Protection of Non-Fungible Tokens in the United States

19th October, 2022 - 6:31 am Categories: Technology 0 Comments

Introduction

Since the advent of the Internet more than 20 years ago, society has benefited from an online network centred on communication, data, and information. A number of independent virtual worlds have also emerged, mostly on social media and in video games like Fortnite and TikTok. The metaverse promises interconnected virtual worlds that can be navigated via neutral interfaces and electromyography motions. Companies will have the unheard-of power to fully utilise the possibilities of the data they gather in the metaverse.

[Image Source:Freepic]

The development of the metaverse, a network of 3D virtual worlds where people may engage with one another socially and commercially mostly through avatars, is something that the technology sector and the video game industry are preparing for. The metaverse does not yet exist and is still a long way from becoming a reality, at least not in the way that certain journalists are currently describing it. This is mainly because for it to succeed, there are strict computational requirements and established procedures.

However, NFTs are already a reality. NFTs are cryptographic data units with distinctive metadata that are based on current blockchain technology. As a result, NFTs can be recognised from one another and can store other types of information, such as various people’s names or artistic creations. Due to their individuality, they can be bought, sold, or traded, with all transactions being recorded in a digital ledger. For the benefit of the entertainment sector, NFTs use the capabilities of blockchain technology to produce non-fungible digital files containing embedded images, graphics, or videos that set the token’s market value. Over the last 30 years, countries with a strong Internet presence have established new rules to address e-commerce, criminal activities involving technology, consumer rights on digital content and the liability regime for Internet service providers, to name a few.

The metaverse is a virtual world where avatars controlled by people or computers can operate virtual objects like furniture, guns, and automobiles, all of which may bear trademarks or other works protected by copyright. The logical conclusion is that the creators of the metaverse will have to respect the rights of inventors, designers, and owners of unique signs as in the real world because IP rules deal with the intangible components of an object, whether physical or virtual. As a result, a particular right holder will have the right to pursue the exploitation of his or her IP rights in the metaverse, for instance, when tied to a digital avatar’s virtual pocketbook or jacket.

Regarding NFTs, the conclusion is similar. NFTs are digital files in which creative works or other subject matter, such as a video or an artwork, can be embedded. As long as copyright provides an exclusive right over original works of authorship and this is distinct from the ownership of any digital object in which the works are embedded, then anyone who uses, for example, a sound recording or a clip from a video game in an NFT will need prior authorization from the copyright holder of such work. There is, therefore, little debate on the application and validity of the current regulations to NFTs and the metaverse.

According to the Berne Convention for the Protection of Literary and Artistic Works, which has been ratified by 181 nations, contracting parties are required to provide writers exclusive rights over their works, regardless of the medium or mode of expression. Other international agreements have also been added to the Berne Convention, such as the 1996 WIPO Copyright Treaty, which updates the Berne Convention for the digital age. The storage of a protected work in digital form on an electronic device is explicitly prohibited by this agreement (Agreed Statement about Article 1(4) of the WIPO Copyright Treaty) (such as an NFT or a file, the content of which is displayed in the metaverse) constitutes a reproduction which needs the prior approval of the copyright holder. It seems that the law does not always travel so slowly.

Regulations in the United States

A “security” is defined as “any note, stock, in any profit-sharing agreement, collateral-trust certificate, preorganization certificate of subscription, transferable share, investment contract,… or, generally, any interest or instrument commonly known as a security” in accordance with Section 2(a)(1) of the Securities Act.

The Securities and Exchange Commission (SEC) has been given the authority by the US Congress to regulate a variety of products as securities, including NFTs. The statute requires judges to consider a product’s economic reality rather than its form when analysing NFT legal concerns.

If an NFT is shown on the decentralised ledger as a collectible with a public assurance of authenticity and corresponds to an existent asset, it should not be regarded as a security. An NFT, however, becomes a security if it has been sold as an asset that will generate a profit thanks to the work of others.

But there is one exception. The NFT is not regarded as a security if the price increase may be exclusively attributed to external market conditions, such as inflation.

NFT platforms that enable the sale and secondary trade of the asset may need to register with the SEC as a broker-dealer, exchange, or alternative trading system. Fractionalized NFTs may be viewed as securities. A weakly regulated alternative trading system is trading venue that matches buyers and sellers for transactions.

The “Howey Test” was established to assess what qualifies as an investment contract following the U.S. Supreme Court decision in the SEC v. W.J. Howey Co. case. One important factor that reflects the American government’s position on NFTs is the Howey Test. The Howey test classifies the NFT assets as investments in a common business with earnings anticipated from the promoter’s or a third party’s efforts.

The Office of Foreign Assets Controls, in general, is responsible for overseeing most US sanctions (OFAC). OFAC has declared that the sanctions system applies to digital transactions even though it hasn’t yet released any guidelines specific to NFTs. Additionally, OFAC has been working to impose sanctions on blockchain-based transactions.

Conclusion

Money services business (MSB) models utilising digital currencies have been subject to FINCEN regulation. “Digital currency,” according to the regulating authority, is a “means of exchange that can operate like a currency but does not have all the characteristics of real currency, including legal tender status.” Convertible virtual currencies (CVCs) are viewed as units that can be used in place of actual money. The capability of a non-fungible token as a virtual currency will decide its classification as a CVC. The majority of NFTs are just a unique, underlying asset represented digitally, making them more likely to be classified as a digital collection than a CVC. However, as NFTs can also be exchanged for fiat, there is a case to be made for them to be regarded as value-substituting money. State-by-state differences exist in the laws governing money transmitters. From a regulatory perspective, establishing NFT laws and regulations is a different game than controlling fungible tokens because it is difficult to predict which use cases NFTs might fit into. It would be unrealistic to believe that NFT legislation is imminent. Before American rules catch up to the advancements in the field, it can take some time.

Author: Tanya Saraswat, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.