This article focuses on the use of NFTs in metaverses. At first, we will briefly introduce NFTs, particularly in the video games industry. Video games feature vast virtual worlds that are a considerable part of many companies’ metaverse strategy, with many of the major fashion brands bringing their products to video games. Subsequently, we will provide insights concerning two key legal areas for NFTs: financial regulation (Section II) and intellectual property rights (Section III) from a German law perspective. Lastly, the interest in NFTs has expanded beyond partnering with interactive entertainment companies and driven transactional interest. Therefore, we will address considerations when targeting NFT companies in an M&A setting (Section IV).
- What is an NFT?
A non-fungible token (NFT) is a unique identifier that can be used to cryptographically prove and assign certain rights relating to underlying assets. NFTs are digital records of underlying rights which have been assigned by a content creator. The rights attached to each individual NFT differ depending on the terms of that NFT. They may for example grant rights to specific digital assets such as artworks, music or a virtual item in a computer game, could grant specific rights to obtain real world assets (for example rights to a signed sports jersey by a professional athlete) or may even grant rights to certain events / services (e.g. a concert ticket can be a NFT). There is no real limit to what bundle of rights can be associated with each NFT (subject of course to general legal principles), but the common characteristic is that an NFT represents a bundle of rights in a real or digital “asset” which is cryptographically stored on the blockchain. While some crypto assets do have certain rights which are attached to them (for example, security tokens may grant the right of a debt security holder or a stablecoin may grant rights to certain reserve assets), which are interchangeable or “fungible”, the rights attaching to the NFT should make that NFT unique – generally speaking this “uniqueness” comes as a result of the NFT rights attaching to the right to use or possess certain artistic creations or access certain services. In this sense, the purpose of an NFT is generally the enjoyment of the underlying assets / rights whereas other crypto assets tend to serve more functional purposes (e.g. as a medium of exchange, or even to use the underlying blockchain).
A key difference between an NFT and other “cryptocurrencies” is the fact that the NFT is not “fungible”, whereas a key feature of a cryptocurrency is the fact that it is “fungible”, i.e. each unit is interchangeable with any other unit of the same kind. This “fungibility” allows a cryptocurrency such as Bitcoin to be used more easily as a medium of exchange than an NFT. “Non-fungible” in the crypto asset sense means that the token cannot easily be exchanged or replaced. Each NFT has a digital signature that makes it impossible for NFTs to be exchanged one another, like-for-like. NFTs, like any other token, can have only one owner at a time and their unique data makes it easy to verify their ownership and transfer tokens between a buyer and a seller. In that sense, an NFT is not ordinarily suitable to be used as a medium of exchange (i.e. it is not typically expected to be useful as a means of payment). Nonetheless, it is not strictly accurate to call all NFTs “non-fungible” (for example, a content creator could theoretically set up an NFT which grants multiple holders the right to the underlying bundle of rights (e.g. if 5 people could own a tweet), or grant multiple holders the same underlying right (e.g. each holder obtains a right to acquire a signed shirt from a sports team).
- Use cases of NFTs in the metaverse gaming industry
NFTs are being used in a number of cases in the gaming industry. We see videogames which allow players to buy NFTs as in-game items on a rather small scale with such items having a mere cosmetic effect (e.g. Ghost Recon Breakpoint) to a large scale usage where the whole game is based on the ownership of NFTs such as Decentraland where players can buy in-game real estate or Star Atlas. Further, NFTs build the basis for play-to-earn titles such as Axie Infinity, The Sandbox and again Decentraland.
The many use cases of NFTs for videogames have also led to the development of marketplaces for videogame NFTs such as Aetsoft. In some cases, marketplace gaming studios can directly drop new NFTs on the platform and players can buy and re-sell these NFT items making it a primary and secondary market for gaming NFTs.
It remains to be seen if the NFTs technology will also be used to create different player experiences for different NFT owners. For example, one may imagine that the game provides access to certain gameplay mechanics or game contents to owners of certain NFTs only.
- Views in the gaming industry
Many members of the gaming industry welcome NFTs as technology with tremendous potential. An argument made in favor of NFTs is that high transaction fees on current platforms can be avoided. Also, some predict that players want to be rewarded for their time of playing videogames by receiving (in-game) currency that may be exchanged into NFTs. Additionally, in the long term, NFTs and blockchain technology may be a corner stone for building metaverses with a clear allocation of ownership to items in those metaverses (insightful in this regard Brendan Greene from PLAYERUNKNOWN Productions and Sébastien Borget from The Sandbox).
However, there are representatives in the gaming industry who are not as enthusiastic about NFTs but rather characterize them as an unsustainable complicated mechanism which achieves nothing new or even see them as scam and evil. Recently, NFTs, crypto and blockchain are being increasingly criticized, also in light of the latest value decrease of the respective crypto-currencies.
We do not want to comment on the opportunities or dangers of NFTs and blockchain for the gaming industry in general in this article but rather provide considerations on the use of NFTs in games from a legal perspective with a special focus on the transactional angle.
II. Regulation of NFTs
- Overview of regulation of crypto assets in Germany
Crypto assets are financial instruments as defined in Section 1 par. 11 sentence 4 of the German Banking Act (KWG) as
“digital representations of value that are not issued or guaranteed by a central bank or a public authority, are not necessarily attached to a legally established currency and do not possess a legal status of currency or money, but are accepted by natural or legal persons as a means of exchange that can be transferred, stored and traded electronically or serve investment purposes“,
other than e-money or a monetary value used in limited networks for certain exempt electronic payments processed by telecommunication providers.
Crypto assets can be distinguished
- from crypto securities that are tokens representing rights against the issuer (also referred to as “security token”). In Germany, it is now possible to issue debt securities (but for the avoidance of doubt not equity securities) in completely paperless form and have them centrally or de-centrally registered under the German e-Securities Act (eWpG). In the latter case, these are referred to as “crypto securities”. Crypto securities, like normal securities are financial instruments, but with their character as securities, they trigger additional capital markets regulation: their first offering requires a prospectus and if they are traded on an exchange, rules on insider trading and market manipulation apply.
- from so-called utility tokens, i.e. digital vouchers that grant its holder the right to certain services or goods that do not primarily create an investor-type expectation to participate in the performance of the business of the token issuer.
Crypto assets, crypto securities and utility tokens have in common that they are of the fungible kind. Their attractiveness as an investment is based on such fungibility which allow the operations of exchanges where these type of assets can be traded and where prices form on the basis of high trading volumes.
- License Requirements for NFT Trading and Custody
The definition of crypto assets primarily targets the regulation of crypto currencies such as Bitcoin or Ether, but also security tokens, given that it also covers tokens that serve investment purposes, although in most cases security tokens are securities (and not “simple” crypto assets), so that even stricter regulation applies.
Only in exceptional and nonstandard structures, NFTs should qualify as financial instruments in the form of crypto assets. Their non-fungibility typically excludes them as a “means of exchange” that can be transferred, stored and traded electronically.
However, digital representations of value that serve investment purposes, are also crypto assets, and, hence, financial instruments. Thus, the question arises whether NFTs could fall under the definition of a financial instrument, even if they are not fungible and would typically not expose the holder to the performance of the business of any token issuer or represent a financial right against the issuer. NFTs are not different from other collectibles like stamps, art, vintage cars, expensive wine or other unique or rare items. The primary purpose of the NFT is to grant its holder the “enjoyment” of the underlying asset. The fact that some purchasers invest in NFTs with the intention to re-sell them at a profit should not make them generally “digital representations of value serving investment purposes”, since the main purpose of the token is to represent the digital asset to be enjoyed. There will always be persons whose primary purpose to purchase collectibles is not the “enjoyment”, but rather their potential for value appreciation, but that does not mean that any NFT automatically “serves investment purposes”. In that sense NFTs resemble utility tokens, which are normally also not falling under the definition of a crypto asset pursuant to the German regulator’s (the BaFin) administrative practice, even if people may purchase them not because of their character as vouchers for services or usage rights but with a view to achieve profits from trading them.
It is even less likely that NFTs are treated as securities, since NFTs are not fungible and only where each security is identical to a security of the same class, it is tradeable on a capital market. Moreover, an NFT does not represent a financial right against any issuer (or a participation in the issuer), but only certifies the “ownership” of a digital asset.
However, given the ability to generate profits from the (potential) appreciation of an NFT, this view is not totally undisputed and there is at least a small risk that merchants dealing in NFTs, or intermediating transactions in NFTs over a trading platform might require an authorization from the financial authorities (BaFin in Germany) based on the theory that NFTs are financial instruments. The difference between collectibles held physically and NFTs is that storage in a wallet makes the NFT tradeable in the same way as crypto currencies and as a result, there are operators of platforms where NFTs can be bought and sold. This risk may be bigger or smaller depending on the features of specific NFTs. For example, the “Bored Ape” NFT was issued in 10,000 copies. Each NFT represents a different depiction of a comic strip-like ape, but the pictures are similar in size and style and the pricing of a specific bored ape may not depend on the ape’s specific look on the picture, but on the general “hype” and the fact that all bored ape NFTs grant the same access to the community of “Bored Ape” NFT owners (the “Bored Ape Yacht Club”). Ultimately, the NFTs might not be as “non-fungible” after all, as people might not care which specific ape picture they own, but just the fact that they own one of the 10,000 different ape pictures. Also, the BaFin’s practice might change as a result of the “hype” around NFTs (similar to the former “hype” surrounding utility tokens), and instead of serving their original purpose to be a “collectible” their primary use shifts to serving speculative purposes and/or becoming a corporate finance instrument or if NFTs are used as a “means of exchange”, for example to store value for purposes of laundering money.
Should NFTs be considered as a financial instrument, the operation of a trading platform or the offering of custodial services (holding and administering the NFT for a client in one’s own wallet or holding and/or administering the cryptographic key to access a wallet of a client) would be a regulated activity requiring BaFin authorization. Trading platforms can be structured in various ways, as they can merely intermediate transactions between sellers and buyers, they can have automatic matching of trades or the platform operator can act as a principal who makes a market in NFTs. Each such activity would require a license, but the capital requirements may vary depending on the respective activity.
Obtaining the authorization is a significant effort (9-15 months) and submits its holder to continued supervision by BaFin and various reporting obligations. In addition, financial services regulation creates significant governance requirements and risk management obligations.
- Add-on services
While the risk that NFT platform operators could be found to operate a licensable crypto trading and/or crypto custody business is (at least at present) relatively low, caution should be taken if further services are provided by traders or custodians of NFTs:
- Accepting cryptocurrencies as payment for an NFT is itself not a regulated activity, but should the platform operator also offer to exchange fiat currencies into cryptocurrencies or vice versa for sellers and buyers of NFTs ahead of an NFT purchase transaction, this would quite clearly be a regulated activity in Germany.
- Collecting funds from investors for purpose of investing them in a pooled common investment strategy focused on NFTs (or even only one single NFT) for purposes of achieving profits from the value appreciation of the NFT(s) will likely be considered as management of an alternative investment fund and may trigger license or at least registration requirements under the German Capital Investment Code (KAGB). This would apply even if the co-ownership interest in NFTs is itself a token. This token would be fungible and is definitely a security. The offering of such token would trigger a marketing registration and a prospectus requirement for the manager of the NFT fund.
- Processing payments from transactions between platform participants typically is a payment service requiring a license under the German Payment Services Supervision Act (ZAG). This is independent of the goods and services traded over the platform and affects any type of platform business. If the platform operator acts as counterparty for the sale and purchase of NFT (re-seller model), the payment services license can typically (but not always) be avoided.
- Anti-Money Laundering Regulation
Traders in NFTs would only become subject to AML obligations if their activity requires a license. This would only be the case if NFTs are considered financial instruments, which particularly applies to crypto assets.
However, merchants who professionally buy and sell NFTs are likely professional traders in (high value) goods. It should not matter that the NFTs are only representations of digital assets. The merchants qualify as obligated entities under the German Money Laundering Act (“GwG”) (without need of any registration), but their obligation to identify customers apply only in case of cash transactions exceeding a certain threshold. It would be rather unusual in practice for NFTs to be sold against cash. The most common form of payment is fiat or crypto currencies. Accepting crypto currencies as means of payment for a physical or virtual good, such as an NFT is not normally a regulated activity. Risk management obligations (such as appointment of a money laundering officer, preparing a risk analysis, training of employees) can be avoided by having a policy in place that restricts acceptance of cash below the relevant threshold of EUR 10,000 (for works of art) or EUR 2,000 if the tokens qualify as “high value goods”.
There are also money laundering obligations for arts intermediaries. As a result, also platform operators for NFT trading who do not act as principal of the transactions would fall under an obligation to identify their customers under the GwG on transactions exceeding EUR 10,000, regardless of whether the price is paid in cash or in fiat currency or (arguably) in cryptocurrency. That raises the question of whether an NFT represents a work of art. This is evident for digital art, but less evident for virtual game items. NFT intermediaries could avoid the risk of falling under money laundering regulation if they stay away from transactions with a value of EUR 10,000 or more.
- International Angle
German NFT trading platform operators would fall under (potential) license and/or AML obligations if they are based in Germany.
Non-German trading platform operators would only fall under German requirements to apply for a BaFin authorization if they actively solicit business from German residents. In case of internet offerings, the answer to the question whether German residents are targeted would depend on an overall analysis of the website (or app). Indicators for targeting the German market would be the use of German language, an URL ending with “.de”, German-specific content, German law-governed agreements, German tax information or German contact details as well as usage of German bank accounts for processing payments.
German AML law would only be triggered if the trading platform operator has a permanent presence in Germany.
The following part will cover what to consider from an intellectual property (“IP”) law perspective and the potential IP risks for companies engaging with NFTs drawing from the current German legislation.
- Copyright Law
Copyright law may be relevant if, for example, a company sells or buys NFTs that represent copyrightable works, like virtual goods in a game or a digital work of art. In Germany, copyrights are not registered, and the copyright itself is a highly personal right that cannot be transferred by its author to third parties. As a result, companies must ensure that the (exclusive) rights to use copyrightable works are sufficiently licensed. In this part, we will analyze the subject and scope of the license. Even though NFTs may also represent physical goods, this part of the blog post will focus on NFTs representing digital content.
- The copyrightable work
Two scenarios may come up: (a) A person or company creates the digital content itself and subsequently sells NFTs representing the digital content to third parties (i.e., users); or (b) a company buys NFTs that represent the digital content that has been created by third parties. Would the buyer of the NFT in each case also acquire the rights to use the digital content or the “rights to the NFT”?
The current common opinion in the German legal literature is that copyright protection concerning NFTs does not generally apply. The German Copyright law grants protection to an author’s intellectual creations as works. In addition, the German Copyright Act provides protection for related rights (or neighboring rights) that constitute an effort of another kind that is similar to the author’s creative work or is made in connection with the author’s work. However, none of the existing types of works or related rights are suitable for NFTs. Any protection granted to the underlying smart contract, e.g. software rights, is likely not extended to the NFT. Nevertheless, NFTs often represent or link to copyrightable works like digital art. When buyers purchase NFTs representing digital art, they may expect to use digital art. So how does the NFT transaction affect the rights to the represented copyrightable work?
- Transferring rights to copyrightable works via NFT transactions?
For transactions concerning physical art, the Germany Copyright Act provides some guidance for cases where the author sells the original of a work by stipulating that – in cases of doubt – a right of use has not been granted to the buyer. Instead, the rights remain with the author of a work, e.g. the artist. The buyer’s only right is to enjoy the work of art and to own its physical embodiment, e.g. a painting. If the parties to a contract concerning physical art want to be certain that the right of use to the work will be granted, they should explicitly include relevant provisions in an agreement. Although artists may use NFTs to determine the “original” of the digital art, the provision in the German copyright law does not apply in this case, and the acquisition of an NFT representing a digital artwork does not have an equivalent regulation either.
Thereby, the extent to which rights to the work are granted mainly depends on the contract provisions between the parties. The Germany Copyright Act specifically states that the scope of a right of use is determined by the purpose of a contract as envisaged by both parties if the types of use were not specifically designated when the right of use was granted. This rule applies to determine whether a right of use has been granted, whether it is a non-exclusive or an exclusive right of use, how far the right of use and the right to prohibit extend, and what limitations the right of use is subject to.
The following two examples can illustrate the importance of contractual agreements for the use of digital art.
- Vignesh Sundaresan, also known as MetaKovan, was registered on the blockchain as the owner of the NFT for the digital artwork “Everydays: the First 5000 Days” by Beeple when he acquired the NFT at a Christie’s auction in March 2021. However, the artist retained the copyright, and MetaKovan only received a digital file of the art and the rights to display the image.
Even though in both cases, NFTs for digital art have been acquired, the extent to which the copyright can be used and commercialized by the owner of the relevant NFT differs significantly. The acquisition of an NFT may lead to the registration of the purchaser as the owner on the blockchain. However, neither the (digital) content represented by the NFT nor the rights to use the digital content are transferred via the smart contract in general. Whether and to what extent the rights to the digital content are assigned depends on the contractual agreement that the parties concluded. This shows that it is necessary to evaluate the contract terms for NFT transactions, and to assess what the parties mean and intend to transfer when they contract about NFTs.
- Connecting NFT and copyrights
Companies should ensure that contracts contain safeguards against such a discrepancy between the NFT and the intellectual property rights concerning the represented digital content, for example, by including a general non-assignment clause in the contract which applies unless the rights to use are transferred together with the NFT to the same purchaser. The non-assignment clause must be passed on to each subsequent purchaser of the NFT. Additionally, an obligation to pass on the non-assignment clause must be included in each contract. These provisions may ensure the connection between NFT and the rights.
Alternatively, any license may be granted on the condition that the receiving party “owns” the NFT, and the license may immediately expire upon transfer of the NFT. This option would require the original creator of the NFT and owner of the rights to continuously contract with unknown third parties, potentially from different jurisdictions. Therefore, the key challenge is to draft enforceable licensing provisions that an identifiable buyer of the NFT agrees to. This can, for example, be achieved by granting the rights to use the digital content only when the owner of the NFT registers on an external website.
The licensor may include a description in the metadata of the NFT stating that terms apply. The metadata should also link to the licensing terms on the external website. NFT buyers can identify the applicable terms transparently as third-party platforms display an NFT description. NFT owners may be asked on the external website to create an account and agree to the relevant terms and conditions if they want to obtain a license. This approach provides more legal certainty as the licensor can document the licensee’s identity and consent to the terms. However, it also requires that an external website is maintained for NFT owners to register.
Nevertheless, contractual provisions stating that terms and conditions are accepted merely by owning an NFT may be unenforceable in some countries, especially if consumers are involved. As a result, owners of the NFT may use the represented digital content without a license and risk infringing the copyright.
- Copyright Infringement
Unauthorized use of third-party copyrights bears the risk of lawsuits, particularly damages claims and cease and desist claims. However, what if not a copyrighted work is used but merely an NFT representing such copyrighted work is created, owned, or sold? Anyone who has the needed technical know-how can create an NFT, even if the NFT represents third parties’ intellectual property without their authorization. Thereby, companies need to assess if the NFTs acquired violate any copyrights of third parties due to a lack of proper licenses.
According to German Copyright Law, authors of a work have the exclusive personal right to exploit their work, including the rights to reproduction, distribution, exhibition, and communication to the public. Provided that the NFT does not store the copyrightable work (which may be possible but expensive), there is likely no reproduction or distribution of the work. Furthermore, the work is likely not made available to the public in this case. This means that no relevant acts of use exist from a German copyright law perspective. However, other laws like unfair competition law, may apply when third parties sell NFTs that may falsely create an impression that copyrights are transferred.
This part on trademark law will focus on the scope of the protection of a trademark and the corresponding possibility to prevent others from using the trademark for NFTs. Trademark law may be involved, for example, if the NFTs make use of a brand. Many popular brands have recognized the potential of NFTs. But there are also risks, as NFTs may “swiftly become a virtual playground for infringers to usurp the goodwill of some of the most famous trademarks in the world and use those trademarks without authorization to market their virtual products and generate ill-gotten profits” (from Nike, Inc. v. StockX LLC, 1:22-cv-00983 (SDNY)). Therefore, this part will assess (1) what goods and services should be covered by the trademark for NFTs, and (2) how to prevent third parties from using a trademark for NFTs without authorization.
- Scope of the protection
In our assessment regarding copyright law, we highlighted the distinction between the protection of the NFT and the digital content that the NFT represents. The same distinction is necessary for the registered goods and services to which the trademark protection should extend. In particular, companies may register trademarks for virtual goods if they want to use their brands in video games or virtual realities. However, these trademark registrations may not cover the use of NFTs unless explicitly included.
NFTs are most notably registered in classes 9 and 42 for software and computer services. However, the specific wording of the register varies considerably. The following three examples will provide a short teaser of possible goods and services. A complete list of goods and services should always take into account the intended use for the brand. Goods in class 9 may include “non-fungible tokens (nfts) and other application tokens“, “non-fungible tokens used with blockchain technology to represent virtual goods” or “digital tokens used with blockchain technology“. In class 42, an adequate equivalent may be “providing online non-downloadable virtual goods, non-fungible tokens or other digital tokens based on blockchain technology” or “creation and provision of blockchain-based non-fungible tokens“.
Goods and services covered in other classes may also be relevant for an extensive protection of the brand. For example, “online retail store services and marketplace services for virtual goods, digital collectibles, crypto-collectibles and non-fungible tokens on a blockchain” may be protected in class 35 if the company intends to sell the NFTs itself. Furthermore, entertainment services in class 41 may complement your brand strategy, among others, with “entertainment services, namely, providing online, non-downloadable digital collectibles and crypto-collectibles associated with non-fungible tokens on a blockchain network“. Finally, some companies may prefer to register their trademarks for “financial services, namely, providing a digital currency or digital token” in class 36.
Trademark registrations for NFTs are still uncommon and it is unclear what the trademark offices will consider sufficient. The examples above provide a basis that should be amended based on the needs of the company, taking into account potential use requirements.
Company’s without adequate trademark protection may face challenges in protecting their brands against trademark use concerning NFTs. Third parties may use a trademark name for the NFTs they create without the proprietor’s authorization. For instance, an NFT collection representing different Baker McKenzie offices could be minted by an unauthorized third party, with NFTs named “Baker McKenzie Frankfurt” or “Baker McKenzie Berlin“. Furthermore, NFTs may represent a physical good and thereby refer to the trademark of the physical good to describe the NFT. It must be determined on a case-by-case basis whether these uses constitute a trademark infringement.
According to German trademark law, the trademark proprietor has an exclusive right to use the trademark. Firstly, the unauthorized use of a trademark must impair one of the functions of the trademark. For example, using a trademark only descriptively may not be prohibited. The use of a trademark for an NFT may only describe that the NFT represents a product distributed under that trademark. However, the use of the trademark may also convey the impression that the NFT is connected to the trademark owner. Both interpretations are plausible, especially since many non-technology companies have started to explore the commercial applications of NFTs.
Furthermore, the use of the trademark must fulfill the specific requirements for infringement. Using a sign identical to the trademark for goods or services identical to those for which the trademark enjoys protection is likely a trademark infringement. Hence, companies need a registered trademark for NFTs to fulfill this requirement. Without such trademark registration, companies may rely on a likelihood of confusion. Third parties may not, without authorization, use a sign that is identical or similar to a trademark for identical or similar goods or services if there is a likelihood of confusion. There may not be a likelihood of confusion among the public if the registered goods or services are not similar to NFTs.
Alternatively, a trademark infringement may exist if a sign is used that is identical with or similar to the trademark if the trademark has a reputation in Germany and the use of the sign without due cause takes unfair advantage of, or is detrimental to, the distinctive character or the reputation of the trademark. Whether a trademark has a reputation in Germany depends, among others, on the market share of the trademark, the intensity, geographical extent, and duration of its use, as well as the extent of the investments made by the company to promote it. Even though infringement claims on that basis are possible, the requirements may be challenging to prove, and this option is only available for very well-known brands.
Finally, trademark protection should not be exhausted. The trademark proprietor may not be entitled to prohibit a third party from using the trademark for goods that have legitimately been put on the market under this trademark. It remains to be seen whether German courts would apply trademark exhaustion for using an NFT if the represented goods have been placed on the market with the used trademark. In summary, the risk that companies cannot prevent a trademark use is considerable.
- Summary IP
Companies should assess their NFT strategy both from a copyright law perspective and a trademark law perspective. NFTs should be differentiated from the content that is represented. If companies want to secure the rights to the content represented by an NFT, they should address any uncertainties in the underlying agreement. Furthermore, infringement of intellectual property rights must be guarded against, both in copyright and trademark law. In particular regarding trademarks, a registration for NFTs is advised.
IV. NFTs in a Transactional Setting
- Target Company owns NFTs – What to consider in an Asset Deal or Share Deal
When acquiring a business, two acquisition structures are predominant: (i) the share deal in which all or part of the shares in the target company are acquired from the shareholders of the target company and (ii) the asset deal in which the buyer acquires the business assets directly from the target company. If NFTs form part of the business assets needs to be considered when choosing the most efficient acquisition structure.
(a) Share Deal
A share deal is much simpler when it comes to acquiring a business with NFT ownership. The target company remains the owner of the NFTs and the respective wallet(s). No transfer actions are required as regards the NFTs.
(b) Asset Deal
In an asset deal, however, if NFTs form part of the target company’s assets, this results in a multitude of questions as to the legal requirements of the asset sale and transfer and the factual implementation of the asset sale and transfer agreement. Following key topics are to be considered:
- The legal status of NFTs is currently unclear under German law. Legal literature seems to prefer to assign to the NFT the status of a so called “other right” within the meaning of Section 823 par. 1 of the German Civil Code in contrast to a tangible asset (Section 90 German Civil Code), a bearer bond (Section 793 German Civil Code), a certificate of indebtedness (Section 952 German Civil Code) or a license to an intangible right. The transfer of rights follows different mechanisms than the transfer of tangible assets, which will need to be reflected properly in the asset sale and transfer agreement.
- The transfer of the NFTs will also need to be technically implemented. The buyer will need to create a wallet with which it can hold and access the NFTs. A direct transfer from the target company to the buyer may be possible by disclosing the respective cryptographic key or giving possession to the data carrier (“cold wallet”). If the NFTs are held in custody by a third party, the claims against the custodian could be assigned as an additional layer of protection. It may then also make sense that the buyer opens a custody account with the same custodian to facilitate the transfer. Alternatively, the target company could sell the NFTs to buyer via a transaction on an NFT trading platform. The latter, however, usually requires that the buyer holds cryptocurrency to purchase the NFTs. Respective exchange and trading fees as well as fluctuation risks would thus need to be considered in this alternative. Therefore, this is unlikely to be a practical proposition.
- Another concern would be to make sure that the buyer is receiving the original token and not merely a copy of the digital asset. The buyer should have the necessary knowledge to understand the technology behind NFTs to make sure it performs the necessary checks.
- Due Diligence
(a) NFT as a legally empty shell – IP considerations
In its basic form, the NFT is a legally empty shell. An NFT as such does not grant the NFT owner any rights or claims to the digital or physical medium which the NFT embodies. Such rights can only be assigned to the NFT by the owner of the rights to such medium.
In the due diligence, the buyer will thus need to assess what rights the NFTs of the target company entail. E.g. have any copyrights been transferred or licensed to the owner of the NFT, is the owner of the NFT permitted to transfer the NFT together with such rights, etc. (see also Section III above).
(b) Regulatory considerations
Further, the buyer will need to assess in detail the business of the target company as regards the NFTs. Depending on the business various regulatory requirements may apply (see Section II above) and buyer will need to assess whether the target company is in compliance with such regulatory laws.
(c) Further considerations
Additionally, buyer may want to focus on target company’s IT infrastructure if target company issues NFTs or administers them. In particular, IT security and maintenance are critical in this regard.
- Purchase Agreement
(a) Purchase Price for Target Company – Payment in NFTs or crypto-currency?
The buyer may consider paying the sellers of the target company by way of transferring NFTs to the seller or in the form of crypto-currency. Buyers intending such payment structure should consider the following:
From a practical perspective, this requires the seller to create a wallet for the tokens, which they might find burdensome. Particularly, wallets can be “hacked” and the buyer should have some idea about how to ensure a safe custody of the token, maybe also involving a third party custodian who has appropriate security structures. The frequency of “hacks” and “thefts” should prompt buyers to also perform a due diligence on third party providers who offer custody solutions.
From a legal perspective, following points are to be considered:
- The buyer may already have NFTs or crypto tokens available, either because the buyer itself created NFTs or issued crypto-currency or because the buyer acquired the NFTs from 3rd parties. In this case, the Purchase Agreement could stipulate that the NFTs or crypto token are being transferred to the seller in lieu of cash and thus are being transferred in fulfilment of the obligation to pay the purchase price.
This has been a standard structure when byuers offered the seller shares in the buyer or an affiliate of buyer as fulfilment of the purchase price. Sellers would then typically ask for warranties regarding such shares, in particular regarding the existence of the shares, the good standing of the issuing company but also of the value of the shares or financial prosperity of the issuer.
This may also become a topic in the negotiations when buyer offers NFTs or crypto tokens. A seller may want to request warranties that among others
- the amount of existing crypto tokens is not unreasonably increased which could result in a decrease of the value of the tokens;
- the tokens can be freely traded; and
- that NFTs do not breach any copyrights or are not otherwise incompliant with any laws.
On the other side, the buyer may consider limiting the seller’s use or sale of the NFTs and crypto token in the purchase agreement. Such limitation could include that crypto tokens are not fully spent within a short time after closing of the transaction on the buyer’s platform since this may give the seller an unwanted advantage vis-à-vis other users of the platform. Moreover, a bulk sale of tokens might have an adverse influence on the price of the tokens. Generally, sellers should understand that they will receive an asset that is significantly more illiquid than cash and the value of which may fluctuate and be doubtful.
- Another problem might arise if the buyer offers to pay in token that are not yet on the market, because the buyer is still in the process of planning a public token offering, for example of NFTs. In such a situation, the buyer may try to make the deal more attractive by offering to pay in token once they have been created (future token), but to offer a discounted valuation, similar to other situations in which “early bird” investors pre-fund the offering costs by prepaying the cost for creating and marketing the token in return for a discounted subscription of the future token.
This type of discounted subscription is typically documented in a so called “Simple Agreement for Future Tokens” or “SAFT”). If discounted token are used as purchase price, the SAFT would need to be adapted to the circumstances and specifics of the transaction. The parties will then need to carefully align the purchase agreement and the SAFT in order to achieve the intended transactional goals. A key feature of a SAFT is that the “early bird” token investor bears the risk of failure of the token offering. If a seller enters into a SAFT instead of receiving cash, the seller might end up having sold its company without receiving any counter-value.
To mitigate this risk, the seller should ask for a right to withdraw from the Purchase Agreement and the SAFT (Section 327 German Civil Code) or to claim cash if the tokens have not been created and transferred within the agreed period. Agreeing for damages if the token offering fails is not recommendable, as it would be very difficult to calculate the damage (which would depend on the hypothetical price development of the NFTs, which cannot be predicted with certainty).
(b) Representations and Warranties in case of Target Company owning NFTs
Specific representations and warranties should be requested if the due diligence revealed that the target company issues, owns or trades NFTs.
First and foremost, a comprehensive warranty on target company’s compliance with laws, in particular regulatory laws is crucial. Target company should be in a position that it has made sufficient efforts to be able to ensure that its creation, ownership, use of or trading with NFTs complies with respective applicable laws.
Further the typical warranties on intellectual property rights should be carefully adapted to also cover that 3rd party IP rights are not breached and that such IP rights have been properly acquired or licensed in connection with the NFT use.
Also, representations and warranties on the assets owned by the target company which are usually less important in gaming transactions gain more relevance in transactions where NFTs and crypto tokens are involved. Buyer may want to consider requesting warranties on
- the existence of the token wallet(s),
- the existence of the NFTs,
- the NFTs being unique, i.e. that there are not multiple NFTs for the same item.
(c) Specific Indemnities
Should buyer identify any issues in the course of its due diligence, such findings would typically be covered by specific indemnities. Pursuant to such specific indemnities, seller would indemnify and hold harmless the buyer and/or the target company from any damages, costs and expenses that occur if the identified issue actually realizes after completion of the transaction.
However, should the buyer identify material issues in relation to compliance with regulatory laws or should severe IP breaches become apparent, such specific indemnities may not be sufficient to protect the buyer. The buyer may will thus need to assess in detail if (i) the identified issues can be resolved before closing, in which case a closing condition should be requested in the purchase agreement, or if (ii) the transaction should not be continued. The latter may become in particular relevant if the target company’s business case is endangered based on the identified issues.