In the past year, fashion, retail, and beauty brands have begun experimenting with various approaches to non-fungible tokens (NFTs)—digital assets recorded on a blockchain ledger to prove ownership and authenticity of anything unique, such as tweets, artwork, images, videos, in-game items, and even title to real property. Unlike fiat currency or blockchain-based assets such as Bitcoin and Ether that are identical, interchangeable, and fungible, each NFT is sui generis (i.e. non-fungible) and unique. It is sometimes helpful to think of NFTs as a digital version of a collectible baseball card or a rare piece of art.
Numerous examples of NFTs offered by retailers have made the news in recent months. Dolce & Gabbana recently sold a nine-piece collection of NFTs of digital images of fashion items, alongside some actual goods, for a total of 1,885.719 Ether, the equivalent of roughly $5.7 million at the time of purchase. Burberry partnered with Mythical Games to sell branded NFT accessories for the video game Blankos Block Party. Other brands like Clinique are selling NFTs exclusively to loyalty program members, and adding online and instore perks for purchasers.
While NFTs can help fashion, retail, and luxury brands drive customer engagement and loyalty, a number of complex legal regimes can apply to the creation, sale, and exchange of NFTs. Brands should carefully consider the applicability of these regimes, many of which have unclear applications to NFTs, before jumping into an NFT project. Below, we provide an overview of a few of the legal regimes that can present challenges for NFT issuers, including retailers.
Will Your Issuance, Sale, or Exchange of NFTs Make You a "Money Transmitter" Subject to FinCEN Requirements and State Laws?
The Department of Treasury's Financial Crimes Enforcement Network (FinCEN) requires certain entities that administer or exchange digital assets to register with the agency as a money transmitter (a type of regulated money services business (MSB)) and comply with a variety of anti-money laundering regulatory obligations.
To date, FinCEN has not issued guidance specific to NFTs, but it has issued guidance addressing the administration, exchange, and use of convertible virtual currency (CVC), defined as "virtual currency" that "either has an equivalent value as currency, or acts as a substitute for currency."1 Virtual currency, in turn, is defined as "a medium of exchange that can operate like currency but does not have all the attributes of 'real' currency" such as government backing.2
Certain NFTs, such as those offered as part of a largely similar class or set of NFTs, could be considered CVC. However, because NFTs by definition are digital proof of ownership of unique assets, they do not typically function as "a medium of exchange" or substitute for real currency and, therefore, many NFTs do not seem to meet the definition of CVC. Instead, their creation, sale, and issuance would be more similar to that of a unique good, the sale of which is generally not subject to FinCEN rules.
With that said, retailers launching NFT projects often contemplate activities that go beyond simply creating and issuing NFTs. For example, a retailer might consider assisting consumers in purchasing NFTs using digital assets or creating a marketplace for selling its NFTs. That activity may subject the retailer to FinCEN regulation, even if the NFTs in question do not constitute CVC.
Additionally, certain NFTs may be considered securities (discussed below). In that case, a retailer engaged in selling NFTs could be deemed as a broker or dealer in securities, which triggers a similar set of FinCEN regulations (in addition to requirements imposed by Securities and Exchange Commission (SEC) rules).
It is also important to keep in mind state laws related to money transmission. Nearly every US state has a law requiring entities to obtain a money transmitter license before conducting business in the state, and a handful of states, including New York, now have virtual currency-specific regulatory regimes. The substantive scope of each state’s law and its applicability to digital assets varies considerably. Most states have not issued guidance on NFTs. While many states are likely to follow the federal approach, a number of states may elect to deviate and take a different stance toward NFTs.
Is Your NFT a Security?
A key question for many retailers issuing NFTs is whether the tokens constitute securities under federal securities law. If the tokens are securities, a variety of requirements, principally set out in the Securities Act of 1933 and Securities Exchange Act of 1934, govern the offer or sale of the tokens.
Section 2(a)(1) of the Securities Act and Section 3(a)(1) of the Securities Exchange Act
define a security to include "investment contracts." Under the so-called Howey test, set forth in SEC v. Howey Co., 328 U.S. 293 (1946), investment contracts generally include the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. This arguably does not include most NFTs, where the owner's expectation of profit is linked to the value of the underlying asset unique to the NFT, rather than to the managerial or entrepreneurial efforts of the companies, foundations, or entities managing the blockchain or protocol upon which the NFT was minted.
However, this continues to be an area of uncertainty as the SEC’s Framework for Investment Contract Analysis of Digital Assets, which provides guidance on how the Howey test’s prongs apply to digital assets, does not specifically deal with NFTs. Given the lack of clarity from the SEC and the broad scope of the relevant statutes, the SEC could attempt to regulate at least some NFTs as securities. For example, SEC Commissioner Hester Peirce has indicated that at least one type of NFT, so-called fractional non-fungible tokens (F-NFTs), may be securities. F-NFTs divide ownership of an NFT into smaller fractions, allowing multiple persons to have an interest in the same underlying asset at the same time. In discussing F-NFTs, Commissioner Peirce noted that companies selling F-NFTs "better be careful that you're not creating something that’s an investment product” because the SEC's "definition of security can be pretty broad."3
In addition, revenue sharing from future sales of NFTs, or similar arrangements, may complicate the securities law analysis. For example, where a retailer creates an NFT, but wants to retain royalty rights, that could be viewed as creating a commonality between the retailer and subsequent NFT owners, because both the retailer and the owner would benefit from an increase in the price of the NFT. Such commonality may imply that the retailer has a continued interest in the price of the NFT and, therefore, that the owner is relying on the continued efforts of the retailer to increase the price.
Is Your NFT a Commodity Subject to CFTC Regulation?
In 2014, the Commodity Futures Trading Commission (CFTC) declared that virtual currencies are "commodities" subject to CFTC oversight under the Commodity Exchange Act (CEA)—a view that has since been confirmed by multiple federal judges. Thus, the CFTC has regulatory jurisdiction over the trading of virtual currency derivatives (swaps, futures, and options), as well as certain investment funds and investment advisers that engage in activities related to virtual currencies or virtual currency derivatives. The CFTC has also asserted jurisdiction to enforce certain anti-fraud provisions of the CEA in the underlying spot markets for virtual currencies and has brought multiple enforcement actions against digital asset market participants, including exchanges, intermediaries, and fund managers.
However, this raises a fundamental question of whether NFTs should be treated the same as fungible virtual currencies for CFTC purposes. Under the CEA, a "commodity" includes all goods and articles, and all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in (with limited exceptions).4 While NFTs are likely goods or articles, at present, there is not a futures market for most NFTs nor is there a clear use case for the development of such a market down the road. With that said, the rapid pace of change in the digital asset space makes it difficult to predict how NFTs might evolve and how the CFTC will view them.
Could Your NFT Project Implicate Economic Sanctions Laws?
Most US economic sanctions programs are administered by the US Department of the Treasury’s Office of Foreign Asset Controls (OFAC). US sanctions can be broadly divided into “primary” and “secondary” sanctions. Primary sanctions apply to transactions and activities involving a US nexus. These include transactions and activities occurring within the United States or in which US persons are involved. Secondary sanctions typically apply to conduct performed by non-US persons, even if there is not a direct US nexus, where the US government has determined that the conduct offends US national security and/or foreign policy interests.
Civil liability for primary sanctions violations is enforced on a "strict liability" basis. This means that any violations of US primary sanctions may give rise to monetary penalties even if the person undertaking the activity had no knowledge, or reason to know, of the violation.
This means it is important for persons issuing, selling, or exchanging NFTs to have a good understanding of the identities of their counterparties to avoid inadvertently engaging in prohibited conduct. This is particularly true for transactions conducted entirely in digital assets, where the level of due diligence required or conducted can vary greatly across platforms. Retailers considering creating platforms through which third parties can engage in the sale/purchase of their NFTs (or the NFTs of others) should also carefully assess the sanctions risk posed by such models and options to mitigate those risks.
What About Intellectual Property Law?
When thinking about intellectual property law, the key consideration for NFTs is understanding precisely which intellectual property rights are associated with a given token. For example, certain NFTs do not confer the right for holders to reproduce the underlying item (e.g. a song or image) or to profit off such reproduction. Nor does the sale of an NFT necessarily mean the creator is prohibited from selling or distributing additional copies of the same item. The rights associated with an NFT can dramatically impact the value of the token. Therefore, it is important that creators, sellers, and buyers of NFTs have a clear understanding of the precise intellectual property rights associated with the token.
Retailers that want to mint and sell NFTs face a number of complex and rapidly changing legal obstacles. The good news is that not every legal regime will apply or present obstacles in all NFT use cases. Before entering the NFT space, retailers should carefully assess which regimes are likely to apply to their intended operations, and whether there is a way to design the project to avoid triggering the most burdensome obligations.
1 FIN-2019-G001, “Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies” (May 9, 2019), at 7.
3 Sophie Kiderlin, Business Insider, The SEC's 'Crypto Mom' Hester Peirce says selling fractionalized NFTs could be illegal (Mar. 26, 2021), https://markets.businessinsider.com/news/currencies/sec-crypto-mom-hester-peirce-selling-nft-fragments-illegal-2021-3.
4 7 U.S.C. § 1a.