Tokens and NFTs

It is important to fully understand the business model underpinning the relevant blockchain project and draft the agreement accordingly.  It is often a good idea to draft a term sheet (signed off by key stakeholders) that summarises the project and the key issues prior to drafting the long form agreement.

Example 1

Token project:  for example, does the project involve the minting of tokens (e.g. NFTs)? If so, identify who will be issuing and minting the NFTs and selling them to end users and who will be providing the identified digital asset or physical object linked to the NFT.  A typical structure is for the licensor (e.g. brand) to license the IP in a digital asset to a tech supplier and for the tech supplier to be in charge of: (i) deploying the smart contract to the relevant blockchain, (ii) minting the NFTs and associating them with the specified digital asset,(iii) selling the NFTs via a platform to end users, and (iv) providing a commission to the brand in respect of platform sales. Key areas to consider include IP rights, regulatory compliance, commercial related issues (e.g. any minimum commitments) and technology related issues such as the availability of the platform.

Example 2

Non-token project: for example, does the project involve the better sharing and recording of data between disparate parties using blockchain-based technologies (e.g. supply chain management)? If so, identify whether you are advising the customer accessing the blockchain network to better share and record the data or if you are advising the tech supplier providing access to the technology platform. A typical structure is for the tech supplier to provide access to an app that the customer can use to view data recorded on the relevant blockchain and provide data for recording on the relevant blockchain. The app then interoperates with a back-end blockchain network (either a public blockchain or a private blockchain). Key areas to consider include technology related issues such as licence rights to the app and also rules governing access/participation in the relevant blockchain network.

International advertising / marketing laws are the subject of only very limited harmonisation, even in trading blocs such as the European Union. The range of laws applicable to the marketing and promotion of tokenised assets and related products and services can be broad, and frequently engages both general marketing law as well as regulations applicable to specific types of products and service, such as a regulation concerning the promotion of financial instruments and services. Determining which laws are applicable to a campaign can be very fact-specific and vary significantly depending on the precise product / service, the form of advertisement and medium through which it is distributed.

Key areas of advertising and marketing law can include general advertising law, financial services regulation, broadcasting law and wider consumer protection laws.

• Information/disclaimers – organisations engaging in tokenisation often encounter genuine dilemmas in relation to the use of disclaimers and / or the extent of disclosure of information about a product or service required.
• Change and enforcement – the attitude of governments and regulators to both substantive laws relevant to the marketing and promotion of tokenised assets and related products and services, and to the enforcement of these laws, is currently highly variable across jurisdictions, and evolving rapidly.

Especially where the rights carried by a token relate to digital content, data or other works typically protected by intellectual property laws, IP considerations are critical.

Key considerations:

• Specific rights to be granted under primary licences (typically, the rights required to mint tokens in the first instance) and under secondary licences (the rights granted to a person acquiring the tokenised asset).  The scope of secondary rights can be particularly challenging to define.
• Particular care should be taken in defining the scope of any exclusivity to be granted to a platform operator or other person seeking rights to create digital works to be associated with tokens.
• The commitments and warranties to be obtained from platform providers.

Organisations must carefully consider licensing and ongoing compliance requirements when developing and issuing tokens. Consideration must be given to marketing restrictions in all countries in which the tokens are offered or promoted. Requirements differ depending on the characteristics of the token and the rights given to token holders.

There is no harmonised regulatory framework for tokens and so regulatory treatment must be approached having regard to each relevant country’s existing regulatory framework.

Key issues to consider include the following:

• Is a token a form of specified investment or financial instrument which could trigger licensing requirements or marketing restrictions in relation to its issuance or trading?
• Even if the token is not regulated as a specified investment or financial instrument, there are likely to be other issues to consider such as money laundering requirements to register with the relevant supervisory authority and to comply with ongoing AML requirements such as applying customer due diligence on prospective token holders and having a designated money laundering reporting officer.

Marketing restrictions also need to be considered and the general regulatory trend towards imposing restrictions on the marketing of fungible tokens with potentially less restrictions on non-fungible tokens, although this would need to be considered across each relevant jurisdiction.

Each participant in the distribution chain for a token offering needs to consider its regulatory position, not just the platform issuing or facilitating the trading of the token.

The regulatory environment is changing rapidly, especially with the EU developing a Markets in Crypto-Asset Regulation (MICAR) and the UK proposing to extend its financial promotion regime to fungible tokens.

In financial services, a variety of use cases for tokens has already emerged, including the following:

• Tokenised securities - they are being used in a variety of contexts, including in crowdfunding (for example, for real estate financing, renewable energy projects and so on). (Re-)payment claims can be connected to tokens, which can serve as proof of ownership of the claim.
• Venture capital funding - VC funds are showing a willingness to use tokenised funding. A token can replace a traditional certificate and create a new, potentially convenient way of financing. Rights associated with tokens can be structured to closely replicate rights traditionally associated with share ownership, such as voting rights.
• Syndicated loans - Traditional banks may, on the establishment of syndicated lending or ‘Schuldschein’, use loans that are issued on the blockchain. The cooperation may include creating platforms on which loans are issued and transferred.

In all of these use cases, it is essential that the legal connection between the token and the related / underlying claim / right is legally effective to avoid the risk of the token being transferred without the claims / rights. In this context, a key question under conflict of laws rules will be which national law applies to the token. This is likely to be the law of the underlying right / claim, although whilst some jurisdictions have sought to create clear solutions for the transfer of tokens and related claims / rights, others are so far choosing to leave it to be dealt with in future case law.

In the field of payments, tokens can be used either as a means of payment whose value may or may not be stabilised with reference to commodities, crypto-assets, or a basket of such assets, or as e-money with reference to one or more fiat currencies. When structuring the issuing of payment or currency token, a clear view on the strict regulation of e-money is essential. At the same time, it will usually be highly recommended to assess whether the rights structure embedded in the token makes it similar to a financial instrument. If so, tokens are subject to the extensive regulation of the financial sector.

Establishing a tokens platform, or minting and trading tokens, often involves a matrix of different contracts, including various sets of terms and conditions covering primary and secondary markets. In the case of NFTs or other tokens with which digital content or data are associated, there can be several additional licences and other contracts. It is important to map the various contractual relationships that need to be created to enable and regulate the minting, primary sale and secondary trading of all types of tokens.

One of the attractions of tokenising certain assets and transactions is the opportunity for automation offered by the use of smart contracts embedded in platforms and tokens. The coding, registration, execution and monitoring of smart contracts is an important element of setting up any tokens issue. It is important to note that smart contracts often do not replace standard written agreements or terms and conditions in their entirety, and often the task of lawyers is to ensure consistency between human-readable terms and the parallel operation of related smart contracts.

As with any other environment, the complex tokens ecosystem must comply with data protection and privacy law. Amongst other things, issuers must consider: (a) whose identities will be retained with respect to a token, and by whom, and (b) how to provide notices and ensure compliant data sharing.

For tokens that feature personal data of identifiable individuals - such as images and video footage - appropriate notice must be provided to those individuals, and a strategy must be put in place to manage data subject rights requests relating to published tokens.

Platform operators will need to consider carefully all of the technical and jurisdictional flows of data necessary for the effective operation of primary and secondary markets, transactions, relevant record keeping and regulatory compliance.

Transactions and relationships on distributed ledger technologies bring with them a host of new and potentially challenging issues when disputes arise. Organisations should be particularly careful about how disputes between participants to each type of transaction will be resolved:

• Forum – The benefits and drawbacks of distributed technology-based dispute resolution systems vs. traditional dispute resolution methods should always be considered, and in light of the specific transaction.
• Appliable law – If traditional dispute resolution is used, the judges in a particular forum should be familiar with the relevant technology. Smart contracts should be enforceable under the relevant applicable law.

Most domestic tax regimes generally do not fully cater for transactions involving tokens, and the tax consequences of tokens transactions remain largely uncertain.

It is vital that organisations are across domestic tax law to verify reporting requirements, tax treatment of capital gains and the possibility to deduct losses.

Non-compliant organisations may be subject to administrative tax penalties for underpayment of taxes, criminal penalties and/or seizure of the tokens.