Pillsbury - Internet & Social Media Law Blog
The non-fungible token (NFT) market has grown dramatically over the past 24 months. NFTs first garnered widespread attention when the artist Beeple sold digital artwork at Christie’s in March 2021 for $69 million. According to the DappRadar Industry Report, spending on NFTs exceeded $25 billion in 2021, but the market has been significantly lower this year and according to the The Wall Street Journal, “flatlined” last month.
NFTs have been linked to many types of assets, including images, videos, audio, collectibles, virtual land and real-world real estate. An NFT can be traded based on the value of the asset it authenticates. Sales can occur through websites or on secondary marketplaces, such as OpenSea or Rarible, or through direct transfers from an owner’s digital wallet to a buyer’s digital wallet. The terms and conditions of the sale of an NFT can be described: (i) in self-executing smart contracts coded onto the blockchain and on websites and marketplaces via terms of use, legal notices, clickwrap agreements, browse wrap agreements or FAQs; or (ii) in written (offline) sales agreements or amendments (collectively, Sales Contracts). Any Sales Contract—regardless of the medium—will only be enforceable if it complies with customary contract law requirements: including the offer and acceptance of clear terms; consideration; legally permissible terms; and eligibility for electronic signing (if applicable). Impermissible or illegal terms will not be enforceable. Certain agreements, including wills and some notices, cannot be signed electronically. And for other types of agreements, it may be unclear whether electronic signatures will suffice.
The potential for ambiguity, misunderstanding, poor contracting practices, undisclosed terms or abuse is greater with smart contracts and online contracts located on websites or marketplaces than with written contracts. Smart contracts are software code developed by programmers and is not yet sophisticated enough to capture all of the terms one would generally want in a contract. Online websites and platforms may not provide reasonable notice of all terms and conditions. Establishing that all terms and conditions of a smart contract or an online contract on a website or marketplace have been disclosed and affirmatively accepted can present challenges and may lead to costly disputes.
Many see the NFT market as an exciting business opportunity that authenticates assets and allows digital creators another avenue with which to monetize their work. But the market is not mature and is full of pitfalls and volatility. Accordingly, it is in the best interests of creators, sellers and buyers of NFTs that contracting best practices be adopted, especially considering the intellectual property and other considerations and risks that apply to NFTs.
Clicking, Browsing and Contracting Best Practices for NFTs
Any determination of the enforceability of a Sales Contract, including rights retained by the creator/seller of an NFT and the rights transferred, including any restrictions on the use of the linked asset by subsequent owners, require the same analysis as traditional, written sales contracts. The seller and buyer must have knowledge of, and affirmatively accept, the terms and conditions of the sale disclosed in a clear and conspicuous manner. As noted above, smart contracts are coded computer programs or transaction protocols stored on a blockchain that self-execute when predetermined conditions are met. Buyers may not be capable of reviewing them and may not even be aware of them. There is no way for the parties to acknowledge and execute the smart contract as there is with traditional contracts. Some smart contract developers are embedding written contracts in English into the metadata to address the fact that smart contracts cannot verify information about the real-world conditions to be met. Even if the contracts clearly reflect the deal terms, however, there are many important legal provisions that are not included in or appropriate for smart contracts. As a best practice, supplemental written contracts should be considered as a mechanism to disclose all terms and conditions not otherwise captured in the smart contract.
Websites, marketplaces and platforms offering NFTs for sale should also consider contracting best practices. “Click wrap” and “browse wrap” agreements are two common characterizations of online contracts. Courts have regularly enforced so-called “click wrap” agreements, where a user’s acceptance of the terms and conditions is rendered by checking a box or clicking on an “I agree” or “Yes” button (or some similar affirmative action). It is less clear whether terms and conditions posted on a site that do not require the user to click on a button will create an enforceable contract, such as “browse wrap” or similar agreements. In the majority of cases to address the enforceability of “browse wrap” agreements, where terms and conditions are posted behind a link labelled “terms and conditions” or “legal notices” and do not require a user to affirmatively assent, courts have generally found such agreements unenforceable for lack of conspicuous notice and assent even if the buyers continue to use the website. Such cases are highly fact-dependent and focus on whether the user received reasonable notice that the terms and conditions exist and are intended to create a binding contract. To ensure the enforceability of a Sales Contract, sellers of NFTs should consider implementing best practices, including:
Creator Rights, First Sale and other IP Considerations
Copyrights present some unique issues and challenges for NFTs. If, for example, the seller does not own the copyrights in the NFT being sold, the copying of the work to create the NFT and the public display and sale of the NFT could, depending on the facts and circumstances, be deemed to be copyright infringement. Even if the initial seller owns the copyrights in the content of the NFT, copyright infringement could arise from resales of NFTs, as discussed below.
Creation of an NFT based on or incorporating an existing copyright protected work that is owned by a third party will generally require the consent of the copyright owner of the linked asset. Unauthorized NFT sales on websites or marketplaces will likely be challenged by copyright owners via DMCA takedown notices and, in the United States, could give rise to copyright infringement claims in federal court. Direct wallet transfers could also be subject to challenge. Understanding the ownership of copyrights in an NFT and, if the copyright owner is someone other than the seller, understanding the connection between the seller of an NFT and the copyright owner of the linked asset should be an important part of a buyer’s due diligence.
In the United States, NFT creators/authors have relied on the fact that, under the Copyright Act, copyrights in a work, which include the exclusive right to make, distribute and publicly display copies, to publicly perform a work, and to create derivative works, remain with the creator/author (unless the work qualifies as a “Work Made for Hire” under Section 101 of the Copyright Act or the copyrights are expressly assigned in a signed writing). Accordingly, a buyer of an NFT may own the token but only be granted a limited license to use the linked asset for personal, non-commercial use, and not for the creation of derivative works. For instance, when the first NFT virtual house, Mars House, was sold in March of last year for over $500,000, creator Krista Kim reportedly retained the copyrights in her work, including the right to display it on her website. Buyers of NFTs seeking additional limited rights or unrestricted rights to commercialize the linked asset should make sure these rights are clearly described and included in the Sales Contracts.
The First Sale Doctrine (codified in Section 109 of the Copyright Act) provides that someone who purchases a lawful copy of a copyrighted work receives the right to sell, display or otherwise dispose of that particular copy without permission from, or any accounting to, the copyright owner. If the initial seller does not own the copyrights in the content of an NFT, an important question is whether the First Sale Doctrine will apply to that sale. If the initial seller does own the copyrights, then depending on the terms of the Sales Contracts, the First Sale Doctrine may not apply to any resales of the NFT. In the absence of a Sales Contract signed by the proper parties and providing for a commission or royalty, a copyright owner would not typically benefit financially from a secondary sale due to the application of this doctrine. Notably, smart contracts used in the NFT market typically require that a certain percentage of the purchase proceeds be paid to the copyright owner upon each transfer recorded on the same blockchain platform, which may help to mitigate the risks of copyrights claims. Accordingly, the First Sale Doctrine may not apply to certain NFT market sales due to smart contracts and other considerations.
How Stable the Foundations?
NFTs are tied to blockchain platforms and cryptocurrencies, and some experts anticipate that many blockchains and digital currencies will fail or be hacked and forced to shut down in the future. For example, many NFTs use links to direct to the site hosting the digital content that the NFT represents. Such websites need to be maintained by someone—oftentimes a web host or the NFT exchange that minted the NFT. However, if that host or exchange shuts down or goes under, the link can break and the NFT will point to a missing file. In another example, the recent collapse of the terraUSD algorithmic stablecoin (and its luna token), one of the most popular U.S. dollar-pegged digital currencies, is an illustration of the risks inherent in trading activities in the broader “crypto” market that includes NFTs. On June 1, 2022, federal prosecutors alleged that an executive at OpenSea abused insider information to profit off NFTs. Nathaniel Chastain was charged with buying dozens of digital collectibles based on advanced knowledge that they would be featured on the marketplace’s home page. He used anonymous accounts and digital wallets to hide his activities. Buyers of NFTs should determine how the token and the linked asset are stored and on which platforms.
NFTs come with a number of additional risks, including:
Creators of NFTs typically want royalty payments upon resales across multiple websites, marketplaces and other platforms and not just the platform that the smart contract resides on. Moreover, when an NFT is purchased from an owner (other than the creator) on a different website, a secondary marketplace or from a digital wallet, the new buyer may only be aware of images and limited information identifying the NFT and the linked asset. The resale buyer may not receive reasonable notice of all surviving terms and conditions of sale in the applicable contracts.
Ultimately, no matter how new the technology, when it comes to Sales Contracts, the fundamentals remain the same. They need to be binding and enforceable on all parties, especially in a new and volatile market subject to fraud and scams. Rights and restrictions should be clear and conspicuous, online and offline. Consent to contract terms must be affirmative and explicit. A standard industry view of contracting best practices should be developed and adopted as soon as reasonably practicable, including terms related to notices, disclosures, covenants, representations and warranties, liability limits, indemnities, waivers and disclaimers, remedies, dispute resolution procedures and governing law.
Participants in the NFT market will request new rights, restrictions, protections and remedies in the future that are likely to lead to more complex and sophisticated terms and conditions. Lack of disclosure and meaningful acceptance of terms, poor contracting practices and ambiguity will increase the prospects for more disputes and lawsuits. The creation and sales of NFTs are often done quickly and without due diligence or consultation with a knowledgeable attorney. It is important, however, to undertake the due diligence process and legal analysis to avoid major issues and expensive disputes down the road.
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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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