One of the unique features of non-fungible tokens (NFTs) is the ability to distribute royalties from resales. When the digital artist Beeple’s NFT piece “Crossroads” was resold on the secondary market for $6.6 million in February at more than 100 times the original sale price, Beeple himself netted a 10% royalty from the transaction. NFTs are smart-contract based digital assets that can facilitate and enforce the terms and conditions of the transaction. How does the royalty structure work in NFTs and to what extent are they customizable, and what are the legal limitations of such “smart contracts”?
Pratin Vallabhaneni and Adam Chernichaw, partners at White & Case, explain how the NFT royalty feature works, the potential legal issues surrounding resale royalty rights, and the regulatory considerations for NFTs.
Pratin Vallabhaneni is a partner at White & Case in the global Financial Services Regulatory practice.
Adam Chernichaw is a partner at White & Case in the Technology Transactions Practice within the firm’s Global Mergers & Acquisitions Group, and is a member of the firm’s Fintech Leadership Team.
Interview with Blockchain Lawyers – Pratin Vallabhaneni and Adam Chernichaw
Joel Cohen: Non-fungible tokens or NFTs can range from digital art to famous tweets to video clips of sports highlights, and they can sell for thousands or even millions of dollars. But today, we'll talk about an unusual feature of NFTs which is their ability to pay royalties, royalties not just on the original sale but on secondary sales, resales that may happen in the distant future. Hello, and welcome to TalksOnLaw. I'm Joel Cohen. Today, we're talking about NFT royalties and we're joined remotely by two blockchain attorneys, Adam Chernichaw and Prat Vallabhaneni of the law firm White & Case. Welcome to TalksOnLaw.
Adam Chernichaw: Thanks, Joel.
Pratin Vallabhaneni: Great. Thanks, Joel. Thanks for having us.
How do NFT royalties work?
JC: So why don’t we get to the royalty functionality of NFTs. First off, did I describe it right in the introduction? How does it actually work?
AC: So the way the royalties work in the context of NFTs is that when an artist or a person who's creating the NFT initially sets it up, they could build into the code by way of something called a “smart contract” a method of pushing a portion of the resale proceeds back to the original creator. And it's called a smart contract but it's not really a contract so to speak. The question is still out as to the bindingness of that contract. It’s just code that is executable upon the occurrence of an event that causes something else to happen, in this case, the transfer of proceeds or portion of the proceeds from the resale of the NFT on a particular marketplace.
Customizing NFT Royalties
JC: You mentioned that the royalty is kind of written into the blockchain. You know, Prat, are they, how customizable are they? Can I write into the contract that I don't want the royalty to continue? Can I write that I want it to continue for 20 years or just for the life of the artist, etc.?
PV: Your creativity and the native technology of the blockchain are really your only limitations. As a practical matter though, what we've seen with early iterations of platforms with our clients is that they've tried to create the most palatable market-friendly construct, and this idea of a perpetual royalty has gotten a lot of traction and inspired the interest in creating NFTs. I suspect over time and what we're actually seeing from clients is more finite terms, limitations on the life of the products and whether that's one year, 20 years, perpetual, all of these issues will be customizable. They will probably be platform dependent, and as I think we see a maturation of the different assets that are grafted onto the NFTs or tethered to the NFTs, we’ll probably have different terms that are more appropriate for different types of NFTs, so whether that's natively digital art or a package of concert tickets that you can use that are linked to the NFT.
JC: The royalties kick in with each resale if it's structured that way in the smart contract but is there a way for someone to then sell the item, the NFT, outside of the original platform?
PV: Yeah, that all depends on what the terms of the platform are. If there is transferability off platform, and we're seeing more of that and there is technological capability to move from the platform's architecture to an off-platform wallet and then one can then in turn transfer from wallet to wallet, there absolutely from a technological perspective is that possibility. Whether commercially, the terms allow for that is totally within the scope of the terms, and I think users need to be really careful in understanding what it is they're actually agreeing to.
NFT Royalties under US Property Law
JC: Maybe this is a good time to touch on US law. In US property law, and perhaps more importantly in IP law, there isn't necessarily a concept of perpetual royalty. It's, you know, once an item is sold, then the rights to that item no longer reside with the creator. So if there is a dispute, how does US law help or what role would US law play?
PV: I would just say that NFTs as a property concept can be decomposed into a few different pieces. There's the underlying reference asset. It may be natively digital or it may not be. It may be transferred from a physical medium into a digital form like a photo that is digitally rendered but not originally created digitally. There's the actual property aspects of the NFT as a token or coin itself. And then there is the user interface and all of the other ancillary information, documents, contracts that may exist and reside on a platform. And it's important to keep in mind the separate and unique nature of each of these different aspects but also how they come together as a bundled product. The underlying reference asset may have an independent legal existence of its own. It has its own property rights, and it has its own maybe statutory framework for royalties, but the token itself exists within a blockchain architecture. It is property. It can be bought and sold. But how it's tethered to the underlying reference asset via the other commercial agreements maybe that come from the platform where they’re bilaterally negotiated between parties, all stitched together these different pieces. And so it's important to remember that smart contracts, as they often say, are neither smart nor contracts, and we are still reliant upon real world agreements and contracts to put all these pieces together.
AC: If you're the consumer, you need to read the terms of service to be clear on what you're actually getting when you purchase or ostensibly purchase the NFT. And when you're the creator, you need to read the terms of service to make sure you're comfortable with what you're actually giving away to the platform.
NFT Royalties under US Law
JC: So before we let you go, we've seen that fungible tokens like crypto, bitcoin, etc., have been subject to increased regulatory scrutiny. How do non-fungible tokens fit into that landscape?
PV: So there are a lot of different regulatory perspectives that we could bring to the discussion. It could be securities law. It could be payments law, anti-money laundering concerns, in addition to all of the commercial and enforceability items we've talked about. At least you know a positive note is that unlike truly fungible tokens, non-fungible tokens can truly be used from use case perspectives as collectibles, and there is a long tradition of collectibles not necessarily being considered securities. But the devil's always in the details. It's really important to look at whether the overall construct of the platform itself, creating the tokens, is a security. And increasingly, regulators are looking at whether movement of tokens, especially of high-dollar value underlying artworks, are subject to anti-money laundering concerns. One of the important points to keep in mind is a lot of these regulations don't just apply to the tokens themselves but they apply to the ecosystem players. So if one is hosting a wallet as a service and taking custody of tokens or transferring these tokens as items of value on behalf of clients or generally offering a consumer product that is regulated by the CFPB or maybe the FTC, there are a lot of ancillary state, federal regulations and laws that one should be concerned with. So we really take an ecosystem approach here. We look at what one is doing, how they're doing it, and you know infer what the law can be from that. But it's definitely a rich landscape of potential loss that could apply to these products and platforms.
JC: Prat Vallabhaneni, Adam Chernichaw, thank you for your time today.
PV: Thank you, Joel.
AC: Thanks, Joel.