The Unknown Legal Future of the Art Market’s New Favorite Medium: Non-Fungible Tokens (“NFTs”)

Just as Marcel Duchamp shocked the art world in 1917 with his absurdist creation of Fountain—a “readymade” sculpture consisting solely of an upside-down urinal with a signature on it—creators of non-fungible tokens (“NFTs”) are now pushing the boundaries of the conventional art world by creating works that exist only in the digital sphere.^[1]  The unique “absurdity” of NFTs breeds desirability, and collectors around the world are jumping at the chance to buy the next big NFT.

On March 11, 2021, Christie’s held an online auction for a non-fungible token (“NFT”) called Everydays: The First 5,000 Days, by Mike Winkelmann, a/k/a Beeple.^[2]  Everydays sold for more than $69 million to Vignesh Sundaresan, a/k/a Metakovan, the founder and financer of the cryptocurrency fund Metapurse, making it the third-most-expensive piece of art by a living artist ever sold at auction.^[3]  Metakovan purchased Everydays with Ether, a form of cryptocurrency.

Less than a week after Christie’s groundbreaking auction, Sotheby’s announced that it would be holding its own NFT auction, featuring the crypto artist Pak,^[4] and that it was also looking into ways to allow bidders to use cryptocurrency to pay for both digital and physical works.^[5]

With prominent auction houses diving into NFTs, digital works are a desirable new item in the art market.  The meteoric rise of NFTs has pushed the art world into a new digital age, but it also raises several questions about the legal implications of creating, purchasing and even selling fractional shares in NFTs.  Although as of yet there does not appear to be any litigation dealing with NFTs, legal disputes loom on the horizon.  To avoid becoming a legal test case, players in the art world should familiarize themselves with the potential legal implications of buying and selling NFTs.

What are NFTs?

NFTs function as a device for authenticating digital assets.^[6]  Through blockchain technology—in which a decentralized computer network permanently binds strings of data—NFTs attach to images on JPEG files, particular MP3s, GIFs, videos or other digital assets, and certify their authenticity and ownership.  In the art world, this process establishes provenance, creating a digitized chain of title, which in turn allows digital images to function like physical works of art on the art market.

Legal Implications

Copyright

An NFT cannot exist without an underlying digital asset.  If that digital asset constitutes an “original work of authorship,” such as a “pictorial, graphic or sculptural work,” it receives copyright protection under the federal Copyright Act.^[7]  An NFT, on the other hand, is likely not an “original work of authorship,” as it is merely a digital record of ownership.  Although it has not been tested in court, copyright protection likely only exists for the asset to which the NFT attaches, not for the NFT itself.

If we look to a physical painting as a comparison, an NFT would function like a certificate of title or authenticity (or both) accompanying the painting, rather than the painting itself.  The certificate would not receive any copyright protection from the painting’s copyright because the painting, not the certificate, is the creative work.  See Star Athletica, LLC v. Varsity Brands, Inc., 137 S. Ct. 1002, 1005 (2017) (“A valid copyright extends only to copyrightable subject matter.”).

Because copyright protection exists independently from NFTs, the query becomes whether an NFT buyer purchased only the token or the token plus the right to possess the (now unique) copyrighted digital work.  Questions over who owns the copyright for the work referenced in the NFT, and who has the right to use that copyrighted work, may result in litigation.

First, artists may sue NFT owners for violating copyright protections.  The Copyright Act provides a bundle of exclusive rights to the copyright holder, including the rights to reproduce, to distribute and to display the copyrighted work.^[8]  Unless the artist conveys the copyright to another in a signed writing, this “bundle of exclusive rights” remains with the artist.

There is an exception under section 109 of the Copyright Act that allows for the resale and display of copyrighted works (whether unique or part of a series of reproductions such as a print) by the owner of the physical work without the copyright holder’s permission.  Under the “first sale doctrine,” if someone purchases the physical work, he or she can sell, publicly display or otherwise dispose of that physical object without the permission of the copyright holder.^[9]  Courts have refused to apply the first sale doctrine to digital works, however, because they do not comport with the legislative purpose of the first sale doctrine.  See Capitol Records, LLC v. ReDigi Inc., 934 F. Supp. 2d 640, 655–56  (S.D.N.Y. 2013) (“[T]he United States Copyright Office . . . rejected extension of the first sale doctrine to the distribution of digital works . . . [because] ‘[p]hysical copies of works degrade with time and use, making used copies less desirable than new ones[,] [while] [d]igital information does not degrade, and can be reproduced perfectly on a recipient’s computer.’” (internal citations omitted)).  It is not clear whether courts will apply this logic to NFTs, but NFT creators should strongly consider obtaining permission from artists before reselling NFTs attached to those works, or risk a potential infringement suit.

Artists may also assign or license some of their rights, such as in the case of the CryptoKitties website.  CryptoKitties, which sells NFTs in the form of digital cats that people can buy and “breed,” provides a non-exclusive license to use, copy and display the “Purchased Kitty” for commercial use of up to $100,000.^[10]  In that instance, the CryptoKitties website could sue the owner of a Purchased Kitty if he or she acted outside the scope of the license, such as by earning more than $100,000 through sales of merchandise featuring copies of the Purchased Kitty.

Second, artists may sue under the Visual Artists Rights Act of 1990 (“VARA”).^[11]  As previously discussed on this blog, VARA grants living artists certain additional rights for “works of visual art.”^[12]  VARA provides the “right of attribution,” which grants the artist the right to prevent others from taking credit for her work, and the “right of integrity,” which grants the artist the right to prevent any modification to her work that would prejudice her “honor or reputation.”^[13]  VARA would allow crypto artists making visual images to sue those NFT creators or owners who do not provide adequate attribution or who otherwise modify the underlying images in a detrimental manner.

Third, infringement suits may arise when the owner of the copyright is not clear.  If an artist creates a work under an employment arrangement, that work may constitute a “work for hire” under section 101 of the Copyright Act, meaning that the employer, not the artist, owns the copyright.^[14]  If two artists collaborate on a digital work, and there is no “employer” who owns the copyright, legal disputes may also arise over who owns the copyright and who may license it.  Recently, after artist Krista Kim sold “Mars House,” the “first NFT digital house in the world,” for more than $500,000, Mateo Sanz Pedemonte, a 3D-modeller who created visualizations of Mars House, threatened legal action against Kim for copyright infringement, claiming that he had rights in the Mars House copyright.^[15]  Kim responded that she had contracted with Pedemonte for freelancing services, but that she never agreed to give him any rights in or to the artwork.

Fourth, in response to the potential infringement scenarios above, NFT owners may assert that their use of digital assets constitutes “fair use” under the Copyright Act.  As previously covered on this blog, the “fair use” defense allows the use of copyrighted materials for “transformative” uses including criticism, comment, news reporting, scholarship or research.^[16]  In evaluating whether a particular use of digital assets referenced in an NFT is “fair,” courts will need to balance four nonexclusive fair use factors codified in the Copyright Act.^[17]  Because the fair use analysis is highly fact-specific, it is hard to predict exactly how courts will rule on NFTs.  If NFTs continue to function as highly valuable tokens sold at auction for millions of dollars, however, their commercial value will likely weigh heavily against a finding of fair use under the first factor, as the seller of an NFT could realize a significant profit from the authorized use of a copyrighted digital asset.

Securities Laws

In addition to potential copyright infringement issues, NFTs may also be subject to securities registration laws, as they may be deemed “securities” under the Securities Act of 1933.^[18]  Before Everydays, MetaKovan purchased a previous collection by Beeple in December 2020, and made shares of the collection available through a digital token called B.20.^[19]  As the bids on Everydays went up, so did the value of the B.20 shares.  The idea that NFTs (or fractional shares therein) may be offered to the public with the promise of liquidity and increasing value raises questions around whether the NFT might be legally considered a security.^[20]

In SEC v. W.J. Howey Co., the U.S. Supreme Court articulated that a financial instrument or transaction is an “investment contract”—and thus a security—if there is:  (1) an investment of money; (2) in a common enterprise; (3) with profits to be derived solely from the efforts of others.^[21]  Under the Howey standard, “[f]orm [is] disregarded for substance and the emphasis [is] placed upon economic reality.”^[22]  Even though NFTs are unique, akin to collector’s items—which usually indicates that an asset is not a security—they may nevertheless be considered securities if they are sold to the general public with the promise of a return, if the issuer influences control in the secondary market, and if issuers influence their value through other services.^[23]  NFTs would therefore be subject to securities registration requirements, with failure to do so resulting in substantial civil and criminal penalties.

Money Laundering

Finally, sales involving cryptocurrencies, particularly NFTs, may also be susceptible to money laundering.  Criminals have for many years turned to the art market to disguise illicit sources of their money, and in recent times they have also notoriously used cryptocurrencies to cover their tracks.^[24]  By combining features of both art and cryptocurrencies, NFTs seem ripe for money laundering abuse—some have even described NFTs as the “best money laundering method in the cryptocurrency world.”^[25]  As cryptocurrencies are still a new form of currency, auction houses are less likely to be able to perform Know-Your-Transaction (“KYT”) analytics to prevent money laundering through these forms of payment.^[26]  The recent Anti-Money Laundering (AML) Act of 2020, which expanded the definition of “financial institution” under the Bank Secrecy Act (BSA) to include “dealers in art” and companies that transmit virtual currencies,^[27] may subject to its requirements any art market institution that facilitates the trading of NFTs.

Conclusion

The legal implications of buying and selling NFTs are murky at best.  In order to minimize the risk of litigation, art dealers and auction houses should draft clear contracts that explicitly address the copyright and other issues associated with NFTs.  They should also consider potential securities registration requirements, and should closely scrutinize buyers and sellers of NFTs in order to comply with government regulatory obligations.

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[1] Amanda Silberling, The Work of NFT Art in the Age of Blockchain Production, Observer (Mar. 15, 2021 12:29 PM), https://observer.com/2021/03/nft-max-osiris-foundation-art-dadaism-cryptoart/.

[2] Kyle Chayka, How Beeple Crashed the Art World, The New Yorker (Mar. 22, 2021), https://www.newyorker.com/tech/annals-of-technology/how-beeple-crashed-the-art-world

[3] Josie Thaddeus-Johns, What Are NFTs, Anyway? One Just Sold for $69 Million, N.Y. Times (Mar. 11, 2021), https://www.nytimes.com/2021/03/11/arts/design/what-is-an-nft.html

[4] Sotheby’s, The Fungible Collection, https://www.sothebys.com/en/coming-soon-collaboration-with-leading-digital-artist-pak

[5] Kelly Crow, Sotheby’s Enters NFT Digital Art Market, Considers Broader Cryptocurrency Options, Wall St. Journal (Mar. 16, 2021 9:23 PM), https://www.wsj.com/articles/sothebys-enters-nft-digital-art-market-considers-broader-cryptocurrency-options-11615944220

[6] See Chayka, supra note 2.

[7] 17 U.S.C. § 102(a).

[8] Id. § 106.

[9] Id. § 109.

[10] Terms of Use, CryptoKitties, https://www.cryptokitties.co/terms-of-use (last visited April 6, 2021).

[11] 17 U.S.C. § 106A.

[12] The Copyright Act defines “works of visual art” as “a painting, drawing, print, or sculpture,” or “a still photographic image produced for exhibition purposes only.”  Id. § 101.  The Act specifically excludes numerous works from that definition, including “any poster, map, globe, chart, technical drawing, diagram, model, applied art, motion picture or other audiovisual work, book, magazine, newspaper, periodical, data base, electronic information service, electronic publication, or similar publication[.]”  Id.  Because the Act does not exclude “digital art” from the definition, some scholars have concluded that “digital works” should be protected under VARA.  See Llewellyn Joseph Gibbons, Visual Artists Rights Act (VARA) and the Protection of Digital Works of Photographic Act, 11 N.C. J.L. & TECH. 531 (2010).

[13] 17 U.S.C. § 106A.

[14] Id. § 101.

[15] Tom Ravenscroft, Dispute breaks out over ownership of world’s first NFT house, Dezeen (Mar. 26, 2021), https://www.dezeen.com/2021/03/26/mars-house-fraud-3d-visualiser-nft/.

[16] 17 U.S.C. § 107.

[17] The four nonexclusive factors codified by the Copyright Act are as follows:

1. The purpose and character of the use, including whether that use is of a commercial nature or is for nonprofit educational purposes;
2. The nature of the copyrighted work;
3. The amount and the substantiality of the portion used in relation to the work as a whole; and
4. The effect of the use upon the potential market for or value of the copyrighted work.

Id.

[18] 15 U.S.C. § 77a et seq.

[19] Gerrit De Vynck and Douglas MacMillan, He just spent $69 million on a digital piece of art. It’s not his first Beeple, The Washington Post (Mar. 18, 2021 9:45 AM),  https://www.washingtonpost.com/technology/2021/03/17/nft-beeple-metakovan-christies/.

[20] Max Dilendorf, Esq. and Gleb Zaslavsky, Esq, Dilendorf Law Firm: Will NFTs be Deemed Securities Subject to the U.S. SEC Laws and Regulations?, PR Newswire (Mar. 16, 2021), https://www.prnewswire.com/news-releases/dilendorf-law-firm-will-nfts-be-deemed-securities-subject-to-the-us-sec-laws-and-regulations-301248675.html

[21] SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946).

[22] Id.

[23] See Dilendorf, supra note 20.

[24] Simon Chandler, Money Laundering Might Taint NFTs Too, Prepare For Tighter Controls, Crypto News (Mar. 27, 2021), https://cryptonews.com/exclusives/money-laundering-might-taint-nfts-too-prepare-for-tighter-co-9689.htm.

[25] Id.

[26] Paige Mason, The looming legal and regulatory questions NFT collectors and sellers should prepare for, The Art Newspaper (Mar. 22, 2021 7:46 PM), https://www.theartnewspaper.com/comment/the-looming-legal-and-regulatory-questions-nft-collectors-and-sellers-should-prepare-for.

[27] National Defense Authorization Act for Fiscal Year 2021, Pub. L. No. 116-283, 134 Stat. 3388.