[Guest post] Free Holdings case raises important issues regarding the legal nature of NFTs

The IPKat is pleased to host the following guest post by Katfriend Paolo Maria Gangi (Studio Gangi) on a recent case addressing the legal nature of non-fungible tokens (NFTs). Here’s what Paolo writes:

Free Holdings case raises important issues regarding the legal nature of NFTs

by Paolo Maria Gangi

The decision of 17 March last of judge James L. Cott of the United States Southern Court of New York in the Free Holdings case poses an interesting question: is an NFT an asset in itself or is it only a certificate of the image attached to it?

The case in brief

Namecoin, is a blockchain based system of “names” that can be registered and sold. Each name is represented by a particular digital identifier (UTXO), a token in other words, which is assigned to the owner of the name and which is tradable (trading the token means trading the name attached to it). Ownership of every name periodically expires and, at that point, anyone may freely claim it on Namecoin by re-registering the expired name. When a name expires, the original token attached to that name cannot be traded any longer but technically still exists in the blockchain. If a new user re-registers a name whose registration is expired, a new token is created. However, and beyond the fact that the registration is expired, any name maintains in the blockchain its own history.

Quantum ...

In 2014, digital artist Kevin McCoy created a piece of digital art named “Quantum” (viewable here) and decided to create a digital record of Quantum by recording a name on the Namecoin blockchain on 2 May 2014. This is generally considered to be the first ever created NFT. McCoy’s registration on the Namecoin blockchain expired In January 2015. On 30 April 2021, Free Holdings, a Canadian company, re-registered McCoy’s Quantum name in the Namecoin blockchain. (The entire history of the name can be seen here)

On May 28, 2021, McCoy minted another NFT to record the Quantum artwork, this time on the Ethereum blockchain.

In May 2021, Sotheby’s announced that the auction of McCoy (re-registered on Ethereum) Quantum NFT would be held in June 2021.

On 23 August 2021, Sotheby’s sold the “re-minted” on Ethereum Quantum NFT to a buyer, Alex Amsel, for a reported sum of $1,472,000 US.

On 1 February 2022, Free Holdings brought an action at law against McCoy, Sotheby, and others, requesting to “declar[e] and adjudicat[e] that (i) Free Holdings is the rightful owner of the Namecoin-based Quantum; (ii) the Namecoin-Quantum has not been burned or otherwise removed from the Namecoin blockchain; and (iii) the statements issued by McCoy and Sotheby’s in connection with their sale of the Ethereum-Quantum were false and misleading”.

Finally, on 17 March 2023, Judge Cott issued his decision, dismissing Free Holdings’s complaint. Judge Cott touched upon the question regarding the legal nature of an NFT. Nevertheless, he dismissed the complaint on procedural grounds, without effectively taking a position on that issue.

The legal nature of an NFT

In each NFT there is a non-fungible token created by the smart contract and an image (e.g., a jpeg) stored on the cloud. The main question of the Free Holdings case is what the legal nature of a NFT is exactly: is it an asset in itself with its own value or, on the contrary, is it a certificate of authentication of the image (i.e., the jpeg) to which it is attached? If the latter, then an NFT would substantially be a sophisticated version of one of those certificates of authentication that are issued to state the provenance and the authenticity of a painting.

The question is not only theoretical but has a very clear practical impact. As it has already happened in various cases relating to the theft of NFTs, an injunction is only conceivable if the NFT is considered an asset as that is the asset to which the injunction is referred.

Why an NFT is an asset and not a certificate of provenance and authenticity

The author of this post firmly believes that an NFT is an asset, a value in itself and not a certificate of authentication for the following reasons.

First, the main feature of an NFT is that is a (digital) asset which can be owned and sold. The right of property dates probably back to the dawn of law and is a cornerstone of most legal systems. It is an abstract legal concept created by jurists to indicate a specific legal relationship between a subject and a thing. The legal notion of property requires, therefore, an object (an asset) - tangible or intangible (assets without physical substance) - which can be owned by someone. Intangible assets are created by the law and do not exist in nature (e.g., a patent). When a legal concept is designed in a way that it is considered an intangible asset, that is usually the case because that concept can then be included under the broad legal category of property so that rules and principles related to the law of property (contract of sale, contract of lease, etc.) are applicable to it. From this point of view, NFTs have been specifically designed as (or at least have become popular because they are apt to be) an ownable property, a digital intangible asset which can be sold, donated, etc. But that digital object is the asset and not the image to which it is attached. The digital image attached to an NFT can be considered part of the asset (the token plus the digital image) but it is not the “property” and this is clearly indicated by the fact that the attached image of very expensive NFTs circulate freely on the web but have no value since the valuable asset is only the token (plus the attached image).

To state that an NFT is a certificate of authentication of a jpeg file is like saying that a patent is a certificate of authentication of, e.g., a machinery.

... and the best-known quantum (mechanics) Kat
- Schrödinger's Kat

Second, as this case clarifies, an NFT is born with the digital artwork. A digital artwork (like every other type of digital file) is non-rivalrous by nature, which means that it can always been duplicated at no cost so that its use by a subject does not prevent other subjects from using it – in other words, it is not inherently characterized by scarcity. On the contrary, a Picasso painting – as it exists as a unique object – is rivalrous by nature as its use by one subject makes it impossible to use it (or display or own it) by other subjects. The creative industry of the beginning of digitization mainly relied on digital rights management to defend IP rights on digital files always subject to be easily copied in series. The Creative Commons licences address the same problem but from the other end of the spectrum. NFTs are of course a great way for the creative industry to introduce scarcity in relation to digital files but the point is that tokens are not interchangeable: their value depends heavily on the following infrastructure:

a) the blockchain (Ethereum is probably more valuable than Tezos);

b) the time when the token is created (the time of creation of the token);

c) the quality of the smart contract (a weak smart contract is less valuable);

d) the terms of the smart contract (royalties, etc.);

e) the history of the token as reported on the relative blockchain explorer.

These are all intrinsic characteristics of the token and not of the attached image.

Third, although the first wave of NFTs consisted only of NFTs incorporating an unique piece of digital art (like the one sold by Beeple for $69 million US), NFTs can be and are being used in many other ways like, to name a few, granting the right to participate in an event or to receive a reward. The idea of an NFT as a certificate of authentication is probably connected to the first wave of NFTs, where the token was coupled with a unique piece of digital art and, therefore, the analogy with the certificate of authentication of the art industry was more striking. But in relation to NFTs incorporating a package of different rights and utility an NFT is like a share of company, which is an intangible asset whose ownership grants several rights (the right to participate in the shareholders meeting, the right to vote, etc.) but still it is treated as, and considered to be, a unique asset: the asset.