alerts & publications
NFT: A Token of Corporate AffectionJanuary 25, 2023
For those of you following along at home, this is the latest in our series of client alerts about NFTs.
Now, not much has happened lately in the cryptocurrency world, right? Sure, there have been a few bankruptcies and some criminal charges, but this does not spell the end of digital finances. The metaverse continues to expand. Web3 is still accelerating. And more NFTs will be in the news in 2023 than ever before. In fact, it seems like there has never been a better time to be aware of all things crypto, including NFTs. Recall that we have looked at what NFTs are, their tax considerations, the impact of securities laws on NFTs, and their role in secured transactions. Here, we turn our attention to the uses of NFTs in the corporate legal world.
What’s an NFT again?
An NFT is a unique blockchain token. It is non-fungible, which means that it is not replaceable or interchangeable. NFTs were designed to prove ownership of unique digital or physical assets, and they are ideal for managing digital versions of existing physical assets (art, trading cards, other collectibles, etc.). The fact that NFTs are “stored” on a blockchain appeals to investors and collectors; the chain of title can be verified. And title to an NFT can be held anonymously.
NFTs are part of the fast-moving crypto-universe and it may be a while before the law catches up, but there are already some intriguing applications for NFTs in the corporate world. Let’s look at some.
Keepin’ It Real
Less than 30% of the world’s land is registered or tracked, and the transactions that are recorded are often written in a ledger, by hand, on paper (and older ones can still only be found on parchment or calfskin). So, maybe it’s time to modernize real estate records. Why not on the blockchain?
Instead of relying on a person to scratch out an entry on a grantor-grantee index, what if there was a way to codify that entry, and all of its metadata, onto a shared, public, unalterable, electronic ledger? (I know: Let’s call it a non-fungible token!) By removing humans from the process, it stands to reason that there will be fewer errors and clearer chains of title through automatic recording.
It is possible that NFTs will someday—soon—be involved in all real estate transactions, including the sale of property, leases, licenses, easements, covenants, condos, tax parcels, loans of various types, title insurance, escrow, property management, fund formation, joint ventures, LLCs, 1031 investors, entitlements, trust and estates, parking, partnerships, infrastructure, financial hedges, environmental, water rights, due diligence, signage, tower licenses, augmented reality envelope, and air rights. Did we miss anything?
So, what will this mean? For one, you might have to rethink what you know about contracts. Today, when two parties enter into a contract, they negotiate the terms and those terms are set for the length of the contract. The terms might not change for decades. After all, that’s how you know how much your mortgage payment will be next month. But with the proliferation of AI, companies are now looking to develop dynamic contracts, with terms that constantly change, in sync with the market. Your office lease, for example, might call for your rent to adjust automatically, in real time, based on the market.
Some parties might like that, while others may not. But the idea is that with all the data and the use of AI, there will be a migration to the mean, leading to greater stability and less risk.
The upside of so-called smart contracts—the automated contracts of the blockchain—is that they take humans out of the equation, as we said. That is also the downside. There will be fewer errors and less fraud, but parties may also lose the right to renege or exit a contract. There is risk in a contract that does not account for humans’ free will.
In a phrase that would befuddle your grandparents (and your parents and some of us), there is “physical real estate” and there is “virtual real estate,” and NFTs can be involved in both. Physical real estate—or “real” real estate—is dirt and rocks and bricks and mortar. Virtual real estate is land or property that you can buy within a virtual environment or game. To confuse matters, some virtual real estate NFTs are tied to physical properties in the real world and may even be replicas of real-world locations. These virtual “properties” are bought and sold as NFTs.
The advantages of NFTs (and the blockchain ledger) in the physical real estate world are obvious: They are programmable, transparent, automated, fast, and efficient. When a real-life asset is registered on the blockchain, a record of ownership is created (no ink on calfskin), and the transparency of that digital document allows anyone to check previous buyers, investments, actions, disputes, and payments. Transfers are completed at high speed and securely, with no traditional middleman and no costs associated with a middleman. And fractional ownership is made more practical in the NFT real estate world than in the traditional real estate world because of the ease of transferring and tracking these tokens without filing all the papers.
Still, the use of NFTs in real estate, particularly in commercial real estate, is not without challenges. First, remember those grandparents we mentioned? There is less enthusiasm for digital assets among older generations, and those people happen to hold the majority of commercial real estate in the U.S. And, while eliminating intermediaries may streamline the process in real estate transactions, such a demise could lead to the extinction of the useful roles played by title companies, property appraisers, and the like. For example, in a world where some real estate purchases are made sight unseen, these actors can guarantee the off-chain existence of the property.
There are legal implications to using NFTs in real estate. With governmental regulation and varying local laws, a wide array of legal preparations may be needed to ensure that the real estate purchase complies with local, state, federal, and even international law. Transferring property to someone else in today’s world requires (i) preparing the deed, (ii) signing the deed in front of a notary public, with witnesses present, and (iii) filing the deed. Until governmental authorities permit the notarization of NFTs and move the filing systems from the county recorder’s office to the blockchain, transfers of deed may hold no value without the old-fashioned signature, seal, and official filing. Some have already found ways to address these challenges. A year ago, a real estate developer in Silicon Valley sold a property by creating an NFT for it, wrapping the NFT in a legal framework, and devising a “know-your-customer” process that negated the problem presented by the anonymity of buyers. The developer also came up with a way to transfer an asset from one wallet to another, collect real names, and complete background checks. In this case, the happy buyer happened to be a millennial from Silicon Valley, who might be more receptive to an NFT transaction than many others looking to own a piece of the rock.
NFTs Offer Divine Provenance
In the same way that an NFT can be used as a “digital deed” for real estate transactions, it can also be used to track the provenance of personal property, whether that’s a piece of art, a yacht, or a sneaker. An NFT’s value is in its ability to verify provenance.
NFTs act as digital records of authenticity and provenance on the blockchain; each sale, trade, and owner are digitally etched in the NFT’s ledger, and the NFT’s metadata can include a certificate of authenticity. By heading off any uncertainty around an asset’s provenance, an NFT might actually enhance an asset’s value. It is important to note, though, that while blockchains and the digital chain of title created by NFTs are tamper-evident, the corresponding real-world items may not be. Although it is nearly impossible to switch out a piece of real property for a replica, this is certainly possible for art work and other collectibles. So, external controls on real-world items that are susceptible to fraud, like RFID tags linked to the NFT, would bolster certainty of provenance on all fronts.
To the surprise of exactly no one in the art world, British artist Damien Hirst is all over this. He issued 10,000 NFTs, each of which corresponds to a unique physical piece of art he made, which is locked in a secure, secret vault somewhere in London. He will transfer rights to the physical piece only when an NFT buyer “cashes in” their NFT with him; he will then destroy the NFT and bestow the physical piece upon the buyer. Who knows what’s next in NFTs and art? If anyone does, it’s likely Damien Hirst.
And now, just for kicks.
Typically, the sale of an NFT does not include the sale of the underlying asset or any intellectual property rights that vest in it. But, there are certain NFTs that are sold together with the underlying asset. One such NFT is Nike’s “CryptoKicks,” which Nike patented in 2019. Nike has tokenized ownership of a shoe by linking an NFT to an actual, physical shoe (or pair of shoes, presumably). This reportedly allows designers and businesses to have control over their shoe design—for example, by limiting the number of copies that can be produced. With the prevalence of fake shoes on the market, CryptoKicks provides an innovative way to combat counterfeiting. It also offers a limited-edition product, engendering brand loyalty between company and customer, and helping keep the business current and relevant.
What if the NFT is linked to an underlying tangible asset but the owner of the NFT does not possess the asset itself? Would a transfer of the NFT have the same legal effect as a transfer of the tangible asset? Imagine a scenario in which the NFT is transferred to a buyer, but the custodian holding the underlying tangible asset sells that asset to somebody else. Although the NFT is owned by a new buyer, the question remains whether the buyer actually holds ownership rights in the underlying asset. If the tangible asset is stolen or fraudulently transferred, the NFT will likely become worthless because it is no longer tied to a physical asset. Lesson: Any potential buyer should make sure that the seller of the NFT can and has legal capacity to effectuate a transfer of the underlying asset as well.
Anyone interested in using NFTs to transfer digital representations of real estate, precious metals, stocks, currency, or any other real-world asset should be mindful that this may trigger the registration and reporting requirements of the Bank Secrecy Act (“BSA”). Keep an eye out for another alert from us on this topic but know this: The Financial Crime Enforcement Network (which enforces the BSA) is looking more carefully at the transmissions of NFTs and digital assets.
Limiting An Identity Crisis
In the real world—the non-digital one, where you get coffee and walk your dog and eat and drink and sleep—you know who you are (albeit often with the assistance of psychotherapy, meditation, and spiritual guidance). You have an identity and you can prove it. It’s right there on your driver’s license, passport, or student or work ID—which is not to say that your identity cannot be stolen (identity theft accounted for US$5.8 billion in losses last year). And if you think identity is tough to secure in the actual universe, imagine how challenging it is to secure identity in the metaverse.
And that’s where NFTs come in. They could power online ID cards, like a digital driver’s license. They’re non-fungible, remember, so they are unique and not replicable. Not only would an NFT allow you to secure your digital identity in the virtual world, but it would also allow you to maintain your secure identity as you travel between virtual worlds. Yes, even non-gamers may eventually inhabit immersive virtual 3D worlds, and securing identity in those worlds will be crucial.
Through NFTs, you’d be able to control who you share your data with and even get paid—via your secure, unique identity—by any business in any world. Your NFT-verified online identity would be issued on the fully transparent blockchain, so you would have access to your data and see where it goes.
NFTs already secure ownership of non-physical assets—music, online property, memes, etc.—so it’s not too big a stretch to imagine a time when they will secure digital identity itself. And verifiable digital identities would allow the enforcement of Data Subject Rights as spelled out in data privacy laws and regulations (e.g., GDPR and CCPA), which have been ineffective in policing personal data collection and transfer. Digital identities offer tremendous opportunities. But blockchain technology is not a panacea. The real challenge is coming up with a way to prove that a particular digital identity represents the person or organization that it is meant to represent. When considering privacy laws like GDPR and CCPA, this question becomes even more complicated—what kind of evidence and how much of it is required to prove a digital identity—and the immutable nature of data on the blockchain might make personal data protection even more difficult to implement under existing privacy laws. Although fraud is apparent and traceable, it is not impossible. For example, depending on how the digital identity is structured, someone could sell or give away the private key associated with their digital identity.
In this rapidly evolving area of law, we will do our best to keep you informed. Stay tuned for the next client alert in our NFT series—it’s about IP. In the meantime, contact the professionals at O’Melveny if you have any questions. We assume you will have some.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Scott Sugino, an O’Melveny partner licensed to practice law in California and Illinois, Wenting Yu, an O’Melveny partner licensed to practice law in California and New York, William K. Pao, an O’Melveny partner licensed to practice law in California, Damilola G. Arowolaju, an O'Melveny associate licensed to practice law in the District of Columbia, Keith Guo, an O'Melveny associate licensed to practice law in California and Massachusetts, and Kevin Togami, an O'Melveny associate licensed to practice law in California contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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