What are NFTs?
NFTs are non-fungible crypto tokens created using blockchain technology. They are crypto tokens that are irreplaceable and consequently represent an individually defined crypto token in terms of type and content.
In Roman times, things were divided into replaceable items – genus (e.g. wine, oil, spices, etc.) and irreplaceable items – species, which represented individually determined items (e.g. works of art, horses, etc.). The distinction between replaceable and irreplaceable items had certain consequences in the legal system as early as the Roman Empire. One of these can be illustrated by the Roman saying Species perit ei cui debetur, genus periere non censetur, which means that the risk of accidental destruction of an individually specific item is borne by the creditor, while the risk of destruction of an item determined by type is borne by the debtor. The distinction between replaceable and irreplaceable goods also has consequences in the area of obligations. A replaceable item may be replaced by an identical individual item, where it is deemed that a replaceable item cannot be destroyed as it can be replaced by another. On the other hand, irreplaceable goods are originals that cannot be replaced by other goods.
NFTs in relation to the other crypto tokens, which are replaceable items1 in a legal sense (e.g. bitcoin, ether, etc.), are in a legal sense individually determined digital records that cannot be replaced by other items of the same kind. This characteristic has made NFTs the identifiers of digital originals, and in legal terms they carry all the characteristics of irreplaceable items.
Market use
The first mass use of NFTs took place at the end of 2017, when crypto tokens representing CryptoKitties2 were created on the Ethereum blockchain. CryptoKitties are unique digital images of cats, mainly used for collecting and trading. The number of transactions with CryptoKitties exceeded 3.2 million in 2018, and the record value of a single CryptoKitty was ETH 253 (equivalent to USD 164,000 at the time)3.
The use of NFTs has increased on the market in recent years. Currently, the most traded items in terms of number of transactions are digital collectibles4, computer game elements5 and other digital art (e.g. images, short films, GIFs) that can be created and sold by the user via online platforms6. The current NFT record is set by a digital image called EVERYDAYS: THE FIRST 5000 DAYS by Mike Winkelmann, which sold for ETH 42,329.453 in March 2021, equivalent to USD 69,346,250 at the time. Also popular among NFTs are images called CyberPunk, where there are 10,000 unique images of 24×24 pixels. CyberPunk no. 3100 was sold in March 2021 for ETH 4,2007.
One of the most high-profile sales in Slovenia was the sale of two unreleased songs by Slovenian electronic music artist Denis Jašerević (Gramatik) in the form of NFTs, where the value of the NFT reached just under EUR 1.3 million. At the end of September, it was announced that Slovenia will be the first country in the world to issue its own NFTs, which it plans to give to every visitor to the Slovenian pavilion at Expo 2020 in Dubai. NFTs are already being used by a number of other Slovenian companies.
Example of an NFT
An NFT does not actually represent the digital file (e.g. image, film, GIF, song, etc.) that is supposed to be the subject of a particular NFT, but merely contains the metadata of that digital file that is stored somewhere on the web. For example, Mike Winkelmann’s digital image file EVERYDAYS: THE FIRST 5000 DAYS measuring 300 MB was stored in a decentralised way on the user network using IPFS8 protocol. The author then created an NFT using a smart contract that specifies the terms of disposal. However, this NFT does not contain the digital file of the image, but only contains metadata including the title of the image, a description of the image, a fingerprint of the digital file (a unique digital identifier) and a web address for accessing the decentralised digital file.
For a feel, I am attaching an NFT record:
{“title”: “EVERYDAYS: THE FIRST 5000 DAYS”, “name”: “EVERYDAYS: THE FIRST 5000 DAYS”, “type”: “object”, “imageUrl”: “https://ipfsgateway.makersplace.com/ipfs/QmZ15eQX8FPjfrtdX3QYbrhZxJpbLpvDpsgb2p3VEH8Bqq”, “description”: “I made a picture from start to finish every single day from May 1st, 2007 — January 7th, 2021. This is every motherfucking one of those pictures.”, “attributes”: [{“trait_type”: “Creator”, “value”: “beeple”}], “properties”: {“name”: {“type”: “string”, “description”: “EVERYDAYS: THE FIRST 5000 DAYS”}, “description”: {“type”: “string”, “description”: “I made a picture from start to finish every single day from May 1st, 2007 — January 7th, 2021. This is every motherfucking one of those pictures.”}, “preview_media_file”: {“type”: “string”, “description”: “https://ipfsgateway.makersplace.com/ipfs/QmZ15eQX8FPjfrtdX3QYbrhZxJpbLpvDpsgb2p3VEH8Bqq”}, “preview_media_file_type”: {“type”: “string”, “description”: “jpg”}, “created_at”: {“type”: “datetime”, “description”: “2021–02–16T00:07:31.674688+00:00”}, “total_supply”: {“type”: “int”, “description”: 1}, “digital_media_signature_type”: {“type”: “string”, “description”: “SHA-256”}, “digital_media_signature”: {“type”: “string”, “description”: “6314b55cc6ff34f67a18e1ccc977234b803f7a5497b94f1f994ac9d1b896a017”}, “raw_media_file”: {“type”: “string”, “description”: “https://ipfsgateway.makersplace.com/ipfs/QmXkxpwAHCtDXbbZHUwqtFucG1RMS6T87vi1CdvadfL7qA”}}}
To identify this NFT, the smart contract number (0x2a46f2ffd99e19a89476e2f62270e0a35bbf0756) and the NTF sequence number (40913) are important. With this information, we can access the metadata stored in this NFT and, using the web address contained among the metadata, the digital file itself, which is stored decentralised on the user network. This means that anyone can use the above information to access the digital file of the image in question and download9 it seamlessly10 to their computer. The NFT holder is therefore not the only one who can access and dispose of the digital file. The NFT holder is the only one who has a token embedded in the blockchain containing the metadata of that digital file, and only the NFT holder can use his private key to dispose of that NFT.
Legal view
On the market, the sale of NFTs is usually referred to as the sale of digital assets or the transfer of ownership of these assets. It is important to be careful since these sales are usually not legally structured and are subject to a number of risks. The legal analysis of these sales is complex and usually implies something quite different from what the buyers of NFTs currently imagine as the purchase and what is often (mis)reported in the public domain.
There are a number of different entities involved in NFT transactions. Typically, the minting (i.e. creation) and sale of NFTs is done through a platform that acts an intermediary in the minting and transfer of NFTs. The party that mints NFTs determines the content thereof, and the parameters of the smart contract that will manage an NFT. The creators of NFTs are usually also the sellers of NFTs. It may, however, be that the seller is not also the author of the copyright work referenced in the metadata in an NFT. In this case, in order to conduct transactions with NFTs in a legally proper manner, the rights and obligations vis-à-vis such author must also be regulated. Finally, there are buyers of NFTs who purchase NFTs from sellers via platform. In the legal analysis of NFT transactions, the legal relationships between all these entities must be properly regulated so that we can exclude the risks associated with NFT transactions.
NFTs typically contain metadata about a wide variety of copyright works (e.g. images, short films, GIFs, etc.). Sales of NFTs are mostly about the sale of these copyright works. For copyright works, the key issue is the transfer of economic copyrights. This means that when selling NFTs, it is necessary to ask whether the purchase and transfer of an NFT also includes the transfer of the economic copyrights on those copyright works. Under the provisions of the Copyright and Related Rights Act (“ZASP“), the transfer of ownership of an item (in our hypothetical case, an NFT) does not affect the individual economic copyright. The question arises whether the transfer of metadata recorded in NFTs can be considered the transfer of the ownership of the item. In any event, the transfer of the ownership of a work does not entail the transfer of (all) economic copyrights. As the sale of NFTs usually does not involve a specific contract governing the transfer of the rights associated with NFTs, there is a risk that the economic copyrights on such copyright work would not be fully transferred, but it would only be a non-exclusive transfer to the new NFT owner of those economic copyrights that are essential to achieve the purpose of the contract. In such cases, it would most likely be a mere transfer of the right to use the copyright work. However, it becomes even more complicated when NFTs are sold on the secondary market – i.e. when NFTs are purchased from a person who is not also the author of the work to which the metadata in the NFT refers. The ZASP stipulates that the copyright holder cannot transfer the copyright to a third party without the author’s permission, unless, of course, otherwise agreed in a contract. This means that if a person buys NFTs on the secondary market without a specific economic copyright agreement, they take on additional risks in this respect. The licence agreement and the copyright assignment agreement must be in writing. If the transfer of rights is not regulated in writing, disputed and unclear provisions are judged in favour of the author and, in our case, to the detriment of the buyer of the NFT. If no additional contract is concluded by the parties to the sale of the NFT, the rights and obligations under the copyright should be judged against the buyer of the NFT.
Given the rigid nature of the disposition of economic copyrights, we see that without the precise regulation of the contractual relations between the parties, there is a risk that the NFT holders do not even hold the corresponding economic copyrights on the works referenced by the metadata in the NFTs. The general terms and conditions of the major platforms, which are usually the only explicit agreement between the parties when selling NFTs, do not regulate the legal relationship between individual parties (author – seller – buyer), but only the parties’ relationship with the platform. Economic copyrights are transferred between parties and not in relation to the platform. A review of the general terms and conditions of online platforms reveals that the general terms and conditions of these platforms do not regulate the transfer of copyrights between parties. In the general terms and conditions of platforms, parties are usually obliged to ensure that the use of the platform will not lead to any copyright infringement, which is significantly insufficient for proper regulation (e.g. of the transfer of economic copyrights).
Given that an NFT is a token containing the metadata of a particular digital work, one has to ask what such a token even is. An NFT could possibly represent a computer program as a copyright work, in particular in view of the example of the NFT presented above, but an NFT cannot represent the copyright work to which the metadata in that NFT refers. An NFT could only constitute a copyright work as such if it contained a complete digital record of the digital copyright work. The NFT comes closest to an identification mark as defined in the Obligations Code (“OC“), as it does not define the obligation of the issuer, nor does it define the issuer or the beneficiary. The contractual obligation is not regulated with the identification mark, but is regulated by a separate transaction. Thus, the main purpose of the identification mark is to identify the creditor of that obligation, not to regulate rights and obligations or the transfer thereof. The latter must be dealt with in a separate transaction. This means that the contractual obligation is created by the conclusion of this separate transaction and not by the issue or transfer of the identification mark, which serves merely as evidence of the existence of the contractual obligation. All these characteristics of the identification mark coincide with those of NFTs. It should, however, be pointed out that legal theory11 takes the view that the OC only regulates materialised (e.g. paper, metal or other material) identification marks and that an identification mark cannot be dematerialised. This raises the question whether an NFT in digital form could nevertheless be considered as an identification mark as regulated in the OC.
The identification mark does not constitute proof of entitlement to a counterclaim, but is merely a certificate that facilitates verification of who is acting as a creditor in a contractual obligation. This means that the right from the underlying transaction can be transferred independently of the identification mark, which is not acceptable for the NFT market, since the market view is that it is the NFT that is the holder of the rights. This characteristic is closer to securities or identification paper, where the NFTs are problematic because of the strict rules of form which the NFTs do not comply with.
All this shows that an NFT is difficult to fit into any existing legal instrument, as it is a sui-generis product with specific characteristics. In this respect, the legal treatment of NFTs is uncertain and introduces risks into the relationship between the parties, in particular if it is not explicitly regulated.
The international element of the legal relationships with NFTs also creates additional uncertainty, as the parties to these transactions are usually from different countries. In the absence of an explicit agreement on the applicable law, the first step is to analyse which law applies to the relevant relationship between the parties. Different legal regimes may ultimately lead us to very different legal consequences of these transactions.
Conclusion
The volume of trading in NFTs and the values achieved by individual NFTs on the market show that this is an area that needs attention, as the wrong legal structure may cause serious consequences on the market. In this context, it is important that the legal relationships between the different stakeholders are properly regulated in the project design, i.e. the buyers of NFTs are made aware of the risks to which they are exposed when purchasing an NFT. As presented above, NFT transactions cannot be fully accommodated within the existing legal instruments. The transfer of any copyright on the work referred to by the NFT is highly questionable. The current legal regime is not fit for the purpose of NFT transactions. It is therefore all the more important to be vigilant in NFT transactions, as all parties involved are exposed to risks if the business between the parties is not further and adequately contractually regulated, either by general terms and conditions or by a contract between the parties. What is interesting in all this is that buyers are willing to pay millions for NFTs containing metadata, including a link to the web address where the digital image file is located, without ever having acquired any copyright on such copyright work. A large part of the purchase price of these NFTs thus represents the subjective price of the collector’s value, rather than compensation for the copyrights on the work contained, which is usually not acquired by the buyer at all. However, if buyers believe that by purchasing NFTs they have also acquired economic copyrights on the copyright work referred to in an NFT, a whole new range of legal issues can quickly arise (e.g. mistake, fraud, deceit, invalidity, etc.). The buyers don’t really think that they have also acquired any economic copyrights by buying an NFT, do they12?
1. Although in technical terms they represent individually defined crypto tokens on a specific blockchain.
2. https://www.cryptokitties.co/
3. This was CryptoKitty Founder Cat #18.
4. Collectable digital cards of football players – https://sorare.com/, GIF cats – https://nekonft.io/ and Pokemon-like images – PolkamonOfficialCollection
5. Two of the more popular games are collecting, cultivating and fighting – https://axieinfinity.com/ and the upcoming monster fighting game – https://www.illuvium.io/
6. The most popular are https://foundation.app/, https://opensea.io/, https://niftygateway.com/ andhttps://rarible.com/
7. Converted into American dollars at the date of purchase, this amounts to USD 7,584,485.82.
8. InterPlanetary File System
9. As this is a decentralised network of users and a 300 MB file, this transfer takes a little longer than we are used to for this type of file on the broadband Internet.
10. Subject, of course, to any copyright associated with that copyright work.
11. A. Polajnar Pavčnik, Obligacijski zakonik s komentarjem (ang. Obligations Code with comments), Book 2, p. 179
12. I hope that potential buyers are not mislead by somewhat awkward media coverage and public statements that, by buying an NFT, they also acquire ownership over the digital work
