunities for error or fraud. NFTs could help increase the accuracy and ease of use of these records, decreasing the friction in the market.

Similarly, an NFT could represent title to an automobile. Instead of a state's Motor Vehicle Commission acting as the central database, all vehicle transactions can be recorded on the blockchain (which could be government-sponsored) with the blockchain acting as the central database. Taking it a step further, imagine a not too distant future where self-driving cars are the main form of transportation. Instead of owning a car outright that you do not use all the time, you may co-own one of these vehicles with other drivers. An NFT could be used to represent that shared ownership and record the terms and sharing percentage, and usage, between the owners.

Gaming

Similar to the fashion industry where an NFT could be tied to a physical item, in the gaming world, an NFT could be tied to certain in-game items such as a character, a "skin" or a rare gaming asset. Each item could be uniquely coded that would exist in the gamer's account as long as the gamer owns it. It could even be transferred, traded or loaned to another account for a certain period of time. An NFT could also represent an accomplishment in a game—for example, you receive an NFT once you reach level 100.

Another example is with fantasy sports games. Games can collect NFTs that represent a certain player on a team. Once you collect enough NFTs, or players, you can field a team to compete against other teams.

Are NFTs securities?

Whether or when a digital asset is a security is a now familiar question (and one we have discussed previously), and NFTs represent just the latest iteration. The US Securities Act of 1933 established the list of regulated securities, tokens and cryptocurrencies are not on the list. Nonetheless, the litany ends with the term "investment contract," which the US Supreme Court determined acts as a catch-all to cover other assets that have similar characteristics to and function like securities. In the seminal case of SEC v. Howey, the Court provided a four-part, substance-over-form test for what constitutes an investment contract (and therefore, a security): (i) an investment of money (ii) in a common enterprise (iii) with an expectation of profits (iv) derived from the efforts of others.

Subsequent case law has also explained when an instrument that is not a security can become one. The Gary Plastic case teaches that an otherwise non-security asset can be packaged, sold or offered in a way that causes investors to have a reasonable expectation of profits from the efforts of others (i.e., in a way that forms an investment contract). Director William Hinman of the Securities and Exchange Commission's (SEC) Division of Corporation Finance gave a speech in June 2018 elaborating on this concept (read our analysis).

What is clear, however, is that a security is created when an investor makes a passive investment in a promoter's enterprise with the expectation of a return on investment. While the SEC has noted mere appreciation as a result of market forces may not result in the finding of an asset to be a security, an increase in value as a result of managerial efforts falls within the realm of Howey.

The answer to the question of whether an NFT is a security again depends on the facts and circumstances. If an NFT merely represents the ownership of an item such as a digital kitten, highlight reel, or videogame collectible—then it is arguably not a security. If, however, an NFT is promoted as a speculative investment, accompanied by the suggestion of a promoter that the NFT will increase in value as a result of the actions of the issuer or the promoter—then the NFT might very well be considered an investment contract and thus a security. For example, if a real estate developer decided to issue an NFT that represented an interest in a building yet to be built and the proceeds are used for development of the building, it would be hard to imagine this wouldn't fall under the jurisdiction of the SEC. It is also conceivable that an ostensibly non-security NFT could be sold or marketed in a manner that it may be deemed to be "wrapped" in an investment contract, thus making the whole package a security.

Further, the concept of "fractionalized" NFTs almost certainly falls within the realm of the securities laws. A fractionalized NFT exists where the NFT itself is held one place and other, separate tokens are issued that collectively represent ownership of the NFT. This shared ownership and investment in a single NFT held by someone else quickly begins to look like an investment contract, especially when the sale of the fungible tokens is accompanied by marketing or speculation. SEC Commissioner Hester Peirce has also recently urged NFT issuers to be cautious if they decide to sell "fractional interests in NFTs or NFT baskets" to consider compliance with securities laws.

If deemed to be a security, every sale of a token would either need to be registered with the SEC or be conducted under an exemption from registration under US securities laws. Any platform, exchange, or similar marketplace would also have to consider whether it, too, would need to register with the SEC.

Accordingly, it is important that the facts and circumstances of each NFT project be carefully analyzed to determine whether it is subject to the US securities laws.

What about commodities?

NFTs, like other digital assets, also raise possible concerns under the US commodities laws. The US Commodity Futures Trading Commission (CFTC) has taken a pretty strong position that virtual currencies like Bitcoin and Ether are properly defined as commodities for purposes of the US Commodity Exchange Act of 1936. A "commodity" includes all goods and articles, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in. Forward sales of commodities fall within the broad definition of a "swap," which are subject—absent applicable exclusions—to regulation by the CFTC and which includes numerous types of derivatives.

Generally speaking, a futures contract is "an agreement to purchase or sell a commodity for delivery in the future (i) at a price that is determined at initiation of the contract, (ii) that obligates each party to the contract to fulfill the contract at the specified price, (iii) that is used to assume or shift price risk, and (iv) that may be satisfied by delivery or offset."

Notably, the sale of non-financial commodities (which many NFTs may likely be) pursuant to a forward contract are excluded from the definition of swaps if the commodity is: (1) meant to be physically delivered even though delivery or shipment is deferred; and (2) the forward contract qualifies as a commercial merchandising transaction.

This begs the question of what "physical delivery" means in the context of an NFT and may have different implications whether the thing being delivered is an asset represented by the NFT or the NFT itself. The NFT could be a forward, future or swap even if its represented asset is not.

Intellectual property considerations

Just because you own an NFT tied to say a piece of artwork, does not mean that you have a full suite of intellectual property rights over that piece of artwork. The smart contract may (or may seek to) set forth all terms of the NFT, but it is likely the original creator (or their designee) will retain ownership of certain intellectual property—or at least that may be their intent. The creator may have the right to issue official copies or prints off of the original. The creator also may have rights over usage to protect its brand.

Recently, we have seen NFTs that have incorporated third party intellectual property rights without permission from the creator. Both Marvel and DC Comics (who are the owners of the intellectual property) in recent weeks have even sent notices to their artists stating that any offer for sale of digital images, whether as an NFT or otherwise, featuring Marvel or DC's intellectual property is not permitted.

As another example, when you purchase a "moment" (or video highlight) from NBA Top Shot, this is essentially only a collectible. You do not have the right to then copy and profit off of that "moment".

A common critique of NFTs is that the object they represent, like artwork for example, can be easily duplicated. "Why pay US$69.3 million for a piece of digital artwork represented by an NFT when you can just screenshot the artwork for free?" But NFTs provide provable uniqueness; and just like counterfeit goods will never carry the same value as the original, so too will original NFTs always carry more value. Like anything else, the value of an NFT is what the market says it is—which ultimately means what someone is willing to pay to own the NFT rather than a copy.

Other legal considerations

Whether NFTs are considered securities, commodities, or something else, there still must be compliance with the US consumer protection laws—both federally and at the state level. Even though a sale is happening digitally (both the sale and the actual "item" of value are digital), sellers cannot engage in deceptive, unfair or misleading acts or practices.

Further, UCC Article 2 governs the sale of "goods" or tangible, moveable property. It provides a framework for parties to enter into certain contractual relationships and fills in the gaps on terms such as breach and remedies if those are not explicit in the contract. A digital representation is not "tangible" per se but what if the NFT is tied to a tangible object? Would the default provisions of Article 2 apply if not explicitly put into a smart or traditional contract?

Will money transmitter laws and regulations apply if an NFT is tied to a monetary value or otherwise represents or is used as money?

Tax implications

While there are still many questions regarding tax implications of creating, buying and selling NFTs, the Internal Revenue Service (IRS) has advised that all digital assets, including NFTs, are treated as "property" for tax purposes. Just like the sale of other forms of property, capital gains or losses are incurred when the NFT is disposed of. If held less than a year, short-term capital gains/losses would apply and if held longer than a year, long-term capital gains/losses would apply. There are questions, however, whether certain NFTs could fall under the IRS's tax regime for "collectibles" which would have particular implications for high income earners. It gets more complicated when the NFT is purchased using a cryptocurrency, which may cause a taxable event both for the cryptocurrency payment and the NFT ownership.



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