Nonfungible token (NFT or Token) was the word of the year in 2021, as NFT sales exceeded $4 billion in monthly trading volume in January 2022 after generating more than $23 billion in sales in 2021.   Celebrities including musicians  Eminem and Grimes  and artists Beeple and Banksy have minted and sold NFTs, and sports leagues like the NBA and NFL have set up NFT marketplaces. Now, large Fortune 100 corporations such as Walmart, Nike, and Spotify are entering the fray, and Mastercard is making it easier to buy NFTs, raising the question, what is an NFT?

What is an NFT? An NFT is a unit of data stored on a digital ledger or blockchain that certifies a digital asset as unique and not interchangeable. An NFT is a digital representation of a work of art or music or a photograph that can be separated from and sold separately from the original work. Hence, at first glance, NFTs appear akin to artworks or collectibles.

Regulatory and congressional concerns with NFTs. The stupendous rise of this market and vast sums of dollars being paid for NFTs has raised alarm bells at the Securities and Exchange Commission (SEC), the Commodities Futures Trading Commission (CFTC), the Treasury Department, and Congress. Congress and regulators fear NFTs are being used as lures to raise capital without fulfilling any of the legal requirements that promoters of such investment vehicles are required to fulfill. They fear the lack of regulation or the circumvention of existing securities laws (that regulate capital raise or issuance of securities) puts consumers at grave risk.

This past month has witnessed accelerated activity in the Senate, Department of Justice (DOJ), and SEC, suggesting the era when NFT sales were largely unregulated may be fading. On June 1, senators Cynthia Lummis and Kirsten Gillibrand introduced a bipartisan bill  (in addition to over 50 bills already introduced) to address digital assets. The DOJ made the first arrest involving NFTs (alleging insider trading) on June 7, following closely on the heels of SEC Chairman Gary Gensler initiating an SEC inquiry into the NFT market. The implications of this legislative and prosecutorial activity are analyzed in more detail below.

Bipartisan bill introduced on June 1. On June 1, Senators Lummis and Gillibrand introduced bipartisan legislation (Loomis-Gillibrand Bill) in the Senate that expands the CFTC’s oversight of crypto-assets. Conceivably, on an initial read, NFTs would fall within the definition of digital assets in the bill. Section 101 (2) defines a digital asset as “a natively electronic asset that (i) confers economic, proprietary or access rights or powers and (ii) is recorded using cryptographically secured digital ledger technology” (emphasis added). Tokens involve distributed ledger technology and transfer of economic or proprietary rights.

Intriguingly, this bill requires “fungibility” in order to invoke the CFTC’s jurisdiction, and thus excludes NFTs from the purview of the CFTC. Fungibility means that a good or asset is interchangeable. For example, one U.S. dollar can be exchanged for another. An NFT in contrast, as the name non-fungible token suggests, is not interchangeable. Specifically, Section 403, CFTC Jurisdiction over Digital Assets, specifically states: “(F) (II) Fungibility Requirement. – The Commission shall only exercise jurisdiction over an agreement, contract, or transaction involving a contract of sale of a digital asset that is fungible, which shall not include digital collectibles and other unique digital assets.” NFTs by definition are not fungible and involve unique digital assets and would hence not fall within the CFTC’s jurisdiction under this legislation. Since the CFTC has long been considered as more “friendly” toward digital assets than the SEC, if NFTs are placed squarely in the SEC’s terrain, is closer regulatory scrutiny inevitable?

Arrest for insider trading in NFTs. While these jurisdictional questions remain open, the DOJ has taken action. On June 7, the U.S. Attorney for the Southern District of New York charged Nathaniel Chastain, a former employee of OpenSea, a large NFT marketplace, with wire fraud in connection with a scheme to commit insider trading in NFTs. U.S. Attorney Damian Williams said:  “NFTs might be new, but this type of criminal scheme is not….Today’s charges demonstrate the commitment of this Office to stamping out insider trading – whether it occurs on the stock market or the blockchain.” FBI Assistant Director Michael J. Driscoll stated:  “In this case, as alleged, Chastain launched an age-old scheme to commit insider trading… With the emergence of any new investment tool, such as blockchain supported non-fungible tokens, there are those who will exploit vulnerabilities for their own gain. The FBI will continue to aggressively pursue actors who choose to manipulate the market in this way” (emphasis added).

This arrest follows closely on the heels of news in March that the SEC is scrutinizing the NFT market (i.e., whether NFTs are being utilized to raise money like traditional securities and ought to be subject to the same rules as stock offerings). In the landmark decision SEC v. W.J. Howey,  the U.S. Supreme Court laid down two key requirements for when a contract or transaction will be considered a security: “whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party” (emphasis added). The SEC may take the position that certain NFTs may constitute securities under Howey.

Treasury: Some NFTs may be virtual asset(s) subject to U.S. AML obligations. The U.S. Treasury has pointed out that NFTs, particularly NFT platforms, may constitute virtual asset service providers (VASPs) per the Financial Action Task Force (FATF), depending on “the nature of the business dealing in NFTs and their function in practice as well as the facts and circumstances of the platform or other person doing business.”

Understanding the “nature” of NFTs beyond the technical definition. As is clear from the above, the nature and circumstances of the specific NFT is pivotal to determine whether it is a collectible (or new form of creative or copyrightable work) or a security (that ought to be subject to the same standards as other SEC-regulated investment vehicles).

Supporters argue NFTs are collectibles. Aficionados like Mark Cuban argue NFTs (such as NBA Topshot, which offers a platform for trading cards embedded with highlights from NBA games) are essentially like trading cards and have a store of value, and many buyers may make purchases anticipating an increase in price. Echoing Cuban, Professor Jonathan Zittrain points out that a big part of the appeal of NFTs may be their feature of being an “asset that can be traded at a later date.” He argued, “‘crypto whales’—people who got rich from that appreciation—have a near-religious commitment” to technologies such as NFTs and cryptocurrency and choose to keep their wealth in such technologies “beyond the usual standards of economic rationality.” Hence, such supporters argue that the potential for increase in value does not change an NFT from a collectible into a security.

When an NFT is digital art or collectible. Conceivably, if an NFT is merely a collectible, it would not be a security under the Howey test. Notoriously, the “Everydays – The First 5000 Days” NFT sold for $69.3 million in 2021 and is one of the highest priced NFTs. Everydays is a collage of digital images minted as an NFT and hence the buyers will receive a unique digital token (and not a painting or a print). Two pseudonymous bloggers, Metakoven and Twobadour, bought this NFT using Ethereum, a digital currency.

Critics however point out the Beeple NFT, one of the most expensive NFTs sold so far, demonstrates that it may not be a cut and dried case. Merely because the NFT involves art does not mean it will cease to be a security if it displays the characteristics of an investment vehicle, as outlined in Howey.

When an NFT is a capital raise, the SEC is alarmed. Critics point out that MetaKovan had earlier purchased over 20 artworks by Beeple for $2.2 million and put them in a fractionalized investment fund, and so this record purchase of the Everydays artwork only increased the value of Metakovan’s digital art token fund, B.20, conceivably, qualifying as a security under the Howey test.  As SEC Commissioner Hester Peirce explained, fractionalized non-fungible tokens and NFT index baskets may be closer to investment product(s) and be deemed securities. If an NFT is considered a security, SEC approval would be required prior to issuance, sale, or consummation of a transaction.

Similarly, critics point to the ‘Burnt Banksy’ episode where money was raised from investors to purchase “Morons,” an artwork by Banksy. The artwork was then minted as a Token after which the original artwork was deliberately set on fire (and video of the burning livestreamed) so that the Token would be the only remaining tangible form of the work, driving up the price. The original painting was bought for $95,000, and Token sold for $380,000 (£274,000), netting a sizeable profit for the buyer and investors.

Copyright implications. While there is significant attention being paid to whether an NFT would fall within the SEC’s purview, the implications and impact of NFT vis-à-vis copyright law has largely been ignored.

NFTs raise new questions for copyright law. First, who would have the right to mint the NFT – would it be the person or author who created the original underlying work (with the NFT being akin to a derivative work) or the person who bought and now owns the physical work? We have witnessed both types mint NFTs. For example, Twitter CEO Jack Dorsey minted and sold his first tweet for $2.9 million (to @sinaEstavi), and this instance falls into the first bucket, where the owner of the underlying work mints the NFT. In contrast, the buyer who purchased the Banksy artwork and then minted and sold the Token falls into the second bucket identified above, where owners of the physical work (as opposed to the original artist) mint the Token.

Second, does the constitutional provision that empowered Congress to legislate and craft copyright law support the destruction of underlying artwork the Token is based upon?  The power to legislate on copyright and pass an act to provide exclusive rights to authors and artists (for a period of time) was provided to Congress by the Constitution. Article 1, Section 8, Clause 8 of the Constitution specifically states: “The Congress shall have Power . . . [t]o promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.”

Does the Constitution provide copyright protection for NFTs if doing so results in destruction of the underlying artwork, such as the Banksy artwork that was burned in order to enhance the price of a Token? In other instances, sellers have deleted tweets after selling the NFTs. Even after Twitter CEO Jack Dorsey minted and sold his first tweet for $2.9 million, he continues to retain complete rights to delete his original tweet. Was copyright created to encourage the creation of more writing and artwork, or to provide rights to and enable various parties to destroy creative works?

U.S. regulatory attitudes changing. NFTs posit intriguing questions. Historically, NFTs did not attract the regulatory scrutiny that closely-related bitcoin and digital currencies attracted. Advocates pointed out that NFTs, unlike bitcoins, are not fungible (i.e., they are not interchangeable with one another) and do not pose any challenge to the monetary policies of nations. Perhaps this explains why, while crypto initiatives such as Facebook’s Libra faced bipartisan opposition in the U.S. and internationally, UK Chancellor of Exchequer Rishi Sunak ordered the Royal Mint to issue an NFT of the pound this summer!

Recent announcements by U.S. regulators, including the SEC and Treasury, now suggest that NFTs require fact-based analysis and will require closer examination when involving payment or investment. At the same time, those who would regulate NFT-related financial activity will need to be mindful of copyright regimes so that the legal treatment of NFTs is consistent and clear.

This post comes to us from Aarthi Anand, counsel at Cahill Gordon & Reindel LLP.