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Legal Considerations When Investing in NFTs

By Joseph M. Mellano, Associate Attorney of Shustak Reynolds & Partners, P.C. posted on Thursday, June 3, 2021.

A digital collage by the artist Beeples recently sold at auction for a jaw-dropping $69.3 million. Twitter founder Jack Dorsey just sold the first tweet he posted on the social media giant’s platform for $2.9 million. In May 2020, the famous “Charlie Bit My Finger” YouTube video fetched more than three quarters of a million dollars at auction! How is this possible? What drives this market? Two words: non-fungible tokens.

What are non-fungible tokens? NFTs are unique, blockchain-linked units of data used to represent specific, intangible items, most commonly digital images, videos, songs, and other media. Each NFT is offered in a limited quantity, and the provenance of any particular NFT is immediately verifiable. Think of them as digital trading cards or artwork prints. They are ownable, collectible assets with real economic value, but you cannot hold them, hang them on your wall, or carry them around. Much like stocks and bonds in a brokerage account, NFTs belong to the investors who purchase them, but investors do not hold them in any tangible form.

NFTs are like cryptocurrency in that they are purely digital, blockchain-based assets traded on decentralized platforms. Unlike cryptocurrency, however, NFTs are non-fungible—meaning no two NFTs are identical—and derive their value from the popularity of the items they represent, not their utility.

NFTs mainly are traded on public, peer-to-peer marketplaces, such as OpenSea, Rarible, and SuperRare. Most marketplaces use an auction format and require buyers to use cryptocurrency, Ethereum tokens being the most common.

Are NFTs securities? Possibly. Whether an investment product is a security under either federal or state law is a fact-intensive inquiry focused on the specific characteristics of that particular product. There is no blanket rule under federal or state law that all NFTs are securities. Each NFT is structured and sold differently, and each must be examined on a case-by-case basis.

Recent guidance from the Securities and Exchange Commission on digital assets suggests NFTs of collectible items—e.g., Beeples’s digital collage, Jack Dorsey’s tweet, or the “Charlie Bit My Finger” video—generally are not securities under federal law because their value does not depend on the managerial efforts of third parties, but on the popularity of the work they represent and consequent market inflation.

The analysis is less straightforward for other types of NFTs and alternative applications of NFT technology, such as the tokenization of insurance coverage or the sale of fractionalized interests in NFTs. Similarly, many NFT-related ventures would involve securities transactions. One example would be an offering of equity—i.e., stock or membership or partnership interests—in a NFT investment fund.

Does an NFT confer any intellectual property rights in the work the NFT represents? Generally speaking, no. Unless the seller owns intellectual property rights—copyrights, trademarks, patents, etc.—in the work and specifically conveys them to the buyer, the buyer does not acquire any intellectual property in the digital expression the NFT represents. The buyer essentially is acquiring proof of ownership of an original, digital work, or an iteration of one; the creator generally retains the intellectual property rights in the work, itself.

Creators may offer single, exclusive NFTs of their original pieces, as Beeples did with his original, digital collage, or multiple NFTs of a single item, as the NBA does with its wildly popular TopShot NFTs. In neither case, however, does the buyer acquire any rights to use, modify, or sell subsequent iterations of the work, unless the creator specifically assigns those rights to the buyer. The only economic interest the buyer acquires in most NFTs is the resale value of the NFT.

In this regard, NFTs are like physical works of art in a collection: although the collector might own an original Jean-Michel Basquiat painting, Basquiat still maintains the exclusive right to profit from the idea his painting represents, e.g., by contracting with a company to produce and sell t-shirts with images of the painting on them. This is precisely what makes NFTs so innovative—they allow for ownership of intangible, personal property separate from intellectual property.  

Are investors taxed on sales of NFTs? Yes, gains from sales of NFTs, like those from the sale of stocks, bonds, and, most other assets, are subject to capital gains taxation, unless the NFT is an original work of the seller, in which case the sale proceeds are taxed as income. Those looking to capitalize on the popularity of NFTs should consult legal counsel or a tax professional to determine how any transactions will affect their tax liability.

NFTs are a complex, new form of  investment, that do not neatly fit into traditional legal frameworks. Legislators and regulators are only beginning to understand them, as are NFT investors. These are uncharted waters for now. We advise anyone looking to invest in NFTs in any material way only do so with the assistance and advice of legal counsel.

Shustak Reynolds & Partners, P.C. focuses its practice on securities and financial services law and complex business disputes. 
We represent many broker-dealers, registered representatives, investment advisors, investors and businesses. 
Attorney Joseph M. Mellano can be reached in the firm’s San Diego office at (619) 696-9500.

 

 
 

 

 

 

 

 

 

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