To the Metaverse and Beyond: Correcting Common Misconceptions around NFTs

Introduction

Non-fungible tokens (NFTs) have become the latest big thing to come out of the blockchain industry and capture mainstream attention. A wide range of artists, brands, investors, businesses and consumers are embracing NFTs. Despite this active interest and substantial investment, however, there continues to be significant misunderstandings in terms of what NFTs represent and their real world applications. This continued misunderstanding comes at a cost, both to investors who may not have purchased the rights for which they thought they had bargained, as well as to artists and businesses who may be missing out on opportunities to properly leverage the new technology.

This is what happened in the case of SpiceDAO, a collective that paid almost USD$3 million for a copy of a rare art book for Jodorowsky’s Dune (a proposed film adaptation of the science fiction novel Dune) on the mistaken belief it would enable them to produce an animated series based on the underlying copyright and trade-mark intellectual property (IP) rights and related NFTs. Unfortunately, only a copy of the unreleased book was purchased and not any of the IP rights required to create new content based on the related copyright. As NFTs proliferate, situations like SpiceDAO’s will continue to occur. To avoid making the same mistakes, industry and market participants should ensure they fully understand the rights associated with NFTs.

NFT Overview

An NFT is a cryptographic asset or “token” linked to an object, which can be either digital (e.g., digital art, music, photos or a service) or physical (e.g., collectables). Ownership of an NFT is recorded on the underlying blockchain – most commonly, Ethereum or Solana. A “blockchain” is a decentralized set of digital records (i.e., a digital ledger) replicated across multiple computer systems by peer-to-peer networking, thereby ensuring transparency and authenticity. An NFT is “non-fungible” because, unlike cryptocurrencies such as Bitcoin, which are fungible like fiat currencies, each token is unique. NFTs are “minted” by artists and other creators who use “smart” contracts to create and manage their sale and resale. NFTs are currently bought and sold on several digital marketplaces (e.g., OpenSea, SuperRare, Foundation and Rarible) using the cryptocurrency of the blockchain on which they are hosted (e.g., Ether).

An NFT’s packet of digital information includes its unique identifier, record of ownership and a pointer (e.g., a URL or a serial number) to another object.¹ That object can be anything – static objects, like digital, intangible and physical assets, or something more dynamic, like the performance data of a professional athlete.² NFTs can also operate as virtual identities that can interact with – and be acted upon within – a system, for example, to provide the holder with additional access privileges in a digital system. To properly harness the unique value that NFTs may be able to bring, a proper understanding of how they function, both from a legal and technical standpoint, and how they interact with the world, is essential.

Common Misunderstandings re: NFTs

Unfortunately, there are a number of misunderstandings about NFTs. In particular, the concept of “ownership” of an NFT is one of the most common of these misunderstandings. Many people assume that ownership of an NFT in and of itself conveys a proprietary interest in the underlying object, much like SpiceDAO thought that ownership of Jodorowski’s Dune would entitle them to the associated IP rights. Ownership of an NFT does not itself, however, create any legal right or interest in the object to which the NFT is linked per se. Rather, unless otherwise agreed by the owner of the linked object, the only ownership right acquired by the purchaser of an NFT is the exclusive right to control the digital wallet assigned to the NFT and any related rights (if any) which are licensed or transferred by the owner of the linked object to the purchaser (such as the right to display the NFT for non-commercial purposes or to resell the NFT) whether by operation of the smart contract tied to the NFT or by virtue of the terms of use of the NFT marketplace on which the NFT is purchased.

Any other legal rights associated with control of the NFT must be directly acquired or licensed from the owner of the linked object. For example, only the owner of a copyright work that is linked to an NFT, such as a digital artwork, can legally authorize the purchaser of the NFT to exercise any copyrights in relation to the linked digital work such as reproducing it, making copies of it, publishing it, etc.

To further illustrate this, outlined below are two different examples of how the concept of “ownership” of an NFT can be different depending on the context: NFT art and digital assets in the “Metaverse”. These are by no means the only examples of the many ways the technology may, and will, be applied, but they illustrate the broader issue.

Case Study: NFT Art

The value of NFT art has grown exponentially – recently, for example, digital artist Beeple’s “Everydays: the First 5000 Days” sold for almost USD$70 million. While the purchaser obtained a copy of the high quality source code for the digital artwork and limited personal use rights, they did not obtain any ownership interest in the copyright associated with the underlying work. This is because the purchase of NFT art is fundamentally no different than the purchase of an oil painting. In both cases, purchasers do not generally obtain any rights or interest in the underlying copyright to, for example, make reproductions of the art for sale to the general public. The copyright interests in works of art can only be licensed or transferred by a written agreement signed by the artwork’s creator (or the creator’s duly authorized agent).

While this issue has been debated in the NFT space for several years, there is no general consensus on how copyrights should be addressed in NFT art transactions. Instead, there is a broad range of ways creators address the copyrights associated with NFT art. In some cases, the copyrights are not addressed at all (i.e., no transfer of ownership or licensing of any copyrights). In other cases, some creators explicitly incorporate the Creative Commons CC0 license, pursuant to which the copyright is licensed subject to the terms of that license. Other creators have set out their own more comprehensive copyright licenses. For example, Dapper Labs, creator of the “Cryptokitty” collection, uses its own customized open source “NFT License” that provides users with a broad license covering both personal uses and some commercial uses, explicitly allowing Cryptokitty owners, for example, to sell Cryptokitty-branded merchandise (albeit with a $100,000 limit).

The recent price convergence of two prominent NFT art collections – CryptoPunks and Bored Apes Yacht Club (“Bored Apes”) – has intensified the debate about the scope of NFT copyright licenses. CryptoPunks, which dropped in 2017 and does not provide a written license for the underlying copyright, was one of the earliest and most valuable NFT collections launched. To date, there have been almost $2 billion in sales associated with the CryptoPunks NFT collection. Bored Apes, on the other hand, which launched last year, has created some favourable buzz among collectors since it provides owners with both personal and commercial use licenses.

Other than the different IP rights associated with the NFTs (and aesthetic differences aside), both collections share many similar traits: both are limited to 10,000 unique pieces, with each piece being randomly generated based on a variety of potential attributes, and trade on a fairly liquid secondary market. Although CryptoPunks had maintained its status as the more valuable collection since inception, the floor price for the two NFT collections converged in December of 2021 as the debate within the community regarding the associated IP rights picked up, with the floor price for Bored Apes now well in excess of the floor price for CryptoPunks.

One of the driving factors behind this shift appears to be the sale by the pseudonymous “Punk 4156”, who sold their namesake CryptoPunk for over $10 million in December of 2021 after expressing disillusionment with the direction the CryptoPunk creators were taking the associated IP rights. While the market appears to be attributing a value premium for the commercial use license by Bored Apes, it has yet to be shown whether there is much value in commercializing one NFT alone or several NFTs in a brand that is effectively comprised of 10,000. This is especially the case given that the license granted with the Bored Apes is non-exclusive, meaning the IP owner retains the right to produce competing derivative products, and the underlying IP could be altered unilaterally by the IP owner at any given time.

Case Study: The Metaverse

As noted above, an NFT often denotes ownership of a purely digital asset, with the holder’s rights to that digital asset established and enforced by the operating code of the system in which the NFT and digital asset exist, and the terms of use of the applicable NFT marketplace. NFTs will therefore likely play an essential role in the development of the “Metaverse”. The Metaverse is a virtual space that exists either on top of (augmented reality, or “AR”) or beyond (virtual reality, or “VR”) our physical environment. Although the concept has recently received renewed interest (for example, Facebook recently changed its legal corporate name to “Meta Platforms”), the idea of a digital space that operates as a second layer of our lived experience has been around for years in the video game industry. Immersive multiplayer environments were popularized in the early 2000s with games such as Second Life, released in 2003, introducing players worldwide to online virtual communities that allow users’ personalized avatars to interact with others in the virtual world. Today, players can and do purchase additional in-game items, like new and unique character skins. A broader experience (for example, across games as opposed to within a single one), combined with an immersive, VR or AR experience, allows for a multitude of possibilities for the evolution of gaming, communication and commerce in the Metaverse.

Ownership of an NFT in a Metaverse application similarly has two layers: the legal agreement between an IP owner and the NFT holder, and the legal relationship between both of those parties and the provider of the Metaverse infrastructure. In addition to the assignment or license agreement between the IP owner and the NFT holder, the terms of use related to the Metaverse environment in which the NFT will be deployed will be an important consideration. In the event that individuals and enterprises invest substantial dollar amounts in creating, monetizing and leveraging digital assets in the Metaverse, these rules written by the infrastructure providers will greatly affect the value of those assets.

For example, even if an NFT holder has certain rights granted by the owner of the underlying IP, they may find that those rights are circumscribed by the relevant Metaverse’s policies regarding the use of NFTs. The constraints put on the use of NFTs in the virtual space may not accord with the rights the NFT holder is typically used to enjoying with other property they own in the real world. Moreover, the Metaverse infrastructure would be provided on an as-is, where-is basis, with no continuing obligation on the infrastructure provider’s part to continue providing the service. Both of these points could substantially affect the use and therefore value of an NFT. Consider a situation where you own an NFT representing a piece of digital real estate, but the infrastructure provider releases a new digital space and announces it will stop hosting the old one. You may still own the NFT, which would still exist on the relevant blockchain, but the virtual world in which it represented digital property has now gone dormant, rendering the NFT potentially worthless. Similarly, if the digital asset contravenes one of the infrastructure provider’s policies (regarding, for example, offensive content) the provider could simply block the use of that NFT.

In either case, parties looking to use NFTs in the Metaverse should be aware that they are operating in an environment where their legal rights to enjoy and freely exploit their property are subject to the control of a third party, which may act contrary to their expectations and to their best interests. This third party risk should be addressed when dealing with NFTs in the Metaverse.

Looking Ahead

Whatever the application, creators and owners of NFTs should pay close attention to the terms of the smart contract associated with the NFT to ensure their respective expectations regarding the associated rights are met. There are numerous prominent examples where the code of smart contracts has failed to ensure compliance with the parties’ intentions, such as the now- infamous hack of Ethereum’s decentralized autonomous organization (DAO). A DAO is a blockchain-based cooperative that is owned and operated by its members, where the relationship between the members and each other is governed by smart contracts. The first DAO, which was launched in April, 2016, raised more than USD$150 million to crowdsource funding for blockchain projects. Within several weeks of the launch, however, other parties were able to exploit a flaw in the underlying smart contracts, which allowed them to siphon off tens of millions of dollars worth of Ether from the DAO. This was reversed through a “hard fork” of the Ethereum blockchain, essentially using majority consensus to override the “fraudulent” transactions; however, that is neither an efficient nor desirable means of addressing the issue.

Like many developments in the blockchain industry, the solutions to these problems will not necessarily be new. In particular, like it or not, the existing legal system (to the chagrin of many cryptocurrency maximalists) applies equally to transactions on the blockchain and in the Metaverse, which are not exempt from such conventional laws. While there is a continuing practical issue of how you create and define legal relationships between parties operating on a blockchain, this issue is not insurmountable. For example, there are several groups working towards general implementation of Ricardian contracts – written agreements that can be read by machines (smart contract) and people (written language contract). If realized, this will provide a framework for the parties to a smart contract to address misunderstandings, malfunctions, and other matters that cannot adequately be addressed by the smart contract’s written code.

As these developments and others continue at a dizzying pace, our team at Goodmans LLP is working to provide our clients with the advice and guidance they need to maximize the value that can be realized through this exciting new emerging technology.