Discussion Post: Existing Legal Frameworks and Problems

CTA: “In these threads, we attempt to further the discussion of a key problem in this category and evolve our understanding of the domain space where research work has not yet answered the specific problem or question being considered. These posts are living documents, and it is our hope that the community will continue to contribute to their structure and content.”

Citation: Fairfield, Joshua, Tokenized: The Law of Non-Fungible Tokens and Unique Digital Property (April 6, 2021). Indiana Law Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3821102

Background

Bank Secrecy Act of 1970 (BSA) - Legislation establishing financial reporting standards to keep organizations from laundering money, and assist law enforcement in detecting and preventing money laundering.

Convertible Virtual Currency (CVC) - According to the U.S. Department of Justice’s Financial Crimes Enforcement Network (FinCEN) guidelines, the term “virtual currency” refers to a medium of exchange that can operate like currency but does not have all the attributes of “real” currency, including legal tender status. A CVC is a type of virtual currency that either has an equivalent value as currency, or acts as a substitute for currency, and is therefore a type of “value that substitutes for currency.” Bitcoin is a CVC.

Legal Tender Digital Assets (LTDA) - Digital assets with legal tender status. Distinguished from CVCs in that they are a substitute for legal tender, and distinguished from a currency in that they do not have a coin or paper money associated with them. Like a CVC, LTDAs have value that substitutes for currency.

The DAO Report - The United States Securities and Exchange report which determined that issuing a cryptocurrency token likely violated the Securities Exchange Act of 1934 as an unlawful securities offering.

Intellectual Property (IP) - A work or invention that is the result of creativity, such as a manuscript or a design, to which one has rights, and for which one may apply for a patent, copyright, trademark, etc.

Intellectual Property License - IP licenses allow individuals or businesses to use another’s IP rights in exchange for a fee. The person or company granting the licence is the licensor, and the person receiving the licence is the licensee.

License Conditions - The terms of agreement to which a licensee agrees to abide by when using IP granted by the licensor.
Personal Property - Synonymous with chattel. Any movable thing or intangible item of value that is capable of being owned by a person and not recognized as real property (i.e. land and property permanently attached to a piece of land).

Intangible Personal Property - Intangible personal property is an item of individual value that cannot be touched or held. This can include any item of worth that is not physical in nature but instead represents something else of value such as images, social and reputational capital, and recently, personal social media pages and other personal digital assets.

Contract - An agreement between private parties creating mutual obligations enforceable by law. The basic elements required for the agreement to be a legally enforceable contract are: mutual assent, expressed by a valid offer and acceptance; adequate consideration; capacity; and legality.

Sales Law - The Uniform Commercial Code (UCC) Article Two is the main body of law regulating sales and leases of goods in the United States.

Goods - All things movable and identified to a contract of sale. It does not include secured transactions, leases, money exchanged as the price, or real property (land and property permanently attached to a piece of land). To be identified to the contract, a good must exist and be one of the objects that is or will be exchanged.

RAM-copy Doctrine - A 1998 case concluded that although a copy made by a computer’s virtual memory was a copyright “copy,” the defendant was not liable for infringement.

Key Problem / Topic Area

Joshua Fairfield argues that NFTs are personal property, not contracts (despite being called “smart contracts’’). This discussion post covers the second section of “Tokenized: The Law of Non-Fungible Tokens and Unique Digital Property,” which argues that because NFT transactions take the form of a sale, the law of sales of personal property should apply, placing them within existing legal frameworks.

For a discussion of how NFTs are framed as personal property instead of intellectual property please refer to “Creating Digital Uniqueness.”

Specific Question or Problem Statement

Does the use of NFTs as collectables more closely resemble the way people buy personal property or the way people license intellectual property? How much control should a seller have over an immediate or eventual buyer’s use of a fully bought-and-paid-for digital asset?

Approach / Methodology

This discussion is devoted to the second of three sections in Fairfield’s article. The current legal regime allows an intellectual property holder to claw back significant rights from purchasers. NFTs, according to the author, are expressly sold on the basis of ownership narratives. Yet the past two decades of legal development have all but eradicated ownership interest online in favor of a contract and licensing regime.

The name “Smart Contract” evolved from crypto-theorists’ desire to do away with the law, which Fairfield says was born out of technologists’ misunderstanding of what a contract is: it is the making of promises, not their means of execution. Automatically executing programs, he says, are not contracts if there has been no bargained-for exchange of promises or intent to enter into binding legal relations. Nearly every legal analysis concludes that while code might help execute a contract, smart contract programs are not themselves contracts.

Existing legal literature on cryptocurrencies suggests that the legal regulation of blockchain depends not on the technology, but on how humans are using it. For example, if a blockchain is transferring value, it is a money substitute under the Bank Security Act of 1970. If a coin is issued to raise funds for a business, it is treated as a security by the SEC. This “use-drives-regulation approach” has held as tokens create property interests. If a token is sold as property, treated by humans as property and passed down through wills as property, the law has begun to take it seriously as property.

If owners treat digital assets as personal property, the law of personal property should apply; therefore NFTs should be treated as a personal property, according to Fairfield.

The few existing legal analyses of NFTs focus heavily on intellectual property. This is largely because ledger technology provides a way to create digital uniqueness. But if this technology is analyzed within the framework of IP and contractual licensing, NFTs simply become copyright licenses with extra steps and lose the characteristics that interest vendors and purchasers. As NFTs enter the mainstream, they will be sold, invoking the law of sales of goods. They will be used as collateral, inherited, etc. and each of those rely on the assets being characterized as personal property rather than intellectual property.

Conclusions / Key Takeaways

Existing legal literature has held that use-drives-regulation applies to blockchain technologies. However, to date most legislation (such as Dapper Labs 2018 decision to retract their Stephen Curry-based Cryptokitties) has reinforced the past two decades of treating digital assets as intellectual property, and therefore as contracts. Fairfield argues that currently NFTs are treated as contracts and property simultaneously, akin to a contract to buy a car (as opposed to a lease) with sellers retaining certain rights. Courts must ask whether parties entering an NFT transaction contemplated conveying a property interest, and if so, whether they intended that contract as an immediate contract with little or no long-term control or a longer-termed contract like a lease or license.

Fairfield argues that NFTs should be treated as full personal property and that sales of NFTs should follow the law of sales of property. Defining NFTs as personal property will have the benefit of “[beginning] to heal the longstanding and growing infection of online spaces with overbroad intellectual property licenses by providing a clear counterexample for courts to build on when differentiating digital property and intellectual property.”

CTA: Future Work / RFP

In establishing the current legal frameworks that adjudicate NFTs, the researcher has laid a foundation from which to extrapolate a new legal framework that combines existing property law with the expected utility that comes with digital personal property having explicit legal contracts explaining what intellectual rights are associated with the sale of an NFT.

Currently, U.S. courts treat NFTs as a combination of IP and personal property. Fairfield argues that users treat NFTs more like personal property than IP and should be regulated as such. As the lawyer/researcher writing the article is licensed in the US, his framing is specifically restricted to the U.S. jurisdiction but the rationale could be used in other common-law using countries.

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Maybe I’m veering off of the article a bit, but wouldn’t oracles justify more of a contract-based legal framework?

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I believe an autonomous oracle gets closer to being an entity that would be able to legally enter a contract, however that would still come with the notion of “a jurisdiction”. In that framing, an oracle would need to justify the jurisdiction in which it is entering agreements, and there would need to be a proper justification to claim “international” if most of the nodes were being hosted in a geographically isolated region, i.e. would be hard to claim “international” if the nodes all existed within countries’ borders.

Further, the oracles would have to have status as either a “person” or a legal entity meaning that someone or some organization would have to establish the oracle’s personhood or legal status. That seems to be in line with what some of the oracle-inclined protocols have proposed as a future for “legal” smart contracts.

The author uses the example of “filling up the gas tank” as an automated contract that takes place between a person and a legal entity with the promise of gas being delivered upon payment clearance. The process and contract are automated, but an implicit contract exists between a company and a person. An oracle could easily play this role as long as there is some legal indication of an associated person or company that reports to a specified jurisdiction. Effectively, an oracle cannot be its own “law enforcement”, and in that context “self-enforcing contracts” is never an accurate term. “Self-executing” is not the same as “self-enforcing”, and the author argues that a contract by definition “cannot enforce itself” since the “enforcement” is the legal jurisdiction that would adjudicate a conflict and not the “execution” itself.

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This might be an interesting intersection between the crypto and non-crypto ecosystems.

From a non-crypto perspective, the notion of self-executing and self-enforcing are different, but does that distinction really hold in crypto? Once executed, what conflict exists that could be adjudicated upon? There might be conflict, but is there an opportunity for adjudication post-execution? It seems like enforcement can only occur pre-execution, which in many ways seems contrary to the notion of enforcement.

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That is not contrary to the notion of enforcement whatsoever. I think the crypto space has unintentionally and inaccurately conflated execution and enforcement to the detriment of understanding that “enforcement” in fact MUST come after execution. In this sense, enforcement is perpetual and not final in contrast to “execution” which has finality with a command set.

In this context, “enforcement” is the adjudication of a contract whether to confirm both parties have received their promise OR to mediate conflict. Execution does not involve conflict mediation and resolution, whereas “enforcement” does.

Further, smart contracts will inevitably have to decide a jurisdiction from which to be adjudicated, or by definition they will not be “legal” in ANY jurisdiction.

This is where the smart contract space has made promises about decentralized enforcement that may just not be possible or legally sound.

I think in the notion of smart contracts having “claw-back” mechanisms that do give them some capacity to “enforce the agreement” there will be some smart contracts that do blur the line of enforcement and execution, but as far as a “legal enforcement” the notion of “legal-self-enforced” is a paradoxical state that cannot be achieved due to the perpetual nature of “enforcement” being a third party process.

An oracle would have to have the same sovereign status as a country or legal jurisdiction to “enforce” the “legal” aspects of a contract, and that is “centralization” thus becoming the antithesis of what decentralization maximists have claimed as their goal.

TL;DR

If a contract is not legal “somewhere,” technically it is not legal “anywhere”

Also, “enforcement” can happen at any time after a contract has been agreed to including before during or after “execution”, making “enforcement” perpetual if it’s true enforcement.

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I agree to the idea that NFTs should be treated as goods rather than IP rights. Not only because the pathway to regulate cryptocurrencies should depend on how people use them, which is referred to by the author, but also the essence of NFT is not fit to the definition of IP rights. And NFTs should be treated as goods only in the context that the NFT is being used like goods. When it is being used as a symbol of right or other things, it should be regulated or apply to the principle of that right or thing. In the light of the rapid and diverse developments of the way we use NFT, this is a reasonable conclusion.

As the purpose of the IP rights system is to protect the results of human diligence and intelligence, NFT could be the protected object of IP rights rather than being IP rights themselves. NFT could be a symbol of owning IP rights as well. IBM’s recent actions are an example of this thought.

The nature of digital assets is still at issue in different jurisdictions. More and more courts recognized its eligibility to be protected by principles of right in personam or personal property, but its position as a property is still controversial. Nevertheless, it should not be deemed as a type of IP rights just because it is intangible.

Is a smart contract a contract? Maybe we can say the action of the use of the smart contract implies the intention to enter into a contract, however, how to explain the consideration, the bargain for exchange, will be a challenge. But the consideration requirement of contract only exists in the common law system, there is no consideration requirement in the civil law system.

As to the enforcement, it is a legal proceeding that only can be taken by courts. The smart contract may ensure the execution in accordance with the arrangement of codes, and when the execution is conflicts with the arrangement of contracts – the contract may be concluded other than the smart contract, or if the smart contract has some significant defects and is appliable to laws against these defects – or other legal statuses, parties involved would need to claim by courts, then it comes to the enforcement.

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This is a great framing. The author had addressed this question in an earlier part of his book, and I summarized it in which he came to the conclusion that "most smart contracts aren’t actually legal contracts". It is in this context that this author is attempting to deconstruct the improperly framed terms to give a new framework in which the law may be more congruous. In this, the author does not offer new terminology. I believe that was intentional in the context that the propositions of “smart contracts not actually being contracts” and “looking at digital property as personal property” may not be widely accepted by the community; and by proxy it may have been premature to come up with new terms before the arguments are accepted.

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I think it is hard to wave off the application of law totally even if the code of the smart contract is perfect, but I believe it can reduce the reliance on the law on a large scale. This is because there are many principles other than contracts that are aiming to protect the parties or the third party regardless of the parties’ true intention has been fulfilled by the contract. This happens in the areas which contain strong public interest or paternalism. Maybe it’s worthy to make research in some specific area to find out that whether the amount of litigation results from the smart contracts is less than those who didn’t use smart contracts. It might be some way to persuade others that smart contracts could do away with the law (to some degree).

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