Protecting your NFT personal property rights

Your NFT may become a mere empty picture frame, here are the legal implications.

Originally published by Wake Forest Journal of Intellectual Property Law: http://ipjournal.law.wfu.edu/2022/02/the-growing-popularity-of-nfts-how-to-protect-your-nft-personal-property-rights/

With an astounding $17.7 billion in sales in 2021 alone, the non-fungible token (“NFT”) has recently undergone a dramatic rise in prominence in the cryptoverse, similar to the “crypto summer” of 2017-18 or the “DeFi summer” of 2020. Although NFTs have been around since 2014, this asset class has only just experienced its first and quite remarkable outgrowth, thus staking its claim in the broader blockchain industry. However, the NFT’s meteoric growth should also foster thoughtful discussion about its underlying technical and legal status as property. Unfortunately, owners of most NFTs are vulnerable to being dispossessed of them, which undermines their very nature as an asset class. This is not only a future threat, it is already happening. Throughout this blog I present this issue through a legal lens, offering guidance and possible solutions to the industry.

What really is an NFT?

NFTs enable people to own unique digital assets, and to track and transfer them on blockchains. With such broad functionality, NFTs are used for in-game items, ticketing, and medical records. High-profile art NFT projects include those by artist Beeple, who sold his digital art NFT for a record-breaking $69 million, and CryptoPunks, and The Bored Ape Yacht Club, which are NFT collections commonly used as profile pictures and confer other social benefits. But what property rights in NFTs are actually conferred to their “owners.” Surely, the staggering value proposition of this particular CryptoPunk NFT would diminish if the purchaser (for a whopping $11.7 million) knew that the NFT may or may not reference any art at all. This is the unfortunate reality for most NFT projects: their artwork is entirely mutable which defeats the entire purpose of those NFTs.

To explain, an NFT is a unique digital token stored on a blockchain—it acts as a record of ownership of an item, like a certificate of authenticity of a cat painting. The cat painting itself does not usually immutably exist on the blockchain. Nevertheless, there is a global expectation that an NFT is the artwork itself because it is common industry practice to equate the artwork with its token.  

Going deeper, on the Ethereum blockchain (where most NFTs exist) all NFTs must conform to the ERC721 smart contract standard. This industry-adopted standard is relatively simple: it specifies which specific address holds a specific NFT, which is nothing more than a unique identifier in a given NFT smart contract. With that said, the only unique aspect of an NFT is that each NFT minted from a given smart contract will have a different identifier (e.g. “3”)—uniqueness is not derived from the actual asset that the NFT represents (like the image of a cat).

Instead, what an NFT really “looks like,” or the unique asset referenced by an NFT is determined by the metadata included in an NFT’s smart contract. This metadata may be “on-chain” or “off-chain.” On-chain metadata is the most secure since it immutably lives on a smart contract on a blockchain. Examples of on-chain metadata are found in projects like Avastars (whose source code may be found here) and Fidenza (whose generative art algorithm is found here). This art is stored entirely on the Ethereum blockchain, but deploying such NFTs can be prohibitively expensive.

Recognizing the high cost of deploying NFTs with on-chain metadata, the ERC721 standard includes a method, “tokenURI,” to allow developers to simply tell NFTs where to find their metadata, and developers can then host that data somewhere off-chain, like on a website. Typically, NFTs do indeed point off-chain to either an HTTP URL metadata file or a hash on IPFS (a data storage protocol). These solutions, however, require constant hosting, most likely by NFT creators. This art, however, does not immutably exist on a blockchain. Consequently, the NFT market is an “absolute house of cards” since NFT owners will lose the very assets that their NFTs are meant to reference if their creator goes out of business or abandons the project, thus shutting down their website or IPFS server.

While one might think that an NFT’s metadata being unhosted is inconsequential if its creator leaves the community anyway (signaling an end to the project), this is simply not the case. One measure of an NFT’s success is through the growth of its community. At some point, the community behind an NFT becomes bigger than its founders and persists after they are gone. A recent example shows that purging a project of its unfit founder may have actually increased the NFT’s value fourfold. Communities that coalesce around NFT projects—and start to govern them—should not be held hostage by mutable metadata monopolized by their NFT’s creators.

What’s the legal bottom line?

These early art NFT projects implicitly grant, at minimum, owners of NFTs a license to display the NFT’s artwork in a limited capacity via a specific NFT smart contract on a blockchain. Beyond a clear breach of contract, many other established legal theories exist that could protect these license holders from having their art “rug-pulled” out from under them: deceptive and unfair practices, conversion of property, implied duty of good faith, misrepresentation, and non-disclosure. Any particular legal analysis will change according to the discrete circumstance of each project, but most analyses should start with answering: (1) who owns the underlying art of an NFT, and (2) regardless of ownership, who has the burden (if any) of hosting an NFT’s metadata? This analysis will roughly follow the below examples.

Larva Labs (the creators of CryptoPunks) employs the Dapper Labs NFT License. The license specifies that NFT creators own all legal rights to the art while purchasers only have limited rights such as to copy or display the “Art.” Critically, it defines the “Art” as “any art, design, and drawings that may be associated with an NFT that you Own.” This license makes it clear that the art of a CryptoPunk may or may not actually be referenced by its NFT. In other words, Larva Labs owns all intellectual property connected to the CryptoPunks and has no duty whatsoever to actually host their metadata. Consequently, there may be little recourse for CryptoPunk owners if their NFT’s metadata becomes unhosted, thus making their NFTs nothing more than empty picture frames.

In contrast, Yuga Labs (the creators of Bored Apes) confers complete ownership to Bored Ape owners and draws no line between the legal owner of any intellectual property and actual ownership of the NFT. Their Terms and Conditions read:

You Own the NFT. Each Bored Ape is an NFT on the Ethereum blockchain. When you purchase an NFT, you own the underlying Bored Ape, the Art, completely. Ownership of the NFT is mediated entirely by the Smart Contract and the Ethereum Network: at no point may we seize, freeze, or otherwise modify the ownership of any Bored Ape.

Bored Ape owners have all legal rights associated with their NFTs. Yuga Labs also binds itself to never “seize, freeze, or otherwise modify the ownership of any Bored Ape,” while defining Bored Ape as both “an NFT” and as “the Art.” As a result, Yuga Labs also has a duty to host their metadata. Otherwise, Yuga Labs would be modifying the ownership of a Bored Ape because the art would no longer even exist.

My goal here is to illuminate this very real issue for individual projects and communities to work out between themselves. Although much of this is complex, it should be enough to say that offering to sell art to people, and then essentially destroying that art, is not good. Playground morals and the law have a lot to say about that practice. This problematic relationship of reliance between an artist and owner also implicates a slew of other centralization issues from both a best-practices perspective and a regulatory perspective. While I expect some NFT projects to call the lawyers and do some clever contracting to solve this issue, I nevertheless encourage community-focused and technology-mediated approaches. Possible solutions might consist of migrating metadata on-chain, employing side chains, or enabling owners to host their NFT’s metadata. One convenient route may be to back up NFT metadata through projects like ClubNFT. But until action is taken, consumer protections may be swept aside as communities get dispossessed of their art due to their mutable metadata.

About me:

Joshua is a proud cheesehead who studied at the University of Wisconsin, now a 2L at Wake Forest Law. He is currently interning at the SEC and a crypto payments company. This summer, he will be joining Crowell & Moring in DC as a summer associate, with plans to work extensively in their digital assets practice. His boyfriend Adam is a veterinarian and thinks crypto is “like Kohl’s cash.” 🤦🏻‍♂️