Exploration of Legal Issues Arising from “Digital Collections” in Practice

Legal Issues with "Digital Collections"

1. Legal issues arising from the application of “digital collections”

Since 2021, the domestic digital collection market has reached a climax. Different from NFTs issued based on public chains overseas, digital collections based on alliance chains in China use RMB as the pricing currency and have not yet opened a legal secondary market.

In order to regulate the development of the domestic digital collection market, in October 2021, the National Copyright Trade Center Alliance jointly released the “Self-Discipline Convention for the Digital Cultural and Creative Industry” with institutions such as Ant Group, JD Technology, Alibaba Auction, and Tencent Cloud, reaching 11 consensus including alliance chain technology control, prevention of virtual currency, prevention of speculation and financial risks, prevention of money laundering risks, etc.

In April 2022, the China Internet Finance Association, the China Banking Association, and the China Securities Industry Association jointly released the “Initiative on Preventing Financial Risks Related to NFTs”, insisting on the de-financialization of NFTs, calling on consumers to establish correct consumption concepts, enhance self-protection awareness, and consciously resist NFT speculative behavior.

However, under the constraints of regulatory documents, the market heat still exposes a series of legal issues. The main two types of issues include: first, the digital collection project party opens a secondary market in violation of regulations, and after speculation, it collapses and runs away, causing many users to lose money, and the project party personnel are suspected of illegal fund-raising; second, the digital collection project party uses unauthorized works on its own, or the copyright owner of the same work authorizes different project parties to cast and issue digital collections, which in turn causes infringement disputes. In addition to the above two types of issues, due to the project party’s “evil deeds”, there are also issues of platform audit obligations and boundary recognition of responsibility.

Therefore, we first need to clarify the legal attributes of digital collections. Secondly, based on the current situation and features of the digital collection market, we need to define the prudence obligations and responsibility of platform parties. Finally, we need to reflect on and summarize the standardized supervision of the digital collection market.

2. Analysis of the legal attributes of “digital collections”

Although there are significant differences between NFTs based on public chains and digital collections, they have many similarities in serving as proof of ownership, etc., so there are also some similarities in legal attributes. There is currently no unified opinion on the legal attributes of NFTs and digital collections. Cryptocurrency enthusiasts promote NFTs as the “future of digital assets”. The birth of tokens means that one day the government will lose its “unique right to mint currency and protect property.” Self-proclaimed experts on YouTube say that owning tokens means owning ownership and enjoying “intellectual property”. So, what exactly do NFT buyers buy, and how are NFTs actually linked to real assets?

Example analysis: Da Vinci wants to turn his work “Mona Lisa” into an NFT digital collection. Currently, there are three factories that can provide NFT casting technology, such as Tencent’s Huanhe platform, Alibaba’s Whale Hunting, and Baidu’s Xilin platform. So, what is the principle of NFT casting provided by the three factories? NFT casting is very similar to a jigsaw puzzle. The three factories can scan “Mona Lisa” and make a complete painting pattern of 100 puzzle pieces that are all different. Each puzzle piece is unique, and this is similar to the uniqueness of the number calculated by blockchain technology through the principle of hash value function, except that the former ensures uniqueness through physical recognition, which is reflected in the uniqueness of each puzzle piece; the latter is a unique digital code calculated through mathematical and cryptographic principles. In the above example analysis, Da Vinci owns the copyright and physical ownership of the artwork. Now, Mr. Da Vinci promises that these 100 puzzle pieces represent the complete copyright and physical ownership of “Mona Lisa”, and if you buy one of them, it represents one hundredth of the complete copyright and physical ownership.

1. Is NFT a copyright contract as debt?

In layman’s terms, it represents a symbolic legal certificate that NFT gives to the buyer. From a legal perspective, owning or controlling an NFT can obtain certain rights that are superior to others, which may be exclusive or relative.

From the perspective of contract law, a copyright contract refers to an agreement between the author of a work or other copyright owner and others on the establishment of mutual rights and obligations in the use and transfer of copyright. Copyright contracts can be divided into copyright license contracts and copyright transfer contracts. In the NFT market, the actual copyright of the original IP work is enjoyed by the owner of the original work. After the transfer or permission of the copyright owner, the project party casts and sells NFT, which is actually a copy, issuance and network dissemination activity of the original digital work. There is usually a direct user agreement or other contract document between the issuer and the buyer of NFT, which actually gives the NFT buyer the rights and interests of the NFT purchased by himself, and the means to realize the rights and interests is to hold and control the NFT. Therefore, in essence, NFT is not the virtual work itself. NFT is essentially a string of numbers generated by a computer program, which is calculated by so-called blockchain technology and has uniqueness. The project party artificially maps some rights on the unique string of numbers, such as the copyright of a certain work, which is what people call NFT; therefore, to a certain extent, NFT can be regarded as a copyright investment contract in law.

To sum up: NFT is just a carrier of rights, just like paper as a carrier of contracts, except that it is a unique digital representation calculated by blockchain technology as a carrier. In essence, the rights assigned to NFT are independent of the physical properties of NFT itself.

2. NFT, as a digital commodity of goods?

From the perspective of digital works, NFT exists in physical or electronic form before being minted. Physical works can also be transformed into electronic works through scanning and other methods, and electronic works can also be called digital works at this time. The act of minting NFT is considered a duplication of digital works, so NFT is also a type of digital work. When the digital work is put into the trading market with a marked price, the NFT at this time is called a digital commodity.

NFT digital work is not the same as NFT digital commodity. NFT digital work is essentially an intellectual achievement in the fields of literature, art, and science that is original and can be expressed in a certain form, and has intangibility; while NFT digital commodity refers to a specific virtual property cast through blockchain and smart contract technology, with electronic attributes. The legal nature of the two is different, and the legal regulatory methods applicable are different, and they cannot be confused.

In terms of legal nature, digital works are intangible intellectual achievements, and digital commodities are virtual property, while blockchain digital assets such as NFT have characteristics different from traditional virtual property. Although Article 127 of China’s Civil Code stipulates: “If the law has provisions on the protection of data and virtual property on the network, it shall be implemented in accordance with its provisions”, China still lacks relevant supporting regulations to connect with it. Whether the object of “data, virtual property on the network” refers to the level of data files, and what kind of protection this kind of protection belongs to, whether it is a creditor’s right, a property right, or an intellectual property right, or a new type of right or interest, are not clear. For new digital assets such as NFT, some people believe that because they exist in the blockchain system, they have brand-new features different from traditional virtual property. These features enable the clear determination of asset ownership and asset quantity information, and the holder can exercise exclusive control over them, which conforms to the characteristics of property rights and should be protected in accordance with the path of property rights protection. When NFT digital works are traded online, the parties to the transaction establish a contractual debt, and the ownership of various rights after the commodity transaction is determined in accordance with the provisions of the contract.

From the perspective of property law, if NFT is recognized as a “thing” under civil law, then, in terms of the attributes of “thing”, ownership under the property rights system includes exclusive possession, use, benefit and disposal of the right object. NFT effectively enables digital assets to be identified through blockchain technology, which means that the object of the right as a thing can be actually possessed by the subject, and the holder of the NFT can use a private key to actually possess and control it, and exclude others from interfering with their own NFT. On this basis, NFT holders can also actually use and dispose of their NFT based on user agreements.

However, the benefit design of NFT ownership relying on smart contracts cannot completely coincide with the legal system of property rights. For example, large projects like Bored Ape sold on opensea, usually stipulate that a portion of the profits will be given to the copyright owner of the work when sold in the secondary market, which essentially belongs to the application of the follow-up right in foreign intellectual property law, but such agreement conflicts with the legal system of property rights. From the perspective of digital commodities, the NFT trading model enables it to transfer property rights like physical commodities, and the real-time ownership information change on the blockchain plays a role in the public notice and credibility of ownership. From the perspective of digital works, the sale of works in the form of NFT does not involve the transfer of copyright, but essentially belongs to the acts of reproduction, distribution and information network dissemination of the work.

In addition, fractional NFT (f-NFT) may also be considered a security under US law. Under the investment contract analysis framework issued by the US Securities and Exchange Commission (SEC), it is generally considered that the main issue in analyzing digital assets under the Howey Test is whether the purchaser has a reasonable expectation of profits (or other financial returns) from the efforts of others, and the purchaser may expect to achieve returns by participating in distribution or other methods of asset appreciation, such as selling for profit in the secondary market. Fractional NFT still represents ownership of assets such as art, music, or video, but as the name suggests, the ownership is fractional. Fractional ownership is called “shards”, and each shard represents a share of ownership. US courts and the SEC typically consider that if non-securities are sold in segments, they may become securities, such as mortgage pools or automobile loan pools. In the NFT market, the fragmentation of ownership is called fractionalization, which brings substitutability to NFT. Depending on the nature of f-NFT, investors may participate in a joint venture by investing in a portion of a homogenized token. By selling f-NFT, the project party may still retain control of the NFT, so the interests of investors and the project party are intertwined, and the efforts of the project party will also affect the market price of the f-NFT held by investors.

3. The Essence of NFT: A Tool for Proof of Ownership in Multiple Scenarios

From an application perspective, whether it is an NFT or a digital collectible, different legal attributes may exist in different application scenarios. Therefore, the author believes that for NFTs, we need to understand their underlying technology from a technical perspective rather than simply defining them from an application perspective. Technically, it is an encrypted equity certificate and an important tool for virtual asset proof of ownership in the development of the future metaverse. As for its legal attributes in different application scenarios, this depends on the role it plays in the specific issuance and circulation of transactions. In different application scenarios, it may be a commodity, a bond, a security, or even a bill, real estate contract, and so on. We only need to analyze it specifically when it falls into the practical application level to be more appropriate.

Three, Regulatory Countermeasures for “Digital Collectibles”

At the end of March 2022, the official website of the US Department of Justice announced a criminal case involving money laundering and fraud. In the case, the creator of the NFT project suddenly abandoned the project after fundraising and fraudulently possessed the investment assets of the project investors. In April of the same year, the Hangzhou Internet Court of China publicly tried a case of Strange Idea Co., Ltd. v. A technology company’s infringement of the right to disseminate information about works on the Internet. The case sparked public discussion on the issue of platform responsibility in NFT project infringement cases.

With the strong support and development of China’s digital economy, it is urgent to take preventive measures against the risks brought by the digital collectibles market. On the one hand, standardized regulation of China’s digital collectibles market needs to balance the relationship between innovation and regulation. It is necessary to fully affirm the important values of art, culture, business, etc. brought by digital collectibles, and also to prevent the risks of disrupting market order and causing losses to investors caused by financial speculation; On the other hand, the regulation of the digital collectibles market should not only be implemented on the specific project parties and entrepreneurs but also give certain audit obligations to the platform providers who provide technical services for the digital collectibles project parties. Provide sufficient rule of law soil for innovative entrepreneurial activities under clear rights and responsibilities.

1. Strictly implement qualification audits for issuers and platform providers

There are two operating models for domestic digital collection platforms. One is that the platform operator does not participate in the transaction of digital collections, but only provides services for on-chain casting of NFTs. The other is that the platform participates in the transaction of digital collections, that is, the platform may directly participate in the transaction of digital collections as the issuer after obtaining the authorization of the right holder of the artwork, that is, the casting and sales of NFT artworks are controlled by the platform operator.

Regardless of which model is mentioned above, NFT platforms play an important role as a bridge between consumers and creators/issuers and should be subject to strict regulatory restrictions. Even though there are no direct regulatory documents for NFT issuance platforms in China, they are still regulated by existing administrative management systems for internet platforms, such as blockchain security assessments and record filings required by Article 9 and Article 11 of the “Regulations on the Management of Blockchain Information Services”. According to Article 8 of the “Interim Regulations on the Management of Internet Culture”, for digital collections/NFT works, if they are identified as internet cultural products in certain specific situations, the platform should apply for an Internet Culture Operation License from the local cultural administrative department.

For the issuers of digital collections, there are currently no clear legal requirements for them to have specific qualifications when casting or issuing digital collections. We believe that in the future, certain licenses or filings can be set up for the issuers of digital collections. If necessary, the issuers can be required to provide a certain amount of asset guarantee to the platform or other third parties before publicly issuing digital collections to ensure that they can assume responsibility for user losses caused by project-side reasons.

2. Guarding against the risk of secondary market trading and speculation

Currently, domestic digital collection issuance platforms do not open secondary market functions, mainly because opening a secondary market itself is a licensed business in China. In 2011, Document No. 38 of the State Council, “Decision of the State Council on Clearing up and Rectifying Various Types of Exchanges and Effectively Preventing Financial Risks” and Document No. 37 of the General Office of the State Council in 2012, “Implementation Opinions of the General Office of the State Council on Clearing up and Rectifying Various Types of Exchanges” imposed restrictions on secondary trading platforms.

The release of the “Initiative to Guard Against Financial Risks Related to NFTs” means that for most domestic digital collection issuers and issuance platforms, the financial risk of digital collections is explicitly prohibited in China, usually occurring in the primary market, and excessive financialization even brings criminal risks to issuers and platforms. This also determines that the digital collections sold domestically cannot have financial components and cannot be turned into financial instruments due to issuance and circulation.

In practice, the financial risks of digitized collectibles in the current market mainly come from project parties opening secondary markets in violation of regulations, causing people to trade, speculate, and maliciously inflate the unit price of digitized collectibles, eventually leading to the collapse of projects and losses for investors. On the one hand, law enforcement agencies should strengthen active law enforcement thinking, and when they discover that relevant parties are suspected of using digitized collectibles to raise funds, commit fraud, and other behaviors during the daily law enforcement process, they should intervene in a timely manner and actively rectify. For those who may be suspected of criminal offenses, they should be transferred to the public security department for investigation and filing. On the other hand, with regard to the financial risks brought about by the trading and speculation of digitized collectible platforms, judicial authorities should attach importance to and organize with relevant departments to classify administrative violations and criminal issues that may be involved in this field, in order to deter those who intend to use digitized collectibles for fraudulent behavior.

3. Clarify the responsibility boundary of the platform

Given the huge profits obtained by the digitized collectibles industry and the chaos inherent in the industry, the platform for digitized collectibles, as a technical party, should be given a certain degree of due diligence obligations. When the platform fulfills its own due diligence obligations, the responsibility of the platform should not be pursued due to the fault of the project party. Only when the platform fails to perform its audit obligations, causing disruptions to market order and damage to the interests of investors, should it bear corresponding compensation liability, and if it involves criminal offenses, it should be pursued for criminal responsibility according to law.

The due diligence obligations of the platform can be divided into three parts: before, during, and after the event. With regard to the prior event, the platform can be given basic audit obligations such as reviewing the qualifications of the settled project parties, KYC certification, requiring project parties to provide a certain amount of margin, and providing equity certification for uploaded works to establish a preventive mechanism. With regard to the during event, according to Article 1195 of the Civil Code and Article 23 of the “Regulations on the Protection of Information Network Transmission Rights”, the platform should focus on reviewing whether users applying for digitized collectible casting provide preliminary evidence involving copyright manuscripts, originals, legal publications, copyright registration certificates, and proofs issued by certification agencies, and the authenticity of such evidence, proving that they are the right holders of copyright or related rights. In the future, digital collectible legal normative regulations can be formulated to clarify and refine specific requirements based on the need for review in different scenarios, types of intellectual property rights, and other factors within the existing legal normative framework. With regard to the after event, when the project party settled on the platform commits relevant infringements, fraud, and other behaviors, the platform should remove the digitized collectibles in the first time, fulfill the obligation of taking “necessary measures”, such as “notification+deletion”, or adopt the effect of disconnecting the infringing work on the blockchain and sending it to the address black hole to stop the infringement; for fraudulent behavior, the project party’s deposit delivered to the platform or stored with a third party can be frozen to fulfill subsequent compensation responsibilities.

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