Category Archives: DLT

The NFT Growth Tax

Between Amazon launching next month its NFT Marketplace – tentatively called the “Amazon Digital Marketplace”, Sotheby’s already launched high-end secondary marketplace for “digital artwork”, and Christie’s launching last year its Christie’s 3.0 – a platform allowing for fully on-chain sales that demonstrates “the auction house’s commitment to both artists and collectors in the Web3 space”, programmable digital assets/NFTs are simultaneously entering both ends of the mainstream market.     

Probably the most important takeaway from such broad initiatives turns on the fact foundational brands have decided to supplant the prior NFT free-for-all initiated by PFP projects, artists and collectors.  Despite potentially risking the same fate of Dapper Labs, Amazon will rely on a private blockchain that takes credit cards while Sotheby’s eliminates “NFTs” from the equation altogether to focus on what it calls “digital artwork” even though digital art has already been around for decades.  What is clear is that Amazon’s use of its own “brand worthy” naming convention – “Amazon Digital”, elevates rather than hinders this new ecosystem. 

Being swept aside by this establishment wave is OpenSea – the newly-displaced old guard and wild-west pioneer who likely never contemplated insider trading as a risk until a former OpenSea Manager was recently convicted of it.  Not surprisingly, OpenSea offloads tax obligations and refers its users to CoinTracker for tax calculations.  OpenSea even explicitly points out to users of the marketplace that “[y[ou are responsible for determining what, if any, taxes apply to your purchases, sales, and transfers of NFTs. If you have specific questions regarding taxes, please consult with a professional tax advisor.”  OpenSea’s sole Help Center entry regarding taxes further drives home the point:  “Users are responsible for determining what, if any, taxes apply to their purchases, sales, and transfers of NFTs. If you have questions about taxes, please consult with a professional tax advisor.”

In sharp contrast, the government is certainly rooting for reliable tax collectors such as Amazon, Christie’s and Sotheby’s to enter the NFT sandbox.  Since 2018 – when the Supreme Court overruled decades of precedent, taxation of online sales no longer depends on physical presence within a particular state.  The new guard will create the proper recipe for mass profitable usage, namely removing tech geek elements, improving user interfaces, adding brand allure, and ensuring government is happy and remaining on the right side of the regulatory fence. 

As Grace Kyne of EY informed attendees at the April 13, 2023 NFT.NYC session “NFTs and Marketplaces: Opening Pandora’s Box”, there are state-specific marketplace facilitator rules that make most marketplaces subject to state tax.  Not surprisingly, Amazon is front and center in pointing that hard fact out to its market participants: “Marketplace Facilitator legislation is a set of laws that shifts the sales tax collection and remittance obligations from a third party seller to the marketplace facilitator. As the marketplace facilitator, Amazon will now be responsible to calculate, collect, remit, and refund state sales tax on sales sold by third party sellers for transactions destined to states where Marketplace Facilitator and/or Marketplace collection legislation is enacted.”

In other words, pushing digital asset sales to Amazon is really every state treasurer’s dream.

This should not come as any surprise.  Ever since the 2019 tax year, IRS Form 1040 has included a question regarding a taxpayer’s cryptocurrency activity. In 2021, the IRS slightly broadened the scope of its inquiry:  “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”  In 2022, the scope of the latest IRS Form 1040 broadened yet again: “At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?

In other words, the IRS expressly seeks disclosure of all digital asset transactions and not merely those involving cryptocurrencies.  The IRS now wants to know about a taxpayer’s NFT sales and any income generating activities where digital assets are received as payment.  On April 5, 2023, the IRS released its IRS Tax Tip 2023-45 which elaborated on this new position regarding a taxpayer’s obligation to report digital asset transactions – including citation to applicable supplemental forms.  By informing taxpayers of their new obligations – by way of tax forms and “tax tips”, it becomes increasingly difficult for them to argue any lack of knowledge on the topic.   The easiest approach will always be one which just assumes all realized digital asset gains are taxable.   

And, to the extent there was any ambiguity regarding more specific tax treatment of NFTs, that might soon evaporate given the IRS – in its March 13, 2023 Notice 2023-27, seeks to classify most NFTs as “collectibles” – a lesser form of asset for purposes of capital gains and other tax purposes.

Specifically, Notice 2023-27 – which seeks comments before June 19, 2023, announces the IRS’s and Treasury’s intention to issue guidance as to whether certain NFTs are “collectibles” under IRS Section 408(m).  Currently, the only available categories of “collectibles” under this section are:  “(A) any work of art, (B) any rug or antique, (C) any metal or gem, (D) any stamp or coin, (E) any alcoholic beverage, or (F) any other tangible personal property specified by the Secretary for purposes of this subsection.”  See 26 USC § 408(m)(2).  The IRS recognizes that NFTs do not presently constitute any of the above – including “art” given an NFT is not the art itself, it is a digital file pointing to the actual digital art typically found using an IPFS gateway such as Pinata.  Moreover, Section (F) expressly references “tangible personal property” so that catchall also does not squarely fit. 

While waiting for comments, the IRS will deploy a “look-through” analysis:  “Under the look-through analysis, an NFT constitutes a section 408(m) collectible if the NFT’s associated right or asset is a section 408(m) collectible. For example, a gem is a section 408(m) collectible under section 408(m)(2)(C), and therefore an NFT that certifies ownership of a gem constitutes a section 408(m) collectible. Similarly, an NFT does not constitute a section 408(m) collectible if the NFT’s associated right or asset is not a section 408(m) collectible. For example, a right to use or develop a “plot of land” in a virtual environment generally is not a section 408(m) collectible, and therefore, an NFT that provides a right to use or develop the “plot of land” in the virtual environment generally does not constitute a section 408(m) collectible.”  See IRS Notice 2023-27.

It is not clear whether the “look-through” approach would be limited to an underlying physical asset tied to the NFT or whether it might include potential money-generating components of an NFT.  More than likely, however, the relevant IRS section could not be broadly interpreted to include future gains unrelated to specific associated assets.  Moreover, earning rewards by way of an NFT should not be taxable given rewards are generally treated as a rebate or discount on purchases – that should be treated no differently than frequent flyer miles.

The lesson learned for businesses seeking to grow NFT adoption is that market validation and future growth opportunities are now inevitable given the tax hounds have gotten the scent.  To the extent there were any previous regulatory barriers to growth opportunities, those will be lifted so long as the government gets it take.

Dapper Labs Ruling Dunks on Private Networks

On February 22, 2023, The Honorable Victor Marrero of the United States District Court of the Southern District of New York released a 64-page opinion providing an instant classic exposition  of the Howey Test applied in a Web 3.0 context.  In denying Dapper Labs’s and its CEO’s Motion to Dismiss the unregistered securities offering case brought against them, the Court relies on logic and attention to detail while using an unobstructed view of the applicable law.  The decision can be easily unpacked and likely distilled to one overarching lesson:  market digital assets using your own private blockchain and marketplace and you should probably hire an SEC compliance lawyer beforehand.

In Friel vs. Dapper Labs, Inc., it is the marketing and sale of NFT “Moments” that give rise to Plaintiffs’ putative class action and not Defendant’s FLOW tokens – which were sold in an initial coin offering (“ICO”) outside the United States.  The Court defines NFTs as “digital assets whose authenticity and ownership can be recorded on a blockchain” and the underlying “Moments are a digital video clip of highlights from NBA games, such as a spectacular dunk or game-winning shot.”  Opinion at 9 (“NBA Top Shot is a platform or application, owned and operated by Dapper Labs and built on top of the Flow Blockchain. The purpose of the NBA Top Shot application is primarily to provide a platform to sell “Moments,” the alleged security at issue in this action.”). The Court could have also labeled Moments “programmable digital assets or PDAs” given these digital assets are both programmable for purposes of writing on a blockchain as well as “programmable” for purposes of automating transactions, e.g., the use of royalty payments.

As with most PDAs/NFTs, “[o]wnership of a Moment is limited to only the NFT itself. When a person purchases a Moment, the owner does not acquire any rights to the basketball highlight depicted by the NFT or the underlying artwork or other intellectual property, and thus does not acquire any rights to exploit the highlight without the express permission of the NBA, NBAPA, and Dapper Labs.”  Opinion at 10.

The Court’s ruling ultimately addressed “whether Moments are more like cardboard basketball cards, i.e., commodities, or more like crypto tokens.”  Opinion at 20.  And, in so doing, it was standing on new ground given that “no other courts have addressed either the exact substance or posture of the dispute here:  whether allegations that an unregistered offer for purchase or sale of, specifically, an NFT constitutes an investment contract under Howey and thus survive a motion to dismiss under Rule 12(b)(6).”  Id.   

The Court had little problem denying the Motion to Dismiss and finding Moments could potentially constitute “investment contracts” based on “the plausible allegations that Dapper Labs maintains private control over the Flow Blockchain, which significantly, if not entirely, dictates Moments’ use and value; that Dapper Labs touted Moments as a means for purchasers to realize substantial profits through the low sale prices for packs and marketing of the substantial profits others had made through sale on Dapper Labs’s proprietary Marketplace; and that without Dapper Labs’s essential efforts in maintaining the Flow Blockchain and Marketplace, Moments would be valueless.”  Opinion at 63.

The fact that Dapper Labs controls the marketplace where Moments are sold as well as the private blockchain where they are minted and associated transactions are recorded were the primary reasons why the Court ruled as it did.  Opinion at 11 (“[P]eople may acquire Moments through a secondary marketplace, hosted on the NBA Top Shot application and created and controlled by Dapper Labs (the “Marketplace”). In the Marketplace, Moments owners can re-sell individual Moments they acquired in packs or that they bought from other Moments owners. They may also gift Moments. Ownership of the Moments, the price paid for the Moments, and the transfer and sale of the Moments in the Marketplace are all recorded on only the Flow Blockchain.”).

Judge Marrero begins his legal analysis by referencing the definition of an “investment contract” found in the seminal case SEC v. W.J. Howey Co. where the Supreme Court of the United States defined an “investment contract” as “a contract, transaction or scheme whereby a person invests [their] money in a common enterprise and is led profits solely from the efforts of the promoter party.” Opinion at 17 – 18 (citing SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)).

As pointed out by the Court, some of the instruments that “at first blush” would not appear as securities include whiskey casks, chinchillas, and rare coins.  Opinion at 19.  Similarly, PDAs/NFTs may not at first blush appear like an “investment contract”.  The Court reasoned that the Dapper Labs token “FLOW is part of the economic realities of the investment scheme in dispute. And, moreover, the Court finds that Defendants are wrong that Dapper Labs’s “embrac[ing] a new technology – NFTs – does not change the underlying legal analysis.” (Id.) In stark contrast to Defendants’ contention, “the involvement of blockchain technology does [] alter” the conclusion, as the Plaintiffs’ allegations make plausible that but for Dapper Labs’s creation, development, and maintenance of the private Flow Blockchain, Moments would have no value.”  Opinion at 22.

Buttressing its view that the private nature of the Flow Blockchain is what sets this case apart, the Court cites a law review article for the following proposition:  “Private blockchains use the same technology as public blockchains, however, a single entity administers them. This results in more control for the entity to restrict permission or allow access to only approved, or invited users.”  Opinion at 4, n. 4See also Opinion at 23 (“In each case, the promoters privatized their ledger, making the purchasers reliant upon the promoter for the asset’s value. That similarity is true whether the instrument is a crypto token or an NFT. And it is the critical similarity here.”).

Again, it is ultimately control over the private blockchain that drives the ruling:

The interplay among FLOW, the Flow Blockchain, and Moments is necessary to the totality of the scheme at issue. Plaintiffs have alleged that, without FLOW tokens, no transactions on the Flow Blockchain can be validated. Indeed, the “Proof-of-Stake” mechanism employed by the Flow Blockchain requires FLOW to power it and incentivize miners to validate transactions. In that respect, FLOW’s utility creates value for Moments through the network’s consensus as to ownership and the price of each transaction.

Opinion at 22.

Indeed, the Court affirmatively states as much:  “[T]he economic realities and technological interplay between FLOW, the Flow Blockchain, and Moments, as alleged by Plaintiffs, are what supports the Court’s conclusions.”  Opinion at 23See also Opinion at 62 (“The allegations that Dapper Labs created and maintains a private blockchain is fundamental to the Court’s conclusion. By privatizing the blockchain on which Moments’ value depends and restricting the trade of Moments to only the Flow Blockchain, purchasers must rely on Dapper Labs’s expertise and managerial efforts, as well as its continued success and existence. As Plaintiffs allege, this is unlike public blockchains, such as that underlying Bitcoin.”) (emphasis added).

Plaintiffs were found to allege a scheme providing directly correlated value between FLOW and Moments, “[i]nsofar as FLOW is necessary to creating the value of Moments via blockchain validation with “[t]he economic impact [being] that as more value is created on top of the Flow [B]lockchain, more demand is generated for FLOW tokens.”  Opinion at 23.

As for the respective component prongs of the Howey Test, such as the “common enterprise” requirement, the Court largely relied on what it called “the ICO Cases” and found this pooling of interests prong satisfied given “allegations plausibly tied the funds received by the promoter through the offering to an improvement of the ecosystem (i.e., the private blockchain) that consequently increases the value of the token offered during the ICO.”  Opinion at 28See also Opinion at 32 (“Plaintiffs allege that Dapper Labs has pooled Moments purchasers’ funds to raise additional capital, outside of and along with revenue, to ensure the Flow Blockchain does not collapse. The reasonable inference to draw from these allegations is that the capital Dapper Labs raises through the offer of Moments is used to develop and maintain the Flow Blockchain.”); Opinion at 34 (“Plaintiffs have alleged that purchasers of Moments are “hitching their wagons to the continued success of NBA Top Shot, [and] to Dapper Labs and the Flow Blockchain that underlies the platform. . . . If the fortunes of Moments purchasers were entirely divorced from the success of Dapper Labs’s Flow Blockchain, then such price reactions based on Dapper Labs’s management of the Flow Blockchain would be unlikely.”); Opinion at 56 (“[I]f Dapper Labs became insolvent and purchasers were unable to trade their Moments on the Marketplace, purchasers would lose the value of their Moments.”).

Of note, the Court rejected any temporal bar that would provide a safe harbor for promoters who waited until their project was far along before introducing the purported investment contract element.  Opinion at 30 (“Implementing the temporal bar that Defendants urge is impractical and would inappropriately limit the scope of investment contracts to pre-development initial offerings.”).

Shared success was found in the fact that Moments’ continued value is contingent on the success of Dapper Labs.  Moreover, this was reasonably inferred given “Dapper Labs controls the Flow Blockchain” and “all that Moments purchasers own is, essentially, the line of code recorded on the Flow Blockchain, as no other rights to use or display the image are transferred.” Opinion at 36

The Court also found that “Defendants’ public statements and marketing materials objectively led purchasers to expect profits.”  Opinion at 45.  Moreover, under the applicable test, the promise of profits must also be “derived from the entrepreneurial or managerial efforts of others.”  Opinion at 52.    More specifically, “[t]he law requires [] that . . . the efforts of the promoters . . . must be necessary to the success of the venture, such that without them, the ‘investments would be virtually worthless.’”  Opinion at 53 (citation omitted). Plaintiffs easily satisfied this requirement for purposes of the Motion to Dismiss.

And finally, the Court broadly concluded that “Defendants’ failure to acknowledge the blockchain technology that underlies Moments is fatal to their Motion in this respect. Without Dapper Labs’s continued maintenance of the Flow Blockchain and the “token that powers it all,” FLOW, Plaintiffs’ [complaint] plausibly alleges that Moments would have no value.” Opinion at 54See also Opinion at 56 (“a company’s efforts to develop and maintain an ecosystem for trading sufficiently establishes the third Howey prong.”); Opinion at 57 (“Dapper Labs’s implicit promise to maintain the Flow Blockchain and facilitate trades on the Marketplace drive Moments’ value.”).

While the Court made the correct ruling as to Dapper Labs, there is always the possibility a future court might misconstrue what was done to the disadvantage of others selling PDAs/NFTs using, for example, a layer 2 platform build on a public blockchain or on a platform not reliant on a native token ecosystem.  Such potential future ruling would be an obvious bridge too far. 

The Court recognizes the potential for such mistakes being made prior to signing off by providing a disclaimer that “[n]ot all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.”  Opinion at 62.

It is highly unlikely that the Court’s ruling could be used against a fine art PDA/NFT platform using public blockchain networks. The Court even acknowledges that truly individual and unique items such as artwork would not easily square with its ruling.  See Opinion at 35 (“In each of the cases cited by Defendants, horizontal commonality did not exist because there was no causal connection between “unique pieces of artwork” being sold and the promoter making the offering.”) (citing Dahl v. English, 578 F. Supp. 17, 20 (N.D. Ill. 1983)); Opinion at 36 (“[I]f, hypothetically, Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero. That is the critical causal connection that other collectibles cases lack, and which is alleged here.”); Id. (“Assessing those allegations in connection with the analogy Defendants favor – cardboard basketball cards – reveals the flaw in their analysis. Hypothetically, if Upper Deck or Topps, two longtime producers of physical sports trading cards, were to go out of business, the value of the cards they sold would be wholly unaffected, and may even increase, much like posthumously discovered art.”).

On the chance a PDA/NFT sale couples with the physical twin underlying it, there would stand yet another reason to distinguish this decision.  See Opinion at 52 (“Other than Dapper Labs’s self-serving definition of Moments as “Art,” Defendants concede that the definition connects only to “the videos and pictures underlying each Moment,” which purchasers do not own, thus ignoring that the “totality of the evidence” supports a finding that Moments were purchased with “investment intent.”); Opinion at 58 (“[W]hile Moments purchasers may “own” the NFT (or line of code that indicates ownership on the blockchain) they have no rights to the underlying intellectual property the NFT depicts.”).

Fine art NFTs also retain another point of distinction with Moments given fine art NFTs will always have intrinsic value.  As recognized by the Court, “Defendants’ argument that “Dapper’s marketing efforts would have no effect on the value of the basketball cards being sold, because each card has an inherent worth” is contradicted by Dapper Labs’s Terms of Use for the NBA Top Shot application, which repeats four times that Moments have “no inherent or intrinsic value.”  Opinion at 57See also SEC v. Kik Interactive, Inc., 492 F. Supp. 3d 169, 180 (S.D.N.Y. 2020) (“Unlike real estate, Kin have no inherent value and will generate no profit absent an ecosystem that drives demand.”).

Almost as an aside, it is also hoped that future courts citing this decision do not value too highly the Court’s comment regarding the hyping of sales – something every promoter or seller does in some form or another.  See Opinion at 55 (“Plaintiffs also plausibly allege that the value of Moments in the secondary market depends upon Dapper Labs’s ability to maintain hype and keep purchasers interested in buying and trading Moments.”).   Fine art gallery owners certainly routinely “hype” their artists in the secondary market and such conduct standing alone should never point the needle in any one direction.   

And finally, to the extent the Court extols in general terms the virtues of blockchain technology as a way of demonstrating why the entire Flow ecosystem – including Moments, necessarily relied on Dapper Labs’s success, the failure to parse between private and public blockchains might cause a future court into mistakenly equivocating privately-run blockchain network with a true public one.  See Opinion at 57 – 58 (“Plaintiffs plausibly allege that Moments would be worth far less without the price transparency and trust that the Flow Blockchain enables as well as Dapper Labs’s facilitation of trading on the Flow Blockchain via the Marketplace.”).  Overall, this language comes off as slanted in a single direction without proper distinctions being made but this criticism remains a minor quibble in an otherwise extremely well-written decision. 

There are certainly valid reasons why platforms built on private blockchains should be treated differently from public blockchains and likely why Voice wisely recently made the move to a public blockchain. Platforms that use native tokens such as Rarible with its RARI token may also have to strategize a bit after this decision. And finally, private blockchains focused on NFTs such as WAX may have to decide how the efforts of its promoters are compensated. At some point in the future, the fact that the Cayman Islands company “Exposition Park Holdings SEZC” owns the intellectual property filings referenced below may create a problem for the WAX ecosystem:

Going forward, the safest approach to take for those looking to build out a PDA marketplace is to partner with a company that has built a platform from the ground up using a public blockchain and without the use of a platform native token or any other direct means of controlling the value of the digital assets marketed using the platform. And, the PDAs/NFTs sold using such a platform least likely to be considered investment contracts are the fine art ones underlying the nascent Digital Art Movement now well underway.

NFTs are Dead, Long Live PDAs

The year may not be 1422 and the ascension of Charles VII to the French throne may not mean much six hundred years later but a formal transition of power from the “non-fungible token” blockchain throne is finally in order – with “programmable digital assets” – or PDAs, taking the place of NFTs.

Built on the same sort of blockchain technology underlying every Bitcoin ever mined, a non-fungible token is merely a digital reference certificate of ownership containing the provenance and ledger of all activity surrounding a specific digital asset. On November 13, 2018, Christie’s New York became the first auction house to register a high-end art sale on a blockchain platform with its $317,801,250 sale of the Barney A. Ebsworth collection.   In other words, the provenance utility of blockchain as a “secure digital registry” was already proven four years ago.

Because they are recorded on a public blockchain, NFT activities can be viewed by the public and any manipulations of data easily discovered.  Indeed, this ability to discover manipulations caused many to consider blockchain entries a sort of immutable ledger – an overstatement but still a useful analogy.

Despite representing only 10% of the total volume in NFT transactions, fine-art NFT sales remain the most fertile growth area for NFTs going forward.  As astutely pointed out by the owner of a leading fine-art NFT marketplace, “cryptographically provable scarcity provides value, while decentralization provides security and transparency — qualities that make both art and cryptocurrencies valuable. The NFT art movement may be nascent, but it has increased its pace from a crawl to a sprint, and the world is taking notice.”  Where Gemini is wrong, however, is in thinking the “NFT art movement” would go any further than it already has in its present incarnation.

While the term “non-fungible token” is technically accurate, it was always somewhat misleading given the term focuses only on the uniqueness of the asset, which may be a key characteristic but certainly is not the sine qua non of these digital assets.  The technology underlying NFTs offers much more than the ability to represent a unique digital item. NFTs have always been created using smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller directly written into the code.  In other words, NFTs can be programmed to perform actions or facilitate certain transactions after certain conditions are met.  For example, these digital assets could be programmed to automatically transfer ownership to a new owner when certain conditions are met, such as the passage of time or the payment of a certain amount of money.

This ability to program using smart contracts provides a level of functionality and flexibility that goes well beyond merely representing a unique digital item.  Art sold as an NFT, for example, can for the first time automatically transfer financial support to a charity of the artist’s choosing.  In other words, these unique fine art objects are much better described as programmable digital assets rather than NFTs even though a “programmable digital asset” can technically be fungible.

A nomenclature change is now in order because the term “non-fungible token” never adequately conveyed potential other use cases for NFTs. While NFTs are often associated with collectibles, they have the potential to be used in a wide range of applications, including supply chain management, provenance, and even real estate transactions. By only highlighting the “non-fungible” aspect of these digital tokens, one overlooks other potential uses and applications – characteristics that can make the art component of the token active and subject to change unlike the dominant static art already in existence for millennia.

At its essence, the term “programmable digital assets” more succinctly captures the potential range of capabilities and uses for these digital tokens, and certainly better conveys their unique position as a new type of digital asset, namely one that is programmable. The off-putting term “non-fungible” conveys a single attribute that can easily be part of a broader marketing discussion.

There is no denying the term “non-fungible token” has gained widespread use and recognition – much of it negative in recent months, so it will be difficult to completely shift to any new terminology without having significant marketing dollars thrown at the problem. Nevertheless, with awareness for NFTs evolving in a negative direction – whether Trump or fraud driven, it becomes even more crucial to apply a new product term.  This new term might as well more accurately reflect the full potential of these novel assets. 

Industry advocates would be smart to do whatever it takes so that NFTs relinquish their throne to a new and more progressive named successor no matter what the cost.  In some ways, this change is already under way. On July 7, 2022, Reddit announced it would introduce “Blockchain-Backed Collectible Avatars” – limited-edition digital assets created by artists which provide unique Reddit platform benefits to owners. 

Despite very much being NFTs, the Reddit announcement did not use the term NFT even once. Maybe in the future a company with deep marketing resources will simply try and co-opt the entire market category by using its own “brand worthy” naming convention for “programmable digital assets” .  Until that happens, however, we should help PDAs succeed NFTs.

It might be easier to imagine this name change a reality while having a Dunkin’ coffee and trying to envision what an EskimoPie or Uncle Ben’s rice pudding dessert with Aunt Jemima syrup would taste like or what an old Weight Watchers ad might look like if played while watching the Washington Redskins’ 1992 Super Bowl victory. 

NFT vs. FTX

Fine art NFTs slowly but surely prop up blockchain technology while also moving the nascent Digital Fine Art movement – like popcorn placed in a Raytheon microwave oven but in a less pedantic manner.  On November 16, 2022, a burning question for NFTs is whether the unfolding FTX disaster advances or hinders their cause.

Over 230 years ago, Courts recognized that fraud taints everything it touches.  Snyder v. Findlay, 1 N. J. Law (Coxe) 48, 51 (1791).  Notwithstanding the good intentions of respected celebrity endorsers Larry David, Tom Brady and Stephen Curry, the fraudster Sam Bankman-Fried – now derided as “Sam Bankrun-Fraud”, incredibly avoided internal detection by stealing and hiding funds using his own personal backdoor software tool.  By trading client assets, his massive fraud did the exact opposite of what his firm contractually promised clients as a condition of FTX’s custody. 

Fried’s fraud has become a major contagion in the crypto world – some are even posturing FTX as Exhibit “A” in their case against crypto adoption.  Despite the pernicious nature of Fried’s massive fraud, there remains underlying positive news given FTX’s failures shine a light on why NFTs will continue having a long and impactive run and why their decentralized nature will eventually become baked into most financial assets.  Indeed, the term “NFT” will hopefully disappear from our vernacular given the underlying technology’s future ubiquity.  Literally no one cares how “Hypertext Transfer Protocol Secure” works so long as the “https” before a website address gets the job done.  Similarly, few really care about the technology behind a “non-fungible token”.   Owners only care about having transferable digital property self-containing proof of ownership, verifiable uniqueness and programmable contract attributes.

The FTX debacle immediately adversely impacted NFT markets because NFTs are purchased and sold using cryptocurrencies – most of which took a major hit beginning on November 2, 2022, the publication date of Coindesk’s expose on FTXAnd, with Solana’s SOL emerging as this worst-performing crypto asset – losing over 41% in value given FTX was an important backer of the network, several Solana NFT marketplaces, namely Magic Eden and Solanart, felt an even greater FTX sting than other NFT marketplaces.   

Despite the fact NFT sales remain on a slow mass adoption cycle, as of November 16, 2022 OpenSea alone still had nearly $33 billion in total NFT trades.  NFTs are well beyond the proof-of-concept stage but mass adoption will continue a slow journey given the constant press assaults.  For example, in a May 3, 2022 Wall Street Journal hit piece suggesting that it may be “the beginning of the end” for NFTs, Zach Friedman, co-founder and chief operating officer of crypto brokerage Secure Digital Markets, is quoted as saying:  “The ones that continue will be utility-focused for sure.” 

That perspective is both correct – utility is an intrinsic feature of all NFTs, and wrong given it begs the question:  Since when does fine art ever need additional utility for it to gain status as “fine art”?  Utility is always found in great art simply by way of the esthetic utility derived.  As of the same month as the WSJ article – May 2022, collectors sent over $37 billion to NFT marketplaces, putting them on pace to beat the total of $40 billion sent in 2021.  Even though the vast majority of these transactions are not for fine art NFTs, the disrespect shown today for Digital Fine Art remains no different than cubist art in 1910. 

At the 1913 Armory Show in New York City, the most famous collectors of modern art originally shunned what they saw.  Indeed, after the show travelled to Chicago, members of the Art Institute of Chicago – the first museum brave enough to display these works, burned mock-Matisse and Picasso effigies on the museum’s steps. Today, the Art Institute of Chicago proudly hangs over five hundred important works created by Matisse and Picasso.  History will always have an uncanny way of repeating itself.

At an Art Basel panel discussion, Esther Kim Varet, owner of the L.A. and Seoul gallery Various Small Fires, reportedly let the cat out of the bag as to why Digital Fine Art runs against the grain of the fine art world: “There are a lot of barriers and it feels exclusive once you get in. And I fear that the more pricing transparency there is … we’re going to have to invent new ways to create this aura of exclusivity or privilege. Not that those things are things that we should value but it’s just kind of what the art world is built on.”

In other words, pricing opaqueness is positioned as a virtue of the art world community.  Not surprisingly, the pricing transparency and documented provenance inherent in Digital Fine Art in the form of NFTs in some ways runs counter to this view of the art world.   While the actual art in Digital Fine Art provides utility plain and simple, the programmable nature of the smart contracts used in NFTs provides a world of opportunity for collectors and artists. Such underlying contractual rights can create a lifetime relationship between collector and artist – one with ties to direct interactions removed from any centralized control.  More to the point, fine art galleries and dealers can readily join in this new form of relationship.  Ultimately, the only barriers to the heights Digital Fine Art can achieve is driven by a lack of imagination and a fear of the unknown.

UPDATE: December 13, 2022

On December 13, 2022, the SEC filed criminal charges against Bankman-Fried. The complaint alleges he “orchestrated a years-long fraud to conceal from FTX’s investors (1) the undisclosed diversion of FTX customers’ funds to Alameda Research LLC, his privately-held crypto hedge fund; (2) the undisclosed special treatment afforded to Alameda on the FTX platform, including providing Alameda with a virtually unlimited “line of credit” funded by the platform’s customers and exempting Alameda from certain key FTX risk mitigation measures; and (3) undisclosed risk stemming from FTX’s exposure to Alameda’s significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens.”

In parallel actions, the U.S. Attorney’s Office for the Southern District of New York and the Commodity Futures Trading Commission also announced their own charges against Bankman-Fried.

Given that he was about to testify before Congress, the timing of the SEC and CFTC actions are not nearly as important as that of the criminal indictment. In effect, the DOJ has prevented a potential treasure trove of wholly admissible statements from being elicited. Now that he has been indicted and arrested in the Bahamas, lawyers will be the only ones talking for money-runner SBF. That’s too bad.

NFT Trading Volumes Shrink 97% From January Peak.  Now What?

On September 28, 2022, Bloomberg – in pure clickbait fashion, published a blurb article using data from three-year old Unicorn, Dune Analytics, that claims the collectible and digital art market went from a high of $17 billion at the start of the year to $466 million this month.  The author ties this downswing to the “$2 trillion wipeout in the crypto sector as rapidly tightening monetary policy starves speculative assets of investment flows.”  Whether or not Dune’s data is on the money is almost beside the point.

If investors are buying NFTs solely as an investment vehicle, they are not truly art collectors.  It’s that simple.  No collector buys art purely for speculation – unless you manage a fund tasked with doing exactly that.  On the other hand, those who purchase collectible NFTs almost always buy for speculative reasons. 

When it comes to deciding what to do during this significant downswing – if it indeed exists, there is not much thinking that needs to be done.  If you enjoy the digital art you purchased, this blip does not matter because it was never solely about making a profit.  Over time, art has been the most favored non-correlated financial asset for the affluent but it was also always more than just a financial vehicle.  That will not likely change in the future.  In other words, if you don’t want to see it hanging in your home, it probably should not be in your financial portfolio anyway.

IP Rights in NFTs, Part I

On August 31, 2022, VC powerhouse Andreessen Horowitz released a series of license templates focused on helping NFT projects create more certainty in intellectual property matters.  This comes on the heels of an August 19, 2022 report, “A Survey of NFT Licenses: Facts & Fictions” that concludes the “vast majority of NFTs convey zero intellectual property ownership” to their owners. 

Seeking to create certainty where none currently exists, the released licenses provide different approaches for NFT projects:

According to Andreessen’s Horowitz’s General Counsel, these licenses “were inspired by 20-plus years of work by the Creative Commons.”  Working with two law firms and several of their portfolio companies, the licenses have been incorporated into a Github repo so creators can build them directly into the smart contracts used in their NFT projects. And, they have been all released under the Creative Commons Zero open source license.  Andreessen Horowitz also claims that its licenses are “legally irrevocable” and create certainty in the marketplace after the license is deployed. 

All of this is of course wishful thinking. 

No matter how noble its motivations, Andreessen Horowitz cannot unilaterally dictate when licenses will be “legally irrevocable” in the same sense a smart contract deployed on one platform may not be enforceable when a minted NFT using that same smart contract is sold on another platform.  Given the many different NFT platforms deployed, this is just one of many issues that likely more pressing.  As for what a suitable NFT intellectual property framework would actually look like, that really depends on the platform used.

Another Day, Another Phishing Exploit Seeking NFTs

On July 15, 2022, several of DeeKay Kwon’s Twitter followers were the latest victims of scammers feasting in the NFT space.  DeeKay is an animator and part of a growing number of innovative artists developing the Digital Art Movement spurred on by NFTs.  One of DeeKay’s admirers is Calvin Cordozar Broadus Jr. also known as Snoop Dogg also known as Cozomo de’ Medici – who acquired DeeKay’s “Life and Death” for “$1m USD, or 310 ETH.”  According to this very important art collector, “all of this [NFT profile picture] mania is bringing massive attention to NFT. And when they come in for an azuki, punk, bored ape, or their choice of “culture token” . . . But then stumble across an @XCOPYART, a @fewocious, a @deekaymotion . . . That’s when one realizes the true power DIGITAL art can have, beyond any traditional art they have ever seen before.”

DeeKay reported his Twitter account was hacked and “and the hacker has been tweeting a fake mint site.  I reacted to it ASAP and spread the word but could not stop the damage in time.”  An unknown number of DeeKay’s over 179,000 followers clicked on a phishing link found in the below fake Tweet – a Tweet that purportedly brought them to a new collection from the artist:

According to Deekay, “[t]he fake mint site was made two weeks prior, 100% copied my original website. I assumed he studied my time when I am inactive too.”   While trying to claim the purported free NFTs on the fake site, victims instead approved transactions granting the scammer access to their wallets and allowing the removal of various digital assets. It is not yet fully known how many NFTs or other crypto assets were stolen from Deekay’s Twitter followers.  Most reports currently peg the number at $150,000 worth of digital assets. 

DeeKay has been trying to “work something out” with those have been scammed.  For example, one victim was gifted “something special” by DeeKay to “help ease” his loss.  Interestingly, DeeKay recognizes the problem with reimbursing victims given that it “also encourages hackers to keep doing their thing since I am the one covering the mess. Part of me says reimbursement should not be a standard way to react, and another part of me says I should still find a way to compensate and find a balance.”  This is no different than the problem caused by insurers who continually reimburse ransomware victims and why ransomware payments should be self-insured.

DeeKay’s Twitter phishing scam comes on the heels of another phishing exploit days earlier targeting Uniswap liquidity providers that used a similar scheme but obtained a much larger $8.6 million in crypto assets.  As reported in Crypto Briefing, the Uniswap fake site “instructed the victims to claim the malicious UNI tokens as a reward for providing liquidity on the exchange, but when the victims agreed to the claim, they inadvertently approved a transaction that granted the attacker access to their wallets. From there, the attacker could make token transfers to drain their wallets.”

The phishing technique used in these scams is relatively easy to pull off given most folks still click on links without really thinking and many users of crypto wallets such as MetaMask have no clue as to what they are really providing consent for when clicking on the consent button.  After going to what appears to be a genuine site, they just assume they are obtaining what they are pitched as the reason for going to the site in the first place, namely freebies of some sort.  In a similar way an email address can be spoofed in a phishing exploit, consents can say whatever a scammer wants it to say. 

Whether it’s DeeKay’s Twitter followers or Uniswap’s liquidity providers, these pools of potential victims are publicly known and easily reached by scammers.  One way of getting away from this vulnerable crowd is by using multiple wallets and intermediaries such as fine art galleries that can work with collectors to improve their security hygiene.  More to the point, until art galleries become a mainstay part of the Digital Art Movement, these sort of scams will continue to proliferate.

UPDATE: July 20, 2022

On July 19, 2022, DeeKay let everyone know he was targeted again – likely by way of another phishing exploit. He suggested that his collectors be aware that he would “NEVER do a free mint.”

Phishing for Green Apes

On May 17, 2022, actor Seth Green announced to the world that he got “phished and had 4NFT stolen”. Apparently, he clicked on a link that led him to a website that requested and obtained access to his wallet – a wallet containing four high-profile collectible NFTs. After he provided the necessary consent, a scammer promptly emptied his wallet of these four expensive collectible NFTs.

Green purportedly knows how to navigate Web 3.0 but does a really bad job of justifying his lack of security hygiene:  “Scam GutterCats clone site. I’m crazy careful with separate wallets and security but still got got. Luckily it’s art not crypto so they can be traced. For anyone that bought them, we can work something out.”

Disregarding whether what was lost was actually “art” in the sense of fine art – they are likely more properly described as innovative collectible NFTs with significant speculative value based on community growth, utility, endorphins, and numerous other intangible measures, Green’s loss presents a valuable security lesson for all NFT collectors and raises issues that will not go away anytime soon. All of this is now ripe for discussion.

Green asked OpenSea not to allow trades in his four missing collectibles.  It is doubtful any marketplace will affirmatively identify, tag, and refuse to trade in Green’s four NFTs. As it stands, there are huge numbers of fake collectible NFTs sold on marketplaces – especially on OpenSea. Despite recent OpenSea changes aimed at addressing “copymints” – fake listings using copies of actual collectibles, the collectible fraud problem will not subside any time soon given this sort of fakery does not require much effort and can be very lucrative for scammers – as well as the marketplaces that thrive on trading fees.  More to the point, even the upgraded OpenSea controls do little to address the core issue of compliance.

To its credit, there are no current OpenSea listings tied to Green’s collectible NFTs but that might change at any time given at least one marketplace has them listed.  As of May 19, 2022, Rarible has MAYC # 19182 listed by public wallet address # 0xae7f30d77b367afe64f04dfd94e95f71f8e4ae66.

And, Rarible apparently also has BAYC # 8398 listed by public wallet address # 0xaf20e2e1dca5dffd0efa1a8055099a947beec8be.

These are not Green’s collectible NFTs simply because they reference the correct collections, point to the right image files, describe the correct collectible rarity properties, and use the right numbering scheme.  On the other hand, both have sold – perhaps in wash trades or maybe not, for significant amounts – 106.5 ETH on May 8, 2022 or $268,912 for BAYC # 8398 right around the time it was purportedly removed from Green’s wallet and 31.5 ETH on March 17, 2022 or $87,129 for MAYC # 19182.  Without a way to provide a universal and easily accepted means of verifying the authenticity of these collectibles, collectors will need to be part detective and part forensic investigator and use ETH explorers to track the relevant wallet addresses. 

Assuming someone did the legwork to confirm these are the actual pilfered collectibles, Mr. Green has several options.  He can continue pressuring marketplaces to refrain from listing them.  That would not get them back, but it might prevent further monetization and may cause the current owners to cut a deal with Green for their return given this lack of monetization.

As with many film actors, Seth Green lives in California where knowingly receiving actual stolen property is a criminal offense punishable for up to a year in prison.  See Cal. Penal Code § 496(a) (“Every person who buys or receives any property that has been stolen or that has been obtained in any manner constituting theft or extortion, knowing the property to be so stolen or obtained, or who conceals, sells, withholds, or aids in concealing, selling, or withholding any property from the owner, knowing the property to be so stolen or obtained, shall be punished by imprisonment in a county jail for not more than one year, or imprisonment pursuant to subdivision (h) of Section 1170.”).  Almost all NFT marketplaces are non-custodial – which means this statute would not really apply to them under any reading of the law.

Given this lack of custody, a marketplace would also not likely be liable for conversion. “The tort of conversion is established when one who owns and has the right to possession of personal property proves that the property is in the unauthorized possession of another who has acted to exclude the rights of the owner.” Angiolillo v. Christie’s, Inc., 103 N.Y.S.3d 244, 260-61 (N.Y. Sup. Ct. 2019).  Similarly, a cause of action of replevin requires that the defendant actually possess the property in question before its return can be obtained in court.  All of this assumes ownership of the constituent parts of an NFT, namely private keys, smart contract software code, IPFS content, etc., constitutes personal property in the first place.

Green’s likely best avenue for redress would be going after current holders of his lost NFTs who might be considered bona fide purchasers or good faith purchasers for value not having knowledge of the tainted title. Mr. Green lives in California and the “stolen” property could be in wallets belonging to persons anywhere in the world.  Assuming he knows the public wallet addresses of the current owners, Green would still not know the country of origin let alone name and address.  If the purchaser is identified, however, negotiating a deal or filing suit will be viable options.

Knowing the applicable law for a claim is significant given in some jurisdictions such as New York the law favors rightful owners seeking their stolen personal property.  See e.g., Solomon R. Guggenheim Found. v. Lubell, 77 N.Y.2d 311, 320, 567 N.Y.S.2d 623 (1991) (“To place the burden of locating stolen artwork on the true owner and to foreclose the rights of that owner to recover its property if the burden is not met would, we believe, encourage illicit trafficking in stolen art.”); Barnard v Campbell, 55 N.Y. 456, 461 (1874) (“The general rule of law is undoubted that no one can transfer a better title than he himself possesses.”); DeWeerth v Baldinger, 38 F3d 1266, 1278 (2d Cir. 1994) (“New York case law has long protected the right of the owner whose property has been stolen to recover that property, even if it is in the possession of a good-faith purchaser for value.”).

In some states and countries, however, it is quite different.  For example, under Swiss law, a bona fide purchaser becomes the owner even if the chattel was stolen or otherwise transferred without the authorization of its owner.

On the other hand, even New York law distinguishes between fraud and theft because the owner who is defrauded acted affirmatively and could have protected herself by due diligence, “whereas the owner from whom property is stolen has not acted affirmatively, and, in many instances, could not have protected herself. The [bona fide purchaser] may be equally innocent in both cases, but the original owner from whom property is obtained by fraud is more blameworthy than the original owner from whom property is stolen, and the former is entitled to less legal protection than the latter.”  Shubert Org., Inc. v. Partridge, 2020 NY Slip Op 32748 (N.Y. Sup. Ct. 2020).

This legal distinction raises an interesting point regarding Green’s “stolen” NFTs.  After all, Mr. Green was led to a website by way of a fraudulent email in the hope of minting himself some Gutter Cat Gang NFTs but instead connected his wallet to an imposter website.  All the while, he would have consented to everything done, including his wallet connection and any subsequent activity.  In other words, he was defrauded.  No one went to his home or computer, stole his private key, went into his wallet, and transferred his collectibles to another wallet.  If Green could bring to court a bona fide purchaser of his quartet of valuable NFT collectibles such a buyer could certainly raise all of this as a defense.

Beyond the security hygiene lessons and potential difficulties in retrieving lost collectibles, Green’s mishap also shines a light on the need for due diligence when using a marketplace.  In sharp contrast to collectible NFTs such as BAYC NFTs, purchasing fine art NFTs from a reliable source such as an established art gallery provides justifiable trading confidence.

UPDATE: June 7, 2022

On May 30, 2022, Seth Green announced he had struck a deal with the buyer of his Bored Ape #8398.

He also mentioned he was “working together to prosecute the original thieves” so presumably law enforcement is involved. The following day, Green made a somewhat cryptic statement: “Had to track the NFT to the current holders & make a deal between us to get them back- although we get to prove the friendship & community we all are building around these artists & collections. Plus now we work together to prosecute the original thief who scammed us both”.

In other words, Green was able to convince the buyer to send Green’s Ape back home for an unknown price. For all we know, it may be what the buyer paid or even a premium on that price. What will be of most interest to the ending of this story is what sort of prosecution takes place against Green’s scammers.

UK Royal Mint Wants to Mint an NFT

On April 4, 2022, the UK Royal Mint was asked to mint an NFT.  As with many announcements today, the Royal Mint’s announcement came in a tweet.

Either the above announcement demonstrates supreme ignorance or utter brilliance.  Offering for sale non-fungible representations of currency – the most fungible of assets, certainly seems on its face nonsensical.  Disregarding the typo, however, it may have been a brilliant marketing gambit – with the Chancellor’s goal of placing the UK on the crypto map furthered.  What happens this summer might be a major step in that direction.  Who knows?  There may even be a Royal Mint NFT drop at NFT.NYC in June.

Axie Infinity’s Sidechain Suffers Massive DeFi Exploit

On March 29, 2022, the developers behind the Ronin Network – an Ethereum sidechain used to support the decentralized game Axie Infinity, announced a major exploit.  The developers revealed that an attacker used hacked private keys from four Ronin Validators and a third-party validator run by Axie DAO – out of a total of nine, to forge withdrawals of 173,600 ETH and 25.5M USDC – valued at over $625 million. 

This sort of 51% consensus attack plagued the proof of work crypto community since its early days but largely fizzled out as a threat as the major blockchains grew more complex and the number of mining nodes grew into the thousands.  The fact that the Ronin sidechain only had nine validators for its exit bridge – with a majority being a mere five of the nine, was a security failing by most vantage points.  Not surprisingly, to “prevent further short term damage”, the Ronin Network immediately “increased the validator threshold from five to eight.” And, more importantly, the network “will be expanding the validator set over time, on an expedited timeline.” 

The race to mass adoption of new networks has caused many DeFi platforms to forego a security-first design.  Rather than viewing such an approach as time-consuming or stifling growth, new networks competing with Bitcoin and Ethereum and underlying many new DeFi platforms, must recognize that only with trust will this community ever grow beyond its current early adopters.

UPDATE: March 30, 2022

According to a text message sent to Bloomberg by Aleksander Leonard Larsen, chief operating officer of the developer behind the Ronin Network, Sky Mavis: “We are fully committed to reimbursing our players as soon as possible. . . We’re still working on a solution, that is an ongoing discussion.”