A Checklist Of Legal Considerations For The NFT Marketplace

By Catherine Zhu and Louis Lehot

With the growing interest from consumers and asset managers, investors as well as entrepreneurs interested in digital assets, we have created this checklist for monetizing items with unique artistic content characteristics through nonfungible tokens (NFTs).

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We have seen businesses that aggregate content to be monetized on an NFT, while others mint the tokens or build NFT marketplaces, and many more that intermediate payment transactions between the creators, the licensors, the marketplaces, and the buyers, the sellers and the exchanges upon which they trade.

Each of these types of businesses, and the transactions in which they participate, will need to consider the legal ramifications of still-developing law, policy and regulation applicable to each link in the chain of NFT commerce.

But first, a quick primer: An NFT marketplace is a platform that connects content creators with NFT buyers with NFT sellers. Sellers mint NFT tokens with the created digital asset in this platform, and buyers can browse listed assets and buy or participate in an NFT auction. There are primary and secondary sales of NFTs in the marketplace with differing transaction costs depending on how the marketplace operates and who facilitates the sale.

With NFTs expanding into the mainstream consciousness, what are some key legal, policy and regulatory considerations you need to be aware of?

Key legal considerations when building an NFT marketplace

• Formation: You’ll need to form a corporate entity before launching a marketplace. This will offer your business the most substantial liability protection, greater ability and credibility when seeking financing from external sources.
• Conduct Code: Most NFTs, given the predominance of user-generated content and transactions in NFT marketplaces, include an extra layer of legal restrictions in the form of codes of conduct to govern interactions on the platform.
• Smart Contracts: The unique digital creation must be independently identifiable, with ownership transferable within the smart contract.  Creators should design-in the economics of trading:  How much for a primary sale, how much for secondary sales, royalties, transaction costs and other features of the aftermarket to enable trading, with funds flowing to the appropriate parties by design.
• Platform Terms of Service: NFT marketplaces must have essential documents such as Terms of Service, which govern the relationship between the NFT marketplace operator and customers, and between the buyers and sellers of the NFTs featured on the platform. A well-thought-out terms of service agreement can help protect your organization from various legal issues and generally have provisions limiting the company’s overall liability.
• Terms of Sale: Sellers or creators listing their NFTs on an NFT marketplace may wish to impose additional terms of sale on purchasers of their NFT, especially if the platform’s terms of service do not sufficiently address risks to the seller or creator.
• Intellectual Property Protection: It is vital to verify each participant’s intellectual property rights through each step of every NFT transaction. Be sure to allocate intellectual property rights between the creators/artists, purchasers/collectors, and other parties involved. The ownership of the original work is copyright ownership, which vests in the creator of the original work. If an NFT is minted and sold, the purchaser will receive a set of intellectual property rights from the creator as part of owning the NFT. The seller of the NFT determines the rights that accompany an NFT.  When examining the ownership of the content that you are seeking to tokenize, consider the rights of ancillary parties:  Is there a record label, a studio, a sports franchise that has the right to participate in the monetization of the content?
• Securities law compliance:  To ensure your newly minted token does not have the characteristics of a security, it’s crucial to design features that demonstrate the distinction between your NFT and what governments seek to regulate.  For example, the proceeds of the primary and secondary sales should not be used to build other NFTs, the platform or the marketplace.  Since currency is fungible, this requires careful planning.
• Payments: If payments are processed on behalf of counterparties, the party touching the money may be a “money transmitter” with its activities governed by applicable Treasury, state and local registration regulations.  To avoid the complex process of registration in innumerable jurisdictions, many marketplaces partner with already-registered entities, acting as content creators rather than payment processors.  But watch for commissions, gas fees and other transaction costs associated with validating transactions and processing payments.  How is each payment characterized?  Is it a fee for content creation or money transmission?  This is a key question for compliance
• Consumer Protection: Most major jurisdictions have laws to protect consumers. Suppose an NFT marketplace adequately fails to inform its customers about what they are purchasing and the risks involved. The FTC may then argue deceptive or unfair advertising, which may lead to hefty fines. NFTs likely will be targeted by cybercriminals for financial gain. Your platforms will need robust controls to guard against such risks. You may also need to implement KYC, anti-money laundering, and other regulatory requirements.
• Data Privacy: Being transparent about your data collection and use is critical. Many jurisdictions require platforms to disclose their data practices in a privacy policy. The fines for privacy violations can be significant.
• What else is in the kitchen sink? The existing regulatory and legal environment was not designed in anticipation of the rapidly evolving metaverse, where digital assets predominate. Nonetheless, some key issues have emerged while investors, financial and fintech companies explore this space.  Is there a gateway to your platform to protect from money launderers and bad actors subject to government sanctions?
• Show me the money: With each piece of content, and each media in which it is reproduced or tokenized, a different license fee may be payable to a different entity in the stream of commerce.  Consider whether an album cover or a musical recording is subject to royalty streams to recording labels, agents, libraries or artists, and whether a payment is due only upon the initial sale or upon each subsequent resale in the after-market.  Analyzing each contract involved in the monetization of content is a key task, and care should be taken to follow the trail through each transaction in the metaverse.

Bringing it all together

If the last two years have taught us anything, it is that technology paradigms shift faster than the speed of law, policy and regulation. While contracts between two parties can be made and amended in a split second, the legal regime that governs does not always keep pace. Like all things, however, eventually the law, policy and regulation catch up.  Sometimes, they land in unexpected places not envisaged at the time of contract.  This checklist should help those involved in creating NFT marketplaces navigate the legal metaverse.

Catherine Zhu and Louis Lehot are business lawyers at Foley & Lardner LLP in Silicon Valley. Zhu advises web 3.0 companies on business expansion, go-to-market and commercialization, IP licensing, and data privacy compliance, governance, and risk management. Lehot is a member of Foley’s NFT taskforce. He assists and advises clients at all stages of their lifecycle.

Illustration: Dom Guzman