NFTs – An Introductory Guide

1. Executive Summary

Non-fungible tokens (NFTs) are a new and unique form of digital asset which enable content creators to commercialise rights and items which were previously unmarketable. NFTs are small pieces of code which are created and traded on the blockchain, and which grant their owners rights to other digital assets –but not, crucially, ownership of the underlying asset itself. All of the rights associated with an NFT are based in a contract, the terms of which are set by the NFT’s original creator (which allows great scope for commercial flexibility). The blockchain technology on which NFTs are based means that they are highly secure and come with an immutable, publicly verifiable chain of title and proof of provenance. The technology is therefore particularly suited to collectors’ items that derive their value from scarcity and authenticity.

2. Blockchain technology

NFTs would not be able to exist without blockchain technology. Blockchains (also known as “digital ledgers”) are, in essence, a sophisticated form of online database. Whilst conventional databases are held in a single “master file” (which may be vulnerable to corruption, theft, or disruption), blockchain technology stores identical copies of the same information across all of the users of a network. This is known as decentralisation (as there is no single “official” or “master” copy of any information), and distribution (as the information is distributed across the network).

In visual terms, the diagram on the left is a conventional, centralised database: the master copy is in the centre, and it is then duplicated by the other network users (all of which communicate with the central system, but not with each other). In a decentraised blockchain database, as shown on the right, the same information is held by each user, and all ofthe users are interconnected. There is no master copy.

Another key feature of Blockchain technology is that it is immutable: information can always be added, but it then becomes permanent and can never be edited or deleted.

The NFT market remains in its infancy, and we are still exploring its myriad applications, but it is clear that blockchain technology is uniquely useful for proving ownership:

• the immutability of the ledger means that there is a permanent record of every action and transaction; and
• the information is highly secure, as any hacker would need to access over 50% of the relevant network in order to make any changes.

One should also note that “blockchain” is best conceptualised as a software feature or method of operation rather than any single computer program. There are a number of blockchain platforms which allow the development of applications based on blockchain principles. In the NFT space, the dominant platform is Ethereum.¹

3. Tokens, tokenisation and fungibility

A crypto token is a unique string of characters, akin to a complicated password or identity code, which uses blockchain technology to document the rights to an underlying asset. The underlying asset may exist digitally as a computer file (as do NFTs and cryptocurrencies), or it could be a physical asset such as land.² Tokens can also be used to record rights to receive services (often known as utility tokens).

Tokenisation is, therefore, the process of converting the rights (ownership, leasehold, license, etc.) to an asset (goods or services) into a digital key on a blockchain. In theory, any and all rights can be tokenised.

Tokens fall into two broad categories: fungible and non-fungible. Fungible tokens such as cryptocurrencies operate similarly to traditional (fiat) currencies in that they represent value rather than a specific asset.

Anything that can be digitised can function as an NFT. As all of the relevant information is stored on the blockchain, the provenance, scarcity and authenticity of a Work can be automatically validated, creating a real-time, immutable certificate of authenticity. An NFT’s transaction chain is also typically visible to the 

Anything that can be digitised can function as an NFT. As all of the relevant information is stored on the blockchain, the provenance, scarcity and authenticity of a Work can be automatically validated, creating a real-time, immutable certificate of authenticity. An NFT’s transaction chain is also typically visible to the public, which adds a layer of transparency to the marketplace (unlikely traditional fine art, which is notoriously susceptible to fraud).

It is interesting to note that NFTs (which are comparatively small pieces of code) are transferred on the blockchain, but the underlying Works are never stored “on-chain”: the file sizes would be unworkably large. Instead, the Work is hosted elsewhere online (“off-chain”), and the NFT acts as a link or key to the Work. Only one person can own an NFT at a time, so only one person can “unlock” the relevant rights.

4. Creating and commercialising NFTs

Creating (or minting) an NFT can be surprisingly straightforward. The first step is to decide which blockchain to use (as mentioned above, Ethereum is by far the most popular). If one uses Ethereum, one will need to open an Ethereum-compatible wallet (a software plug-in), which can be obtained free of charge from a number of providers. Wallets are used securely to store all kinds of crypto tokens, including both NFTs and the cryptocurrency known as Ether (also Ethereum-based, which is used to sell and purchase Ethereum NFTs).

NFTs are created and sold via marketplaces such as OpenSea, SuperRare, Foundation and Rarible. All marketplaces fulfil the same purpose (creating, buying and selling NFTs), but each marketplace has its own terms and conditions, meaning the commercial terms vary (not unlike choosing one auction house over another). Most major marketplaces have a simple “plug and play” interface whereby a creator can tokenise a digital file, upload it to the platform, then fill in a series of forms to set the sale parameters (including, for example, the date and time of sale; whether the NFT is to be sold at a fixed price or at auction (and if the latter, whether there is a reserve); and what commission the creator will receive on any subsequent resale–a unique feature of NFTs). This information is used to create a smart contract –a slight misnomer for the conditional computer program that controls the bare bones of the subsequent transactions (“if X occurs, effect Y”).

Anyone can create an NFT (including the authors of this note, who are unencumbered by artistic talent), which means that most NFTs are of relatively low quality and/or value. There can therefore be significant advantages to using one of the more “exclusive” platforms such as Palm or Rarible which limit potential uploads and/or allow creators greater scope to negotiate their terms.

5. What rights does an NFT contain?

The short answer is “whatever the creator wishes to include”. Multiple layers of rights exist in tokenised Works, and each layer may be subject to separate ownership and licence terms. This leads to a network of rights as complex as it is flexible:

• A tokenised Work may have been based on one or more pre-existing works, which may have been digital (such as a digital photograph) or physical (such as a canvas or film reel):
  • the pre-existing work will be owned as an asset–either by the original artist, or by a commissioner/purchaser; and
  • intellectual property rights also subsist in and to the pre-existing work. In the case of fine art, those rights will usually be retained by the original artist, as artists typically sell their works but not the IP rights therein. Different rules apply to the ownership of copyright in different media. For example, the copyright in a film will automatically belong to the producer (absent any separate contractual arrangement). In the case of a book, the author will own the copyright in the text itself, but the publisher is likely to own the copyright in the typographical arrangement.
• All tokenised Works exist as digital files:
  • again, the digital file is an asset which is typically owned by the creator of the file; and
  • there are also intellectual property rights in and to the digital file (typically copyright, as set out in section 6 below). These IP rights also usually be owned by the creator of the file.

In many (but not all) cases, the owner of the digital file is the same person who creates the NFT.

• At the top of the chain is the NFT itself:
  • the NFT is an asset owned first by the NFT creator, the, after it is sold, by any purchaser down the chain (see section 6(a) below); and
  • and there may also be intellectual property rights in the NFT (such as copyright in the metadata text accompanying the token –the token’s “blurb”). This is typically retained by the NFT creator.

NFTs as digital assets are transferred by means of smart contracts, as described above. As part of their metadata, most NFT descriptions will contain a link to the specific terms and conditions (T&Cs) applicable to the NFT itself. These terms will apply to all sales of the NFT, but as a collateral contract; the terms are not coded into the NFT itself. Those T&Cs determine the rights that are attached to the NFT.

As we know, NFTs are bought and sold. NFTs grant a licence to use the intellectual property rights in the relevant tokenised work for specific (usually non-commercial) purposes. The exact purposes (i.e., the scope of the licence) will be set by the NFT creator but will typically be a right to display the work for non-commercial purposes, but not to make any further copies of it. As a rule, the sale of an NFT does not affect the ownership of:

• the digital file as an asset; nor
• the IP rights in the digital file (which are retained by the NFT creator –albeit subject to the terms of the NFT licence); nor
• any underlying work(s) as digital or physical assets; nor
• the IP rights in those underlying works; nor
• the IP rights in the NFT.

The purchaser owns the NFT, and the NFT gives rights (licences) to the Work, but the purchaser does not tend to purchase the Work itself, and the purchaser’s use and/or treatment of the Work is restricted by the licence. In most cases, NFTs can be sold without restriction provided that the NFT creator receives a royalty (typically 10% of each resale value).

As a result, NFTs occupy an unusual semi-exclusive space whereby the Work itself may be viewed (or watched or listened to) millions of times around the internet, possibly entirely lawfully, but only the owner of the NFT is entitled to the specific copy of the Work that was tokenised. The value of NFTs is therefore derived from prestige, exclusivity and collector culture, and NFTs are proving to be particularly well-suited to Works that have a cultural value greater than the sum of their parts. There is no limit to how many NFTs a creator can mint, but the relationship between value, supply and demand should be considered with care.

Likewise, as NFTs are, at their simplest, a collection of rights, they can be “bundled” with non-digital rights. For example, inMarch 2021, the popular American rock band Kings of Leon auctioned several artwork NFTs, each of which came with VIP concert tickets. The natural drawback to including time-limited goods or services with NFTs is that the resale value of the NFT could suffer once those rights have been exhausted, but the converse is that the initial sale price may be higher.

6. Legal considerations

As with most rapid technological innovation, the legislature and judiciary are running to keep up with the NFT boom. English law has, to date, been able to accommodate NFTs within pre-existing legal categories and structures, but NFTs have also introduced some new questions.

a. NFTs as property

It has been established under English law since 2019 that NFTs are property.³ As such, NFTs can be subject to freezing orders and asset preservation orders in civil proceedings in the same manner as any other intangible property. In the cases the courts have considered to date, they have given considerable weight to the findings of the UK jurisdiction task force on “Crypto assets and smart contracts”⁴, which was willing to view NFTs as intangible property in the same manner as other novel choses in action such as carbon credits and milk quotas. If this approach continues, NFTs will likely be subject to the same theft, fraud and proceeds of crime legislation as any other asset.

b. Intellectual property in Works

As we have established, most NFTs are based on licences. In most cases, the licensed right is copyright, although trade mark rights may also be relevant if an NFT or tokenised work contains a protected trade mark (especially if the mark confuses purchasers as the origin of the asset). Less commonly, design rights, goodwill and rights in confidential information may also be contained in and/or infringed by NFTs.

It is therefore imperative that NFT creators ensure they have procured all necessary permissions and consents relating to any third party intellectual property that may be included in a Work. Looking at the various rights in section 5 above, the creator of an NFT would need to ensure they either own or have licences to the intellectual property rights in the tokenised digital file as well as the underlying work(s). We recommend conducting a thorough due diligence exercise in respect of all materials that are intended to be tokenised, as the creation and commercialisation of an NFT could feasibly infringe numerous parties’ intellectual property rights simultaneously (even without any intention to do so).

Likewise, NFT creators and rightsholders will need to give some thought to their IP enforcement strategy. Whilst the value of some NFTs may not be diminished by the relevant content existing elsewhere online, where NFTs relate to supposedly “exclusive” content, a creator will want to protect their interest in commission on resales by preventing unlawful use of the work by an NFT purchaser (or any third party). Infringement by an NFT owner (whether a minter, seller or purchaser) is particularly difficult to enforce due to the pseudonymous nature of token ownership, meaning that a prospective claimant would usually need to seek third party disclosure from a marketplace or wallet operator, who could then be compelled to identify the individual.

c. Commercial and consumer contracts

The licence granted pursuant to an NFT will be governed in accordance with the NFT’s T&Cs. There are therefore two angles to the T&Cs: firstly, the other rights holders down the chain (including the owners of the tokenised work, any underlying works and the intellectual property rights in either of them) will likely need to ensure that they retain ownership of their assets and rights, and they may also wish to retain certain rights to use and commercialise the works. Secondly, the T&Cs will need to be clear that the NFT-holder is not permitted to perform any actions which erode the value of the underlying works and/or the NFT itself (which would impact on the secondary market for the NFT and thus the NFT creator’s future revenue streams). Given the inherent difficulties in enforcing blockchain contracts, an NFT creator should carefully consider what future disputes may arise and if they could be mitigated by any contractual terms included in the T&Cs.

It also appears reasonably likely that the English courts will apply existing consumer protection principles to NFT agreements (at least to the extent that an NFT is purchased by a consumer). An NFT’s T&Cs should therefore comply with consumer (and digital commerce) legislation, which generally means balancing the rights and interests of the NFT creator on the one hand and subsequent purchasers on the other.

In addition to the NFT T&Cs, a creator will need robust contracts in place with the relevant platforms and marketplace used to create and sell the NFT, as well as with any other consultants and service providers (as in any commercial venture).

d. Regulation and tax

The regulation of NFTs (or the lack thereof) is highly localised and different in each jurisdiction. In the UK, for example, NFTs are not subject to any specific regulation or taxation regimes, but –perhaps unsurprisingly -HMRC has briefly stated in recent guidance that NFTs are subject to capital gains tax.⁵ In the US, some cryptocurrencies and other tokens –particularly tokens focused on capital growth or a passive return -have been found to fulfil the definition of a “security”, meaning that they fall within the regulatory auspices of the Securities and Exchange Commission. (Many NFTs will not amount to securities, however, which drastically reduces the regulatory burden.) The tax residence and status of an NFT creator should be given careful consideration to ensure that the financial returns are as efficient as possible, and any marketing campaigns will need to be compatible with any specific regulatory requirements.
 

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¹ Others, inter alia, include IBM Blockchain, Ripple, OpenLedger and EOS.

² The Land Registry is exploring the possibility of using blockchain technology to speed up and simplify property transactions, for example, although the project remains in its early stages.

³ AA v Persons Unknown [2019] EWHC 3556 (Comm).

⁴ Legal statement on cryptoassets and smart contracts, paragraphs 74 –81.

⁵ https://www.gov.uk/hmrc-internal-manuals/cryptoassets-manual/crypto22200.

The views expressed herein are solely the views of the authors and do not represent the views of Brown Rudnick LLP, those parties represented by the authors, or those parties represented by Brown Rudnick LLP. Specific legal advice depends on the facts of each situation and may vary from situation to situation. Information contained in this article is not intended to constitute legal advice by the authors or the lawyers at Brown Rudnick LLP, and it does not establish a lawyer-client relationship.