Legal Issues Arise as Tangible Assets Acquire Internet Identities  --- A 'non-fungible token' is a crypto asset that represents or points to an asset that is either digital or physical. NFTs for tangible assets give rise to a range of novel liability questions and associated costs.

November 01, 2021 New Jersey Law Journal

By Jonathan Bick      Bick is counsel at Brach Eichler in Roseland. He is also an adjunct professor at Pace and Rutgers law schools, and the author of “101 Things You Need to Know About Internet Law” (Random House 2000).

Midwest Tungsten, a supplier of metal for industrial uses, recently paired a blockchain with a 14.545-inch, 2,000-pound cube of tungsten to produce a non-fungible token (NFT). Assets that are digitally transferrable between two parties via blockchain are commonly referred to as “tokens.” An NFT is a crypto asset or “token” that represents or points to a physical or digital asset such as art, videos, land or, in this case, a cube of tungsten. NFT for tangible assets give rise to a range of legal liability issues including those related to asset storage, transfer, visitation rights (in the case of tangible NFTs), privacy rights, as well as related costs.

These tokens are designated as “non-fungible” because they are not interchangeable for other items; they are unique. Bitcoins, which also are blockchain assets, are not unique and are therefore fungible. One bitcoin, like one dollar bill, has the same characteristics as another; they are readily exchangeable because they are of exactly equal value. 

NFTs give the NFT holder the ability to claim ownership of any unique asset that it represents. The resulting NFT is trackable, easy to transfer, and uses a trustworthy technology, namely, blockchain. Blockchains are widely distributed digital ledgers, which make them nearly immutable, that are used to record transactions in “blocks” of computer code that are time-stamped and linked together, evidencing the provenance of an asset, either digital or tangible. Blockchains also disclose the history of transactions for digital assets, making it impossible for an assets record to be modified or deleted.

From an economic perspective, NFTs make it possible for creators to generate unique and finite tokenized versions of digital creative works and to commodify such assets, while ensuring that the digital creative work cannot be counterfeited. For instance, an NFT creator can establish both the sales price and the maximum number of replicas of the asset that are associated with the NFT. This allows the NFT creator to maintain the scarcity of their asset, which can increase the NFT’s value, as in the case of lithographs.

From a technological perspective, each NFT is composed of code stored in the form of a smart contract that is issued as a token and stored on a blockchain. NFT ownership is managed through the unique ID and metadata that no other token can replicate.

Smart contracts are computer programs stored on a blockchain that are self-executing when predetermined conditions are met. Since they are self-executing, the participants can be certain of the outcome without any intermediary’s involvement or time loss. In addition to distributing funds, more sophisticated transactions may be executed such as releasing previously executed agreements to transfer title of the underlying NFT asset, or initiate royalty, license or rent agreements.

The use of smart contracts, which results in the immediate transfer of the title of the tangible NFT’s underlying asset if there is a failure to timely pay storage and/or insurance costs to the tangible asset holder, may result in legal difficulties. Such difficulties have resulted from supervening events such as impossibility/impracticability of performance, frustration of purpose, failure of conditions, anticipatory repudiation, and later agreements/contract modifications between the parties.

The technical protocol of an NFT incorporates the immutable nature of blockchain technology. More specifically, blockchain cannot be edited or deleted, it can be viewed publicly, and it can be traded with verifiable ownership which includes the history of its ownership.

These blockchain features could result in data privacy and related data protection issues.  For example, some data privacy statutes allow individuals “the right to be forgotten” and/or the right to rectify inaccuracies in their personal data. The blockchain protocol and its immutable characteristic may make it impossible for an NFT holder to comply with such rights and thereby breach data protection law.

In the past, NFTs were executed for assets which might be digitized, and thus represent easily reproducible items such as photos, videos, audio, and other types of digital files as unique items. As such, they were analogous to a certificate of authenticity, and combined with a blockchain technology to create a verifiable public proof of ownership.

Since the copies of the original file are not restricted to the owner of the NFT, they may be copied and shared like any file. The lack of interchangeability (fungibility) distinguishes NFTs from blockchain cryptocurrencies, such as Bitcoin. Nevertheless, once NFTs incorporate tangible assets like original sheet music, sports memorabilia and fashion items owned by celebrities, NFTs were no longer merely certificates of authenticity.

The tangible element associated with certain NFTs (such as the one associated with a 2,000-pound cube of tungsten) give rise to novel liability questions and associated costs which differ from digital assets associated with other NFTs. For example, while a digital asset securing an NFT (such as a photo image) may be stored in a computer, a tangible asset securing an NFT (such as a cube of tungsten) should be stored in a vault or other physical container. While a digital asset may be transferred electronically, a tangible asset requires physical handling. While a digital asset may be visited remotely, a tangible asset will likely require an audit at its storage location.

However, some liability issues are common for both tangible and digital NFT assets. More explicitly, both tangible and digital NFT assets have an NFT, and the assets it represents are typically stored separately. For both tangible and digital NFTs, the NFT is stored on the blockchain and contains information on where the digital asset is located.

For digital NFTs, the NFT is connected to the digital asset via an internet link. However, if the digital asset is deleted, or the server hosting it fails or otherwise goes offline, the link will break and the NFT that remains will be worthless because it would no longer be associated with the digital asset, and there is no way to back up the NFT. Whereas for tangible NFTs, the NFT discloses the location of the tangible asset’s storage location. If the storage location is destroyed or the tangible asset is lost or stolen, the NFT that remains will be worthless because it would no longer be associated with the tangible digital asset.

In the event the NFT is unique and cannot be replaced, the NFT holder might be left without recourse. This in turn may result in financial losses, business interruptions, regulatory record keeping violations, and contract breaches.

NFTs associated with both tangible and digital assets may result in intellectual property legal difficulties. The NFT is protected by one copyright and the asset associated with the NFT is protected by another copyright (if digital) and possibly a trademark (if tangible).

When a purchaser buys an NFT, the purchaser owns the NFT itself, which is a record of ownership of the unique asset of the underlying asset (which is protected by a copyright). When the NFT is transferred to another, both the NFT and its copyright are automatically transferred. However, the intellectual property rights associated with the underlying asset may not necessarily be automatically transferred, unless stated otherwise.

The ownership of the underlying asset may be by contract. More specifically, the NFT contract will determine if the copyright to the underlying digital asset or property rights in a tangible asset can be transferred. Smart contracts, which govern the NFT, can be coded to specify that certain proprietary rights, including intellectual property, transfer upon the sale of the NFT. In addition, standard terms and conditions, contracts for sale, deeds of assignment or licenses, expressly setting out how rights to the underlying asset are dealt with, can be incorporated into the sale of an NFT.

Other legal liability issues arise when a party issues an NFT of a public domain work or other property for which the issuer has no rights and falsely claims ownership. Alternatively, an NFT issuer could infringe trademark and/or copyright rights of another due to misrepresentation.

Additional legal difficulties may arise from the enforcement of the smart contracts written into the code of NFTs that allow for the distribution of funds for the payments both to the creators of digital related NFTs and sales income for owners of tangible NFTs. One obvious legal difficulty is associated with transaction taxes since U.S. law does not recognize resale rights relating to creative works, so the law provides no recourse for unpaid resale royalties in the United States.