Key Considerations in NFT Transactions for Fashion and Retail Companies

Non-fungible tokens continue to have their moment. Despite having moved beyond peak buzz earlier this year, consumer demand for NFTs quietly continues to mount. An August 2021 report from McKinsey on NFT market growth confirms what many marketers in the Sports and Fashion industries have surmised from their work on the front lines — consumers, fans, and collectors are rewarding brands and teams that can deliver authentic NFT offerings.

Key Legal Considerations

1. Pay attention to regulatory tripwires. Perhaps the two most significant areas of uncertainty with respect to the NFT regulatory landscape are: (a) whether NFTs will be deemed a security; and (b) whether NFT exchanges and platforms will be deemed “money transmitters” (which implicates anti-money laundering and heightened financial reporting compliance). Congressional or regulatory agency intervention has the obvious potential to dramatically change the risk profile of NFT activity. But the landscape can just as effectively be altered by an adverse judicial ruling.
   In light of this, it is critical to consider specific NFT-platform covenants, positive and restrictive, to avoid conduct or even the appearance of conduct, that would trigger regulatory scrutiny. In the case of securities, the covenants should go further to prohibit conduct with respect to advertisements, the execution of buy/sell orders, and any other activities relevant to your transaction that may be construed as market manipulation.
2. Termination optionality. The typical “compliance with all laws” type covenant will generally not suffice. Given the high degree of uncertainty around liability in the event of regulation, and the fact that liability may arise absent regulation via civil litigation, termination triggers should be expansive and anticipatory in nature, allowing a client to pull the plug on an offering upon certain early, adverse signals.
3. Metadata management. Metadata refers to the actual collectible being purchased by a consumer or fan. The NFT is merely the unique identifier on the blockchain that authenticates the metadata. Due to storage constraints, in almost every case, NFT metadata will be stored off the blockchain. Close consideration should be given to token standards (e.g. ERC721 or ERC-115 URI JSON schema) and storage issues. It is generally inadvisable to allow a buyer to self-host or directly possess licensed metadata due to a brand’s or team’s potential need to terminate access on a license violation. But what happens if the hosting service or NFT platform ceases doing business? Brands/Teams will want to ensure that buyers have uninterrupted access to the metadata. Negotiations may require successor hosting arrangements or hosting on distributed file storage systems such as InterPlanetary File System.
4. IP Issues. Consideration should be given to ownership of the underlying IP and, if licensed, to terms of use. Since the smart contracts upon which NFT operate are incapable of “adjudicating” breaches that occur in the real world, brands/teams will need to ensure the inclusion of a kill-switch in their smart contract code enabling the issuer to terminate access on good faith belief of a purchaser’s license breach. Additionally, NFTs offer issuers unique secondary market challenges and opportunities. Brands and teams should ensure that all resales of their NFTs are subject to a knowing and voluntary consent to the original license terms (which, for example, would exclude resales to minors without parental consent). Issuers will also need to consider the extent to which they will exploit the residual royalty opportunity on the resale of NFTs.