Australia: The NFT – perils and pitfalls in the commercialisation of copyright works

Since first published as a concept paper in 2008 under the pseudonym Satoshi Nakamoto, various use cases for implementing blockchain and distributed ledger technologies have proliferated ubiquitously both as mediums of exchange and as digital payment substitutes for cash. Undoubtedly, the anonymity of exchanges and the absence of third-party intermediaries have assisted in their popularity.

At its heart, these new poorly understood (and often hyped) crypto-technologies seek to create a value exchange protocol that can record transactions between two parties efficiently and in a verifiable and permanent way. The record of this value exchange protocol is recorded in a database (i.e. blockchain) which is inherently resistant to modification of the data and may be centralised or decentralised in public or private networks.

Technically, the records of such transactions comprise a continuously growing series of records, called blocks, which are linked and secured using cryptography. Once recorded, the data in any given block cannot be altered retroactively without the alteration of all subsequent blocks and the collusion of the network. In essence, the blockchain becomes a tamper-evident record of transactions – immutable. Each block typically contains a cryptographic #hash¹of the previous block, a timestamp and transaction data,² although the artwork itself is not stored within the NFT (more on that below) or the blockchain.³ The technology lets people who do not know or trust each other build a dependable ledger of the information captured within the blockchain, in a peer-to-peer environment.

On the back of the myriad of newly introduced crypto assets of various flavours, the latest to enter the fray are the so-called Non-Fungible Tokens (NFT's). Unlike fungible items such as cash or bitcoins, non-fungible items are things that cannot be exchanged for one another because they are unique. NFT's are tokens that are linked to or represent ownership of unique items (e.g. digital artwork and other items)⁴ and are owned by users on a blockchain. As NFT's enter the mainstream, crypto-wallets and new user-friendly platforms are enabling consumers to buy, sell and transfer NFT's effortlessly with sales over the last 12 months said to have increased from US$250 million to over US$41 billion⁵ in 2021.

The metadata embedded in the token representing the NFT is stored cryptographically on a blockchain via a smart contract underlying the NFT. It is this storage of the NFT using blockchain and distributed ledger technologies that give rise to the critical features of immutability, provenance and independently verifiable ownership. Each NFT has an underlying smart contract⁶ which is self-executing software that can transfer rights/assets that are stored as records on the blockchain based upon certain events that are embodied in the software.

As each NFT has its own pedigree linked to the terms of its underlying smart contract, NFT's are not created equal. In fact, many of the NFT's on the market although representing ownership of digital artwork, do not give the owner of the token any rights to the associated copyright work itself. Many NFT's thus do not assign copyright in the work to the owner of the token. This is often the case as the owner of the freshly minted first token may not own the copyright in the first place, the terms of the smart contract to not specify assignment of the copyright, or even if the smart contract purports to do so, the underlying smart contract may not comply with the formal requirements in the relevant jurisdiction. For example, assuming the NFT is governed by the laws of Australia, the Copyright Act 1968 (Cth) requires that assignment of copyright has no effect unless it is in writing signed by or on behalf of the assignor.

This cannot be the case with self-executing smart contracts and so legal ownership of copyright by a token owner is not able to be achieved in Australia and those jurisdictions where similar written requirements are in place. However, in Australia, the Courts have held that an informal assignment may be given effect in equity as an agreement to assign. In those circumstances, it may be possible to perfect the legal assignment of copyright if the terms of the smart contract prescribe a further assurance clause to ensure compliance with formalities of the Copyright Act for the assignment of copyright to be in writing. It remains to be tested in Australia whether the purchase of a token from someone using a smart self-executing contract could be considered to have been signed by the parties and effective under the Electronic Transactions Act 1999 (Cth) especially when the parties to the transaction may remain anonymous depending on the design of the NFT and type of associated blockchain.

As a result, the best that may be achieved in jurisdictions like Australia is for the smart contract underlying the NFT to have licensing terms embedded which govern the use rights of the copyrighted work which the owner of the token will obtain upon purchase. Such NFT's may also specify royalty payments be made to the copyright owner automatically as the token is transferred without the involvement of intermediaries. Although untested in Australian courts, such NFT's are likely to give rise to legally binding contracts as general contracts do not need to be in writing.

Given the proliferation of NFT's across several use cases, a general lack of awareness of the underlying technology by lawyers and the public, and a relatively unregulated crypto-asset market giving rise to scams and the potential for use of NFT's in money laundering and cyberattacks, it should come as no surprise that in response to the Senate Select Committee's final report,⁷ the Federal Government announced in December 2021 that by the end of 2022 it will undertake a mapping exercise of existing cryptocurrencies and tokens to better inform consumers and others of the risks and benefits that may arise, and several other related actions.⁸

There is clearly momentum for legislative change afoot. Investors and other interested parties would be well placed to keep alert to the changing landscape as these reforms unfold.

This publication covers legal and technical issues in a general way and it is not designed to express opinions on specific circumstances. It is intended for information purposes only and should not be regarded as legal advice.

Footnotes

¹ Hash = 64-bit hexadecimal number.

² The transaction data also typically includes the token name and symbol.

³ Optionally, the transaction data may also include a link to a file of the copyright image hosted on the Inter-Planetary File Storage (IPFS) which is run completely distributed on a P2P network using content based addressing.

⁴ Aside from digital artworks, NFT's can also be used in principle to sell concert tickets, domain names, real estate and anything that is unique and requires proof of ownership.

⁵ Almost $41 billion worth of Ethereum-based NFTs were sold, according to Chainalysis research cited by the Financial Times.

⁶ Most NFT's are minted using smart contracts written to the Ethereum blockchain using standard ERC-721.

⁷ In October 2021, the Senate Select Committee on Australia as a Technology and Financial Centre released its final report on the regulation of crypto assets in response to growing concerns about the volatility of cryptocurrency markets.

⁸ These further actions included (a) receiving a report from the Board of Taxation on an appropriate framework for the taxation of digital transactions and (b) an examination of the potential of Decentralised Autonomous Organisations (DAO's) and how they can be incorporated into Australia's legal and financial regulatory frameworks.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.