The ABCs of NFTs

Over the last few months, we produced a series of client alerts about those powerhouses of the crypto-universe, DAOs. Now we’re tackling non-fungible tokens or, as they’re almost always referred to, NFTs. In this initial alert, we will explain the basics of NFTs and touch on some of the legal issues surrounding them. In coming weeks, we will dive deep into what you need to know about laws involving intellectual property, securities, and bankruptcy before jumping into the NFT market.

If you are reading this, you probably have some familiarity with NFTs. You probably know something about Bored Apes and Crypto-Kitties and NBA Top Shots. You may know that Prada started a line of NFTs, that filmmaker Kevin Smith released his latest movie as an NFT, and that Warner Bros. announced a partnership with Nifty’s to launch a collection of NFTs called Looney Tunes: What’s Up Block? And you might not be surprised to hear that the total value of NFTs sold in 2021 was more than US$17 billion.

We’ll start with some basics, and many of you—like those who know that someone paid US$69 million for an NFT created by artist Mike Winkelmann (aka Beeple) of a collage of 5,000 digital images—may think you can skip ahead. Don’t.

Are you sure you know exactly what an NFT is?

So, Christie’s auctioned Winkelmann’s original piece of art for nearly US$70 million, right? Not exactly.

An NFT is a unique blockchain token. Token here is not like a subway token. A subway token was like a casino chip, identical to a million other subway tokens that people slipped into a turnstile to board the New York City subway. An NFT is the opposite. It is non-fungible, which means it is not replaceable or interchangeable, and it is designed to prove ownership of a unique digital or physical asset.

And just to be clear: The NFT you just bought is not the art itself, either. Your NFT is the record that says you and only you own the art—and what that means exactly depends on the fine print. Also, the “art” your NFT refers to is not necessarily art as you might think of it. It could be a digital image, a song, or a video clip, but it could also be digital perfume or a virtual sofa or the rights to advertise on a tennis player’s arm—it could be any one-of-a-kind digital asset.

So, those modern Medicis out there snapping up NFTs are not really “art collectors.” They are “blockchain-token collectors.” They are not buying an oil painting or a bronze sculpture; they are buying a set of code on the blockchain that contains metadata. That metadata includes various categories of information identifying a digital asset, including the address to a smart contract (the basis for all NFT transactions) and links to the token ID. The code points to the digital asset that you and everyone else on Earth can see, but only the NFT buyer owns the pointer.

It’s not so different from dealing with traditional art. After all, anyone can search online to find digital copies of Andy Warhol’s famous pop art depictions of Marilyn Monroe, but that doesn’t mean everyone owns the original Shot Marilyns series of silkscreens. In fact, just a few months ago, art dealer Larry Gagosian bought Shot Stage Blue Marilyn at a Christie’s auction for US$195 million, making him (or perhaps one of his deep-pocketed clients) the owner of one of the most expensive works of 20th century art. If he had bought an NFT, he would have a digital certificate of authenticity minted on the blockchain, giving everyone notice that he owns the authentic asset. 

Think of it like the deed to a house. The deed isn’t the house; the house isn’t the deed. You can’t sit on the couch in the den of the deed, but without the deed, you have no house and no den and nowhere to sit. And how do we know who owns the house? The deed.

Can't anyone just copy the asset?

Of course! Just like anyone can print a copy of Warhol’s Marilyn or of the Mona Lisa, for that matter. But it’s pretty easy to determine the authenticity of that Mona Lisa on your wall (it’s a fake!), and it’s just as easy to determine the authenticity of an NFT. Remember: The metadata lives on the public blockchain.

This is not to say that someone couldn’t create a fake NFT, with phony code, but because the blockchain is transparent and public, tracing the provenance of an NFT is pretty easy. Someone could create a fake Chanel purse (no one would do that!), but the person with the real Chanel has a certificate of authenticity. And most people know that a “Chanel” purse bought off the back of a truck for US$100 is probably not authentic.

So, you can’t really fake an NFT since anyone can verify its code on the blockchain, but you can make a copy of the art, just like you can make a fake Chanel purse. It just won’t be worth very much.

Where are NFTs bought and sold?

Well, there’s Christie’s, but that’s really not for most people or for most NFTs. OpenSea is the largest NFT marketplace. Think of OpenSea as eBay for NFTs. On OpenSea, you can search for the type of NFT you want. Let’s say you like a particular Bored Ape NFT, you can see the other versions of the design on OpenSea—as you now know, each is unique, with its own combination of features. Maybe you want one with a little red hat, gnawing on a slice of pizza, and wearing a puka shell necklace. OpenSea is where you go to find and buy it. OpenSea is also where you can sell an NFT you create.

Like eBay, OpenSea is an open platform. But some NFT providers have created their own, closed platforms. That’s what the NBA did with its NFT partner, Dapper Labs. If you want to buy an NBA Top Shot Moment NFT—a digital video highlight clip—you have to go to the Top Shot marketplace. And for legal purposes, the type of platform matters; there are different risks and ways to protect the intellectual property depending on the platform.

But once someone owns an NFT, they can obviously do what they want with the asset...

Not necessarily. We’re going to talk about this more in an upcoming client alert, but licenses, and rights and limitations, vary from NFT to NFT. The terms and conditions vary, too. Before you invest in an NFT, read the fine print. What exactly are you buying? How terms and conditions are presented to customers and how customers are consenting to them matters a lot when it comes to NFTs.

For example, sometimes NFT owners are allowed to copy and display an image of the asset and sometimes they aren’t. Sometimes they can create derivative works and sometimes they can’t. Buying an NFT for NBA Top Shot, for example, gives the owner a limited license to use the asset for personal use. But only for personal use. This is unlike Bored Ape Yacht Club NFTs—people have launched restaurants based on specific Bored Ape NFTs. 

At least NFTs are safe and sound...

As safe as anything in the crypto-universe. Well, actually, they can be less safe than many digital assets. Since an NFT is a pointer, so it is conceivable that someone could see to it that your pointer no longer points where you thought it pointed, or to anything at all. And since you keep your NFT keys in a digital wallet, your credentials in that wallet could be stolen, such as through a phishing attack asking you to share your wallet credentials (via ruses aptly named “wallet drainers”). The NFT system is built on trust. Not only can you be tricked into giving up your credentials, but you can also be suckered into buying something fake. And some shady types do not deliver the products they promise, while others have been accused of rigging the market. 

Fraud aside, the market is volatile, and it is highly speculative. Remember the early stages of e-commerce, when people were (rightly) afraid to type in their credit card numbers? Let's just say that NFTs present some unique security questions.

Speaking of questions...

Yes, everyone has a lot of them. And some questions have no answers. Yet. There is a lot about NFTs that has not yet been determined or settled. 

The point is NFTs are new. The legal terrain is unmapped, and you will need some wise counsel to help navigate it. We will do our best to keep you informed. Stay tuned for the rest of our NFT series, which will cover the IP basics, corporate uses of NFTs, US securities issues, how to perfect your security interest in NFTs, and how UK law is treating NFTs.

In the meantime, don't hesitate to contact us. We’d be happy to help. 

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. William Pao, an O’Melveny partner licensed to practice law in California, Scott Sugino, an O’Melveny partner licensed to practice law in California and Illinois, Amy Siegel, an O'Melveny partner licensed to practice in California, and Scott Pink, an O’Melveny special counsel 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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