Juliet Moringiello and Chris Odinet, on the Law of Tokens

For weeks, months even, I have been in a lather because an article about property law has been the most downloaded article on the SSRN top tens on commercial and contracts law.  Property law was probably my least favorite course of the first-year curriculum.  Also, non-fungible tokens (NFTs) make me feel like someone has poured champagne on my cranium, like Tony Soprano when he thinks about ducks. 

But Professors Moringiello (below left) and Odinet (below right) drew me in, first baiting the line by insisting on the significance of their article for contracts law as well as property law.  Intrigued, I downloaded.  And then they begin with a discussion of an NFT of Nyan Cat (see video below).  I'm hooked.

The authors begin with a helpful summary of what an NFT is:

The idea behind the tokenization of an asset (whether tangible or intangible) is that the owner of the asset creates a digital item (essentially, an entry in a blockchain ledger) that is to be identified with the asset itself. The creation of this digital entry is called minting . . . . After its minting, the token is sold, often through an auction facilitated by the same online platform that performed the minting. . .  The purchaser of the token then ostensibly also owns the underlying asset, or at least that’s the whole idea behind tokenization—that the owner of the token acquires authentic title to the reference asset.

Proponents of NFTs, the authors tell us, claim for this new technology a spectrum of attributes: they convey "ownership," constitute "intellectual property," and are the "future of digital property."  Tokenization will smash the state monopoly over currency and the protection of property rights.  At the same time, it will democratize finance.  All that is solid melts into cyberspace!

The authors pretty effectively deflate the hype surrounding NFTs.  They then offer some ideas for the regulation of NFTs in light of their actual effect on legal rights.  They proceed in three steps.

Step I:  Nothing to See Here

The authors point to myriad examples of tokenization -- that is, there are a variety of legal mechanisms that create things that establish legal rights in another thing.  Negotiable instruments do it, securities do it, even educated deeds do it.  Let's do it, let's fall in love with tokenization!  Sorry, got carried away.  These tokens were originally tangible items, but now in many areas, such as securities, tokens became digital and intangible long before cryptocurrency and NFTs.

With this foundation, the authors then proceed to discuss a typical token minting operation and a dataset of terms of service on minting platforms.  They do this to demonstrate the disconnect between Internet representations of what NFTs are and what the law of tokens actually provides.  They immediately notice ambiguities in the minting operations.  The minting websites do not explain what the transaction accomplishes, and a blog post on one website, which purports to explain the uses of NFTs in the real world, seems to be mostly inaccurate and misleading.  It suggests that, by buying an NFT, one gains some sort of property rights in the underlying asset -- that is, some physical object in the world or a digital version thereof.  It certainly is not the case when I buy an NFT of a digital image of the Mona Lisa I thereby acquire an interest in the Mona Lisa itself.  And the sites' terms of service all provide that the owner of an NFT has no property interest, including intellectual property rights, other than the right of display, in the underlying asset.

The authors conclude this section on a bleak note:

If the great innovation of NFTs is that they somehow clarify rights in underlying intangible assets, the terms of service illustrate that this innovative goal has not been achieved. It is noteworthy, however, that despite the statements made to the general public about the connection between NFTs and underlying assets, the various terms of service either say nothing on the matter, directly disclaim any such tethering, or at least confuse the reader as to whether a connection exists.

This raises a question that inspired Nancy Kim and me to write about the power of the Internet Giants years ago.  Why do people distrust the government but trust private sites set up based on the profit motive?  These sites have no interest in protecting your property rights in your NFTs.  They can shut down at any point, and when they do, poof!  They can also kick you off their sites and seize your digital assets.  Again, poof!

II. You Had One Job!

Having shown that tokenization is nothing new, the authors then argue that NFTs don't even perform very well as tokens.  They do not tether -- that is, they do not embody property rights in the reference object.  Other tokens do tether; that's their main function.  To the extent that NFTs do not, perhaps they aren't really tokens at all.  NFs perhaps?

But perhaps NFTs scratch a separate itch.  Original works of art are unique and thus have unique value.  Copies are imperfect.  Enter the Internet.  Digital art and digital copies of that art are indistinguishable.  Digital art thus has a problem the authors call (and I assume they are not responsible for this term) "non-rivalrousness."  Enter NFTs. Maybe if you have an NFT evidencing your possession of the original digital art, you have a way around the non-rivalrous nature of digital art.  Except you don't.  The creator of the digital art still owns the intellectual property in the art.  Nor do they address the problem of non-scarcity.  Digital art remains infinitely replicable.  The authors predict that the NFT craze will dissipate once these characteristics (or non-characteristics) of NFTs become clear.  In the meantime, artists, hurry up and create NFTs before everyone realizes that they are worthless.

The authors discuss NFTs from the perspective of two prominent theories underlying property law.  The exclusionary rights theory posits that the most important aspect of property law is that it gives the holder of such rights some power to exclude others from enjoyment of the property.  NFTs fail under this theory because they convey something more like a non-exclusive license, and even that they do only contingently, because the website can at any point exclude the NFT purchaser from access to their account and thus from their "property."  Nor would third parties know what they were getting in an NFT transaction, and so NFTs actually raise the information costs in such transactions, the very opposite of what clear property law rules are supposed to achieve.  

The alternative theoretical model for property rights, the progressive property theory views  property law as embracing norms of social obligation and responsibility aimed at promoting human flourishing.  NFTs do not achieve that goal for two reasons.  First, they rely on cryptocurrencies, the mining of which is harmful to the environment.  Second, the cryptocurrency crowd currently is, and is likely to remain, an exclusive club, as the platforms are structured to favor people who can make large purchases.  

III. What Is To Be Done?

Finally, the authors offer guidance to courts and policy makers.  Looking at two typical NFT transactions, the authors argue that NFT holders would always lose in conflicts over legal interests in the reference object of the NFT.  A property interest in a thing always beats a property interest in an NFT of that thing.  It follows that, in a secured transaction governed by the UCC's Article 9, a secured party would be unlikely to be satisfied by a perfected security interest in an NFT.  It would thereby gain no security interest in the underlying asset, and the security interest in the NFT itself would be difficult to enforce.  The authors go into the weeds of Article 9 to explain why that is so.  In the interests of space, I will not follow there.  

Finally, the authors advocate for the regulations of NFTs.  The purveyors of these investment vehicles are engaged in misrepresentations of their legal efficacy and thus of their value.  The Federal Trade Commission and state attorneys general are well-positioned to monitor and discourage deceptive trade practices, with sanctions if necessary.  Action by public officials is necessary because mandatory arbitration provisions and class-action waivers, standard in the NFT platforms terms of service, render individual suits incapable of effecting the desired disciplinary function.

 I learned a ton reading this article, especially as I think about property law and UCC Article 9 as little as I can get away with.  That said, I have to admit that the article more than held my interest. It's fascinating and approachable, even for the property law- and technology-phobic.  I can see why the article is top of the charts, and as advertised, their work also considers the law of contracts, especially in connection with the NFT platforms' terms of service.