By Louis Lehot and Catherine Zhu, business lawyers at Foley & Lardner LLP in Silicon Valley
A few years ago, initial coin offerings (ICOs) were all the rage in the cryptocurrency world. They offered many projects the ability to raise funds quickly and easily, but they also drew the scrutiny of regulatory agencies. As I pointed out at the time, the regulatory landscape for ICOs was something of a Wild West, with multiple agencies claiming jurisdiction. While the ICO market eventually cooled, the rise of NFTs demonstrates a similarly complicated relationship with existing regulations. As we sketched out in our initial guide to legal issues in NFTs, the cost of non-compliance can be fatal. With the benefit of more experience, we are sharing key considerations in building an NFT marketplace.
To recap, an NFT is a nonfungible token. Fungibility is the property of being interchangeable, which is a core requirement for money. A ten-dollar bill can be exchanged for two fives, ten ones, or some other ten-dollar bill because individual units of money are largely irrelevant. Only the aggregate value matters.
In contrast, a nonfungible token is a virtual item that is cryptographically unique or at least limited. Real-world counterparts include works of art, baseball cards, and limited-edition lithographs. NFTs are basically digital collectibles on a blockchain, but thinking of them as analogous to Pokémon cards is simplistic. A cryptographically verifiable token has far-reaching utility because of its portability as a digital asset and its immutability on the blockchain. Ownership of a token can be mathematically proved, which gives NFTs security that is difficult to attain through conventional means.
Despite that utility, NFTs do not necessarily fit well into the existing regulatory framework, and the level of legal complexity depends on how the token is used. A simple collectible, such as an NFT of Jack Dorsey’s first tweet, is relatively straightforward. But NFTs can be complex media or tokenized representations of real-world objects, all of which could invoke additional laws and regulations.
Consider an NFT that incorporates multiple forms of media. Did the creator of the NFT secure the appropriate permissions from all copyright holders of the works included in the NFT? Since anyone can create an NFT, how can you prove the provenance of the media? What rights does the creator of the NFT retain, and what rights does the buyer of the NFT purchase?
Or consider an unusual case enabled easily by blockchain technology. What would happen if the owner of an NFT sold fractional ownership in the token? The short answer could be “nothing.” But if those shares are fungible and represent equity in the NFT, then the NFT or at least the shares in the NFT may qualify as a security, which would invite additional regulatory hurdles.
Another emerging use case is real estate or really any industry where identifying precise ownership is important. Tokenized real estate could simplify transactions, reducing them to a simple digital transaction, but the legal implications of such a process would be much more complicated. Consider:
- Do you have the underlying intellectual property rights required to mint an NFT? Are royalties owed to third-parties?
- Could your NFT be characterized as a security? Will the proceeds be used to build other NFTs or the NFT marketplace on which it was sold? If so, Houston, we may have a problem.
- Where will your NFT be sold? If arguably a security in the United States, best to find a jurisdiction where the sale and resale is permissible and ringfence out purchasers where it is not.
- How will your token be sold? Who will calculate the funds that are owed to whom? Who manages payments? Are you required to register as a money-transmitter?
- Who has the rights to the intellectual property being sold? Consider who is owed a royalty.
- How do you know that the persons transacting in the NFT are not subject to sanctions?
- How do you know that the funds you are processing are not part of a money-laundering transaction?
Building an NFT marketplace requires a bouquet of complementary experts who can create (or procure third-party vendors to obtain):
- Unique content
- Front-end user interface
- Wallet and smart contract
- Minting of NFT
- Marketplace to support primary sales and transfers to process secondary resales
- Custody of funds pending distribution
- Distribution of revenues
- Payment engine
- Conversion of crypto-currency to fiat currency and withdrawing to a bank account, as necessary
- Auction technology to ensure a dynamic and liquid market
- License to sell underlying content, if required
If you are considering entering the NFT marketplace, make sure that you identify how your project relates to the existing regulatory landscape. You may find very few issues, but you should do your due diligence and make sure before you progress too far. The NFT craze may continue to decline, but NFTs themselves will likely still be with us for many years.
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Louis Lehot is an emerging growth company, venture capital, and M&A lawyer at Foley & Lardner in Silicon Valley. Louis spends his time providing entrepreneurs, innovative companies, and investors with practical and commercial legal strategies and solutions at all stages of growth, from the garage to global.
Catherine Zhu is a leading business, commercial, and privacy lawyer with Foley & Lardner LLP. Her practice focuses on complex commercial agreements, licensing transactions, data sharing transactions, revenue growth, business expansion, legal process optimization, and data privacy.
Originally published at https://www.digitalconnectmag.com.