For many, Non-Fungible Tokens (NFTs) have become synonymous with art, gaming and digital collectibles. The rapid increase of NFTs over the past two years has in part been driven by tech companies and international brands that envisage people living their lives across both the physical and virtual reality worlds. Indeed, by the end of 2021, sales of NFTs had hit US$25 billion, with the market expected to grow to a staggering US$240 billion by 2030. This raises the question: will this asset class be utilised in corporate transactions and, if so, what are the potential risks?
Below, we give a brief description of how NFTs may be used in corporate transactions.
NFTs as property
The English courts have recognised the need to provide stakeholders in this rapidly growing sector with clarity. In Lavinia Deborah Osbourne v (1) Persons Unknown (2) Ozone Networks Inc Trading as Opensea, NFTs were treated as property under English Law for the first time, allowing recourse to remedies for victims of crypto-asset fraud. This judgment followed from an earlier ruling in the High Court, in which cryptocurrency, in this instance Bitcoin, was identified as being capable of being property (see AA v Persons Unknown, Re Bitcoin  EWHC 3556 (Comm)). Whilst these cases are the first of their kind, they are a clear step towards attempting to provide a classification of crypto-assets, including NFTs, and enable cryptocurrencies and NFTs to be treated as 'property'.
NFTs in corporate transactions
In a previous article, we discussed how the engagement with the metaverse by law firms and other advisers has the potential to change the way in which corporate transactions are completed. In that article we discussed how the law, infrastructure and tools available to individuals would need to adapt to overcome some of the risks that we identified. Similarly, whether NFTs can be used within corporate transactions will depend on the development of technological and operational infrastructures to support their use, both as an asset and as a tool.
With regards to utilising NFTs as an asset, their value is found in their unique identification codes and metadata, which allows them to act as a digital certificate of authenticity and hold a digital record of transactions. The English courts stated that there is a realistically arguable case that NFTs could be treated as property. This decision, combined with the recent valuations and rarity of some NFTs, means certain NFTs are presently being used by parties as an asset within transactions, either as a form of consideration or security.
Separately, the technological characteristics of NFTs, such as their digital audit trail, could be utilised as a tool to create a more efficient transaction process. For example, a share certificate could be turned into an NFT as the original share certificate's digital twin, which could assist with facilitating the verification of documents. However, the risks with creating digital twins of share certificates are that:
- it is not clear how the share certificate NFT would track any changes made to the original certificate; or
- it is debatable whether issuing a share certificate NFT to a shareholder would be a valid delivery of a share certificate under section 769 of the Companies Act 2006.
Also, share purchase agreements could be embedded as NFTs in blockchain, with consideration being transferred by way of cryptocurrency or NFTs, thus creating an incontestable payment trail. This concept could also be applied to the due diligence process. With a metaverse-based data room and NFTs providing a formal verification system that is mathematically validated, third party verification would no longer be required and costs would therefore be reduced.
Finally, NFTs could prove to be a crucial bridge between the virtual and physical worlds, as they could be either linked to a physical asset or their technology utilised to confirm the ownership of the same. The result? Quicker transaction processing times, increased transparency and verification providing added security to all parties and ultimately lower costs for clients.
The risks of using NFTs
Although not all required technological and operational infrastructures exist yet to accommodate NFTs in corporate transactions, there is still a surprisingly low uptake of NFTs in corporate transactions. We have set out below some of the reasons why individuals might be wary of using NFTs and the potential risks associated with NFTs.
First, a significant challenge for using NFTs as a means of consideration or security is their lack of inherent valuation. Their value is ultimately derived from the value placed on them by investors and, given their nascent presence in financial markets, they have not proven to hold long-term value. Parties to a transaction using NFTs as consideration or security, therefore, would face the risk of significant fluctuations in the asset's value. This risk factor alone, especially in large corporate transactions, is currently a significant barrier to their utilisation in this context.
Second, whilst the market for NFTs continues to grow exponentially, they currently remain on the fringes of the finance world. Presently, a limited number of individuals hold NFTs, in turn limiting their utilisation within wider industries and sectors. However, in the future, as the utilisation of NFTs increases, so will the risks associated with this asset class. Lack of clear guidance is widespread. The Financial Action Task Force (an intergovernmental organisation setting international standards to combat money laundering, financing of terrorism and threats to financial integrity), simply states that whilst NFTs are not currently considered to be virtual assets based on their general use, this assessment should be evaluated on an individual basis. It noted that in practice they "may fall under the [virtual asset] definition if they are to be used for payment or investment purposes". This definition, which is centred on the use of NFTs, will require individuals and advisers to actively monitor the risk of transactions breaching regulations. Furthermore, despite the lack of regulation, as use and associated risks grow, advisers will face risk and compliance obligations, including Anti-Money Laundering and "know your client" checks. This is certainly likely to increase once the European Markets in Crypto-Assets Regulation (MiCAR), which is expected to come into force in 2022, is formally adopted. However, MiCAR is a European Union (EU) initiative and will only apply to cryptoassets issued (or cryptoasset-related services provided) in the EU. Within the UK, the regulatory treatment of NFTs is inconsistent. Providing NFT exchange or wallet services is considered regulated activity under the UK money laundering regulations. However, HM Treasury proposals for regulating the promotion of cryptoassets is likely to exclude NFTs from scope (unless the NFTs provide the holder with rights equivalent to a regulated investment). Until more specific guidance and regulation is introduced in the UK, and the associated risks reduced, it seems unlikely that advisers or clients will feel confident enough to employ these assets within corporate transactions.
Third, the tax treatment of NFTs in corporate transactions is another risk factor that companies, buyers, sellers, or investors would have to bear in mind. The nature of the transaction will determine the tax status of NFTs; for instance, the following factors, amongst other things, would need to be considered:
- is there a sale or a license of an NFT;
- is the transaction at a national or international level;
- is the transaction B-2-C or B-2-B; or
- the rights attaching to the NFT.
The tax treatment of NFTs would essentially depend on the nature of the transaction and the underlying asset. At the time of writing, HMRC has not issued specific guidance on the taxation of NFTs. Therefore, the added risk of additional potential financial outlay, from both the imposition of taxes and the corresponding administration, will likely affect how favourably NFTs are viewed from a corporate perspective. Given the limited guidance, those utilising NFTs, both as an asset and as a tool within transactions, will need to conduct additional record keeping of any transactions to proactively address any future reporting obligations and counter any investigations by the relevant tax authorities.
Looking to the future, the exponential development and growth of this market suggests that these challenges will need to be addressed quickly to avoid and control risks. This in itself will require regulatory bodies to be attuned to developments within the market and fully understand its capabilities as an asset and as a corporate transaction tool. Once the challenges are overcome, advisers, individuals and businesses should be poised to capitalise on the opportunities that NFTs provide to streamline and shape corporate transactions. The opportunities will be even greater as businesses, including law firms, continue to actively engage with the metaverse and develop a transaction process that exists across the virtual and physical worlds. NFTs may hold the key to bridging the divide between these worlds.