The following MBW article comes from Adrian Perry, Jenny Konko and Juliana Moraes Liu of Covington & Burling LLP, the multi-award winning law firm whose lawyers have advised and represented clients including major record labels and music publishers, trade organizations like the RIAA and NMPA, and leading performing rights organizations like BMI and GMR.
MBW publishes this article as the NFT space continues to evolve in music, and continues to attract the attention of rights-holders: for example, US-based artist 3Lau, who made $11.6 million from NFT sales in February, just launched a digital marketplace that plans to sell song rights as NFTs, backed by Founders Fund and Paradigm.
Increasing numbers of musicians and other owners of music royalty streams are looking to capitalize on non-fungible tokens (NFTs) by selling NFTs associated with music royalty streams. But selling such NFTs without proper due diligence and planning can quickly land artists and other royaltors in hot water legally, resulting in hefty fines, or even jail time.
The prospect of upfront cash, and even back-end money from future sales of the NFT, are attractive. But content rights, securities laws, anti-money laundering and sanctions laws, cryptocurrency volatility, and tax considerations are just some of the issues to keep in mind before taking the plunge into this complex, developing market.
Following are five priority issues artists, managers, and other royaltors should thoroughly vet before getting involved in NFTs associated with music royalty streams.
1) Content Rights
Before issuing or selling NFTs associated with music royalty streams, issuers (i.e., individuals or entities that create or mint NFTs) should be sure they have lined up all the proper approvals from any creators, co-collaborators, or others holding rights in the content generating the royalties.
Failure to do so could cause a disruptive and costly dispute regarding either the content rights related to NFT royalty streams, or the division of those royalties among owners of the related content, and ultimately result in removal of access to the royalty stream. This could then lead to contractual disputes with NFT purchasers depending on the terms provided to those purchasers upon sale and resale of that NFT.
“All terms of use and/or other contractual terms applicable to purchasers buying that NFT need to be made clear upfront.”
To avoid problems later, any possible limitations or restrictions on intellectual property or contractual rights impacting the royalty stream should be determined in advance.
Also, all terms of use and/or other contractual terms applicable to purchasers buying that NFT need to be made clear upfront so they know what they are actually getting (e.g. Are there risks the music royalty stream will end after a certain number of years? Could the content generating the royalties change ownership such that the issuer no longer has rights to the music royalty stream associated with the NFT?).
2) Securities Laws
Because NFTs share characteristics with other digital investment vehicles, issuers (and potentially other related parties, such as the operator of the secondary marketplace platform on which the NFTs are bought and sold) need to be aware that they may be subject to cumbersome securities regulation and oversight related to laws governing securities traded on stock exchanges.
The Securities and Exchange Commission (SEC) has indicated that it will decide whether a particular NFT is considered a security on a case-by-case basis. For instance, NFTs that create or implicate rights to future profits (e.g., an NFT in future earnings) may be more likely to be considered securities under the SEC’s framework.
These determinations are specific to each NFT and may be affected by the presence (or absence) of sale and resale restrictions, the amount of NFTs sold, and whether any discounts were offered.
3) Anti-Money Laundering and Sanctions Law
NFTs issuers need to understand that NFTs, if not properly monitored, can be manipulated by bad actors for illegal activity, like fraud and money laundering. This means the issuer and others profiting from such NFT sales may be subject to legal risks under various laws.
If an NFT associated with a music royalty stream experiences a sudden, significant jump in reported listenership, it can be challenging to discern whether the increase is due to the associated artist’s success or nefarious activity.
“NFT issuers need to be aware of the risks associated with, and avoid, unknowingly selling NFTs to persons located in countries that have been sanctioned by the US government – doing so is violation of federal law.”
Cryptocurrency sale and resale prices are volatile and may include speculative components. At the same time, the identity and/or location of an initial or secondary purchaser may not be immediately apparent due to the lack of transparency and decentralization associated with blockchain technology.
In addition to fraudulent and illicit use concerns, NFT issuers need to be aware of the risks associated with, and avoid, unknowingly selling NFTs to persons located in countries that have been sanctioned by the US government – doing so is violation of federal law.
These risks can be mitigated, but only with careful diligence and by using controlled marketplaces that police their resale markets for fraudulent, manipulative, or disruptive activity.
4) Taxation and Crypto Currency Volatility
NFT issuers should always expect to pay income taxes on NFT sales, just as NFT purchasers and resellers may be subject to taxes associated with capital gains and losses.
This becomes more complicated because many NFTs are purchased and sold using cryptocurrencies – which are subject to their own taxation regime that issuers and buyers alike need to understand.
Buyers of NFTs also may be assuming higher tax impact risk due to cryptocurrency volatility. If a cryptocurrency is used to purchase an NFT and it experiences volatile conversion rates or rapid appreciation, the tax liability of these transactions may be difficult to predict.
5) Non-U.S. Legal Risks
Issuers of NFTs associated with music royalty streams may wish to capitalize on an artist’s global fan base by selling and allowing resales of NFTs internationally, but sales outside of the United States require legal diligence and planning.
NFT issuers should maintain control over the jurisdictions of NFT sales and be familiar with applicable foreign regulations to avoid unintended violations of law.
“NFTs simultaneously pose a great opportunity for the music industry and introduce novel legal risks.”
For example, an NFT that is transacted over with multiple cryptocurrencies and fiat currencies may qualify as a currency exchange under UK law and be subject to additional regulation and oversight across foreign jurisdictions.
Operating on the technological frontier, NFTs simultaneously pose a great opportunity for the music industry and introduce novel legal risks. The legal framework surrounding NFTs is likely to develop more fully in the years to come, but in the interim, it is critical for all entities in the NFT space to conduct robust diligence and contact legal experts who can help you navigate the risks and benefits associated with the issuance and sale of NFTs, particularly those associated with music royalty streams.Music Business Worldwide