The growing popularity of Non-Fungible Tokens (NFTs) and the Metaverse has led to an increase in the complexity of NFT projects, bringing enhanced brand interaction both on and offline. The originality shown by creatives and programmers in this space is truly astonishing.
However, those behind these exciting NFT projects risk being caught out if they fail to consider important legal issues arising from such projects, such as regulatory obligations and the protection of valuable intellectual property rights.
For all their ingenuity, there is an inherent risk of litigation arising out of NFT projects, old and new; it may be new technology but the old laws still apply. In this article, our media and crypto assets solicitor Will Charlesworth explains that whilst the risk of a mis-selling claim or an infringement action cannot be eliminated, with careful planning, that risk may be managed and mitigated.
What are the legal considerations when creating an NFT project?
There are several key legal elements to consider when creating a new NFT project:
- Intellectual property rights
- Smart contract drafting
- Corporate structure
- Terms and conditions
- Third party agreements
This article will consider the regulation governing NFTs, with the remaining topics being examined in a series of follow-up articles.
It is worth noting that whilst it is ideal to undertake a review and implement any recommended actions before an initial NFT drop, it may still be possible to apply certain corrective actions post-drop.
Are NFTs regulated in the UK?
Although NFTs are not (yet) specifically regulated, if they exhibit characteristics of other regulated investments, they may trigger legal obligations around their promotion and sale.
NFTs commonly contain provisions for enhanced rights, rights to future remuneration, guarantees as to value, connections with tangible goods etc. and these can influence an NFT’s classification.
Liability for compliance will sit with the regulated entity and is difficult to pass on. As well as any financial penalties, the reputational risk of non-compliance can be severe and the Financial Conduct Authority (FCA) is focussing on crypto assets currently.
The first step is to consider the nature of the token, as this will determine to a large extent whether it is regulated or not:
- A ‘security token’ (regulated) provides rights and obligations akin to specified investments, and is similar to shares in a company, debentures or units in a collective investment scheme. Consequently, any NFT project wishing to issue such tokens must ensure they have the correct permissions and follow the relevant rules and requirements.
- An ‘e-money token’ is regulated under the Electronic Money Regulations 2011, for example, stablecoins. Again, any NFT project wishing to issue such tokens must ensure they have the correct permissions and follow the relevant rules and requirements.
- A ‘utility token’ (unregulated) is one that provides consumers with access to a current or prospective product or service and often grant rights similar to pre-payment vouchers. Such tokens may grant membership to a club or provide access to exclusive content, for example.
- An ‘exchange token’ (unregulated) is a type of crypto asset that is usually decentralised and primarily used as a means of exchange.
It is important to consider the above in any NFT project.
Is minting an NFT regulated?
Whilst Opensea and Rarible have become popular places to mint NFTs, many NFT projects prefer to undertake the minting of the tokens themselves. This, however, can raise a regulatory issue, as the project creators are technically creating a new digital asset, which the FCA determines is subject to the Anti-money Laundering Regulations (AML). The effect of this is to place an obligation on the project creators to undertake AML checks on purchasers of tokens.
In addition, the provision of related services, such as an exchange platform for tokens, can constitute a regulated activity for the purposes of financial regulation.
Is the promotion of NFTs regulated?
With an increase in the number of crypto scams, the Advertising Standards Authority (ASA) has focussed its regulatory enforcement on this sector, including the sale of NFTs. The effect of this is that the advertising and promotion of NFTs is subject to the ASA’s new guidelines, of which every NFT project creator should be aware.
It should be noted that several large NFT projects have fallen foul of these guidelines, including Arsenal Football Club in respect of their promotion of a “fan token”, so they should not be ignored.
Social media influencers and other celebrity personalities are an important part of the promotion of many NFT drops. However, as the party with primary liability for any regulatory breaches, it is important for the NFT project creator to have some controls and rules in place with the influencer; this includes seeking to avoid mis-selling claims from not only regulators but also consumers. A straightforward approach to this issue is to put in place a written agreement between the parties, setting out the obligations on both sides; risk cannot be eliminated, but in this way, it may be mitigated and managed.
Is the sale of an NFT regulated?
The process of the sale of tokens may involve receiving and processing personal information of purchasers, and that personal data will be subject to UK GDPR regulations. These regulations place obligations on the data controller and processor (primarily the NFT project creator) as to the protections and limits on processing such data (including right to erasure). Some of the requirements to ensure compliance with the regulations are that:
- there is an adequate cookies policy in place online;
- internal policies are put in place to ensure anyone in the organisation can ensure compliance and understands what to do if there is a data breach; and
- there are sufficiently robust and comprehensive agreements in place with third parties that process data on the project’s behalf.
Further, any individual or business processing personal data is required to register with the Information Commissioner’s Office (ICO).
A breach of the above regulations can lead to a maximum fine of £17.5 million or 4% of the total annual worldwide turnover, so it is essential that any party processing personal data is familiar with the regulations.
An increasingly popular feature of NFT drops is a delayed reveal of the art behind an NFT, typically known as a “Mystery Drop”. In a Mystery Drop, it is only after you buy the NFT (normally for a set price) that the NFT (and its art) is revealed to you. The allocation of NFTs to buyers is purely by chance.
The problem with the delayed reveal/mystery drop feature is that it runs a very high chance of being classed as a “lottery” under the Gambling Act 2005, which is illegal unless it is operated under licence from the Gambling Commission.
The criteria of an illegal lottery, and why an NFT drop may be caught by these regulations, will be explored in more detail in a future article. However, if there are concerns in the meantime on this, please contact Will Charlesworth to discuss this further.
It is most likely that the sale of tokens under an NFT project will be subject to existing consumer rights legislation (the Consumer Rights Act 2015), which impose various obligations on the seller to ensure that, for example, what is sold is not misdescribed, it is fit for purpose and is of satisfactory quality.
The above legislation places an obligation on the NFT project to ensure that the token offered is as described in the whitepaper and in any other materials created to promote the sale.
Mis-selling claims present a potentially high risk for project creators and undoubtedly will form a large percentage of future NFT litigation. It is therefore recommended that project creators are aware of the obligations placed on them as sellers, ensuring that what is advertised for sale matches what is sold and that there are sufficiently robust terms and conditions of sale in place.
Navigating the regulatory landscape
It may appear that the existing regulations place overly onerous obligations on NFT project creators. However as explained, not all will apply, and with straightforward commercial legal advice, the regulatory landscape can be easily navigated.
Of course, regulation is only one of several legal elements to consider when launching an NFT project, and future articles will look at additional elements such as intellectual property rights, smart contract drafting, corporate structure, terms and conditions and third-party agreements, in more detail.
If you would like to discuss an NFT project, please contact Will Charlesworth.
This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.