Art Law, NFTs, and Due Diligence

Tuesday, March 16, 2021

By now, we’ve all heard of cryptocurrency, especially Bitcoin, when it hit the scene in 2009 with the goal to decentralize the finance system. This decentralization dream lives on in the latest blockchain trend – Non-Fungible Tokens (NFTs). NFTs are digital images intended to be preserved as art and track ownership. It’s an exciting new development for the crypto world. Corporations, however, need to be mindful that this space also has been described by some as the “Wild West,” thereby opening the door for misuse, cyberbullying, property theft, market fixing, money laundering, sanctions violations, and other serious legal violations and infringements.  There is much talk of NFTs being unchartered territory as the new crypto world is termed “unregulated,” however this is not entirely accurate as our existing laws and regulatory agencies govern these age-old nefarious activities and abuses, even in this space. Compliance and training in this space is cheaper and easier than damage control after an investigation.

For the uninitiated, blockchain is a digital shared ledger of transactions maintained by a series of computers on a network which all come to an agreement regarding shared data. Since it’s shared, transactions are recorded once, and are accessible to all network participants. The blockchain is also immutable meaning a participant cannot alter a transaction after its been recorded. If an error occurs in a transaction, a new transaction is required to rectify it. Transactions are recorded as “blocks” of data. As more transactions related to the first block occur, more blocks are added to create a chain of data. The blockchain records when a transaction occurred, the order of transactions, and the digital addresses of the parties involved in the transaction. This creates a clean transaction history of the digitized procedure only for the item exchanged on the blockchain.

Items exchanged on the blockchain are referred to digital assets or tokens. They can be tangible or intangible, fungible or non-fungible. Some digital assets are purely digital, for example cryptocurrency. Others can represent physical items, like a digital picture of a sculpture, such are NFTs.

NFTs are digital assets which differentiate themselves as being authentic and unique. Each NFT has its own value and can only be owned by one entity. The idea is that an NFT is the digital equivalent of owning an original painting rather than a print copy. In the current internet world, with the ease of copy and paste and screenshots, this record of authenticity and ownership is intended to secure the value of the NFT.

There are digital marketplaces for selling NFTs. The most notable examples of these platforms are Rarible, OpenSea, Foundation, and Nifty Gateway. On these sites, creators are supposed to sell their own NFTs. Some users sell NFT collectibles, like CryptoPunks and CryptoKitties, which function as digital trading cards. Even the NBA is involved in the NFT world, selling digital trading cards featuring clips from basketball games on TopShot.

Other creators are artists selling NFTs of their artwork. The most popular example of an NFT artist is Beeple, who made headlines after selling a NFT artwork for $69 million in a Christie’s Auction. Not every NFT artist is selling their work for millions of dollars at Christie’s. Rather, most artists upload their work to a platform like OpenSea and set a price. During this process, a “smart contract” is created which is essentially code programmed to execute a transaction, thus not a contract detailing the terms and conditions or rights of the parties. Part of these codes include royalties for the NFT creator. This allows the original creator to realize a royalty after they sell the NFT. If a collector of an NFT later decides to sell that work, the creator will get a royalty from the resale.

Creators of NFTs sell their work for any price. In the physical world, an artist would go through an appraisal process and justify the price of their art. Here, the market is determining the value of NFTs. And as the market becomes inundated with buyers and sellers, new creators are selling their NFTs for huge prices, like $20,000, without a guarantee of value nor is the price necessarily based on the quality or complexity or time to complete the work, or prior sales. These works do not have a record of worth or their value as collectibles. There’s no guarantee that they will appreciate. Meaning, buyers of these collectibles, believing that they will increase in value so they can later sell at a profit, are in a prime position to lose money. Artists and others in this space reserve referral fees for connecting buyers and sellers, and anyone can be a middleman by self-proclamation. Corporations need to address that as these works sell for millions, the market is primed for nefarious uses like money laundering, fraud, and sanctions violations.

The blockchain allows for anonymity. You don’t have to use your real name. Anyone in the world with an internet connection and a credit card can purchase cryptocurrency and then buy NFTs. Sellers do not always know who their buyers are or where the money is coming from.  Further, art, including NFTs, is subject to compliance and trade regulations, as well as anti-money laundering and bribery laws and more, meaning the onus is on the parties to the transactions to not only comply with US laws, but to comply with myriad global and regional laws governing the same prohibited or licensable activities, including conspiracy laws.

Some platforms include in their Terms of Use that no sanctioned person or a person in a sanctioned country can engage with their platform, but there is no apparent enforcement of these terms or due diligence software screening these transactions. The Terms also include clauses about not using the platform for criminal activity. But without a compliance program which includes transaction monitoring and vetting of users, there is no enforcement leaving companies and individuals exposed to criminal and civil fines and penalties.

These platforms, and the community of creators and collectors, believe in community enforcement – a hallmark of decentralization. There is only so much a community can enforce. The realm of compliance laws changes frequently, is complex and difficult to track for a company or bank, let alone the crypto space.  Community enforcement is not viable for due diligence and sanctions violations or other similar criminal activity which is already regulated and prohibited

The SEC has started enforcement actions in the blockchain and cryptocurrency arena in the last couple of years. The SEC investigations and settlements with Telegram and Kik demonstrate how seriously the SEC is taking this. The Telegram and Kik cases demonstrate how platforms could violate securities laws unintentionally. While current NFT platforms may not intend to become securities dealers, they could find themselves categorized as such if they decide to sell tokens to users as way to finance improvements to their sites. NFT creators and collectors could also find themselves investigated by the SEC. As creators decide to embark on more sophisticated and expensive projects, they could decide to offer interest in their projects to investor-collectors and issue a token or NFT to demarcate the interest, for example.

The CFTC is another agency who governs such activities in the NFT and crypto space. In 2020, the CFTC charged a Colorado resident with a digital asset trading Ponzi scheme. With cryptocurrency and blockchain naïve artists and creators entering this space, they are vulnerable to similar scams. A bad actor could take advantage of this space and offer “wealth management funds” or “liquidity pools” for creators to invest their new cryptocurrency from selling their NFTs and collaborating or pooling their assets for egregiously inflated or suspect bidding prices directed at driving up the costs and bids for such items.   

In December 2020, the Financial Crimes Enforcement Network (FinCEN) proposed rules to close anti-money laundering gaps regarding cryptocurrency transactions, including the NFT space in late 2020. These proposed rules clarify recordkeeping and reporting rules for financial institutions regarding cryptocurrency. They also decrease the reporting threshold from $3,000 to $250. These rules are aimed at decreasing illicit uses of cryptocurrency such as money laundering and evading foreign sanctions. The anonymity of cryptocurrency, especially with the use of cryptocurrency wallets not hosted by a bank or other centralized institution (“unhosted wallets”), provides an opportunity for money laundering and sanctions evasion. To combat this, FinCEN is proposing rules that would include verifying the identities of cryptocurrency users transacting with users with unhosted wallets or hosted wallets in specific jurisdictions. Mainstream NFT platforms require the use of a hosted wallet (e.g. MetaMask) to engage with the platform. However, there’s currently no guarantee that the cryptocurrency in that hosted wallet wasn’t initially transferred from an unhosted wallet or are proceeds from a nefarious use.

On March 9, 2021, FinCEN released a notice to financial institutions regarding the Anti-Money Laundering Act of 2020 (AMLA), encouraging financial institutions to report suspicious activity relating to antiquities and art. NFT marketplaces generally deal in art trading and such transactions would be subject to the AMLA and reporting requirements. Similarly, the Department of Treasury, Office of Foreign Assets Control (OFAC) and the Department of Commerce, Bureau of Industry and Security have historically investigated and fined or required licenses for art transactions and intangibles like research or writings or speeches in violations of trade sanctions law or other enforcement activities.

The Office of Foreign Asset Control (OFAC) is also actively enforcing sanctions violations using blockchain. On February 18, 2021, OFAC reached a settlement agreement with BitPay for facilitating cryptocurrency payments between U.S.-based users and users in sanctioned jurisdictions. As for sanctions evasion and artwork, OFAC issued an advisory in October 2020 about the use of high-value art in sanctions evasion, stating that OFAC considers transactions involving high-value art with cryptocurrency with a blocked person or their facilitator to be sanctioned.

Platforms acting as marketplaces for NFT commerce need to place priority on compliance programs to protect against nefarious uses such as securities violations, sanctions violations, and money laundering. To do so is always smarter and cheaper than at the time a problem surfaces.

For assistance and advice concerning corporate or government investigations and trade sanctions, contact Teresa Taylor.

Teresa Taylor
202.454.2885
taylortn@butzel.com

Lindsey Dennis
202.454.2854
dennisl@butzel.com

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