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How Web3 Will Drive Drastic Changes in Business Models and Legal Issues

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How Web3 Will Drive Drastic Changes in Business Models and Legal Issues

Web3 has become an oft used buzz word. But what exactly is it, how will it drive new business models and what are the legal issues that will ensue? This course will break down the meaning of Web3 and explore how decentralization and community governance will be at the center of this revolution. It will cover the role of blockchain technology in the Web3 ecosystem, including NFTs, DAOs and metaverses. One of the things that makes Web3 more revolutionary than evolutionary is the need for companies to significantly change their business models. The course will address the Web3 business models and explore the different business considerations facing Web2 companies versus Web3 companies. One of the key business issues is the changing role of IP rights and monetization in these business models. This will lead us into the fascinating legal issues that arise in the Web3 world. We will cover IP issues and the challenges that companies are facing and will continue to face in Web3. We will also cover the approaches to regulating decentralized, community based projects and other related legal issues. Lastly, the course will consider whether Web3 is elusive (in the near term) and whether for business and legal reasons the world will have to settle for Web2.5.

Transcript

- Hello, everybody, and welcome to today's seminar on why Web 3 will drive drastic changes in business models and the legal issues that will ensue. It's hard not to see the news these days and hear about Web 3, there's a lot written about it and there's a lot of misconceptions. We're gonna talk a little bit about what it is and really, the big picture fundamentals behind it and why it's so important. I think it's critical to understand that to really be able to effectively advise clients in this space. And then, we're gonna talk of course, about a lot of the legal and regulatory issues that result as people use these technologies and business models. Briefly, my background. So, I head up the Blockchain and FinTech Team at Sheppard Mullen. I've been doing work in the legal field since the mid eighties, about almost 35 years, and focus a lot on interactive entertainment, done work in the game space. Historically, did a lot of work in the virtual world space. I've seen all the evolutions that have happened in the technologies and business models as we've moved from so-called Web 1 to Web 2 to currently, Web 3. So, I've got a pretty interesting perspective on some of that, which I'm gonna share with you today. So, just to get into it, we think about Web 3, before we get into the technology, what are the issues that it's really trying to solve? What are the problems that exist that's causing, what I believe, is a very tectonic change in the way technology and business will be done going forward? So, there's three key issues in my mind. One is trust, one is transparency, and one is decentralization. And let's take a look at each of those and understand where we've come from and then, where we are with respect to those. So, when we think about trust, there's been many, many well-publicized scenarios where people were entrusted with billions of dollars and they breached the trust that was placed in them. Going back to the eighties, Charles Keating, the savings and loan crisis through Lincoln Savings & Loan was a huge, huge debacle where he was trusted with billions of dollars that went missing. Bernie Madoff, all of you are familiar with, of course, he had tens of billions of dollars that people entrusted to him, with some people, like their life savings, and of course, that trust turned out to be misplaced. And then, there's more modern-day Theranos and Elizabeth Holmes, and the mistrust that was placed in her again, involving billions of dollars, but even more importantly, people's lives. I mean, they were doing blood testing and allegedly, they were misreporting some of the results, which impacted a lot more than just money. When we think about trust, recent surveys showed that the least trustworthy companies by industry are actually some of the ones that people rely on the most for their health and financial wellbeing. So, you see from the chart here, the pharmaceutical industry, the health industry, and financial institutions, are among the least trusted big entities. And in another survey, they found that governments are even less trusted than businesses, and that the decline in trust in government has rapidly accelerated over the last several years. And I think ironically, even Bernie Madoff, one of his quotes is that "The whole government is a Ponzi scheme." And this is coming from someone who knows a bit about Ponzi schemes. Okay, transparency. So, what is transparency? Transparency is the ability to see meaningful information in this context. And where have we seen a lack of transparency where bad results have followed? Think about Enron, for example. Enron was a huge conglomerate with many related entities and a huge number of off balance sheet transactions and just incredible complexity and lack of transparency. And even apparently, a lot of their auditors and lenders didn't really understand what's going on 'cause they couldn't see all of the information and connect all the dots. And we all know how the Enron debacle failed. Think about the 2008 crisis as a result, in part, what was precipitated by the collapse of the mortgage markets and led to the broader financial markets disaster. A big part of that was because there was a centralization of a lot of power among very few companies that were controlling the mortgage markets, and it appeared that these instruments were insured when in fact, there really was this cross-collateralization among the big players and there wasn't a transparency as to that, and it flew under the radar for a while until that blew up, and we're all aware of what that led to as far as the financial crisis in 2009. Another type of lack of transparency beyond financial is a lot of the big social media companies today. They have concentrated an incredible amount of power, they have billions of users, they see incredible amounts of information about people, and they use algorithms to influence what we see, whether it's the social media posts that we see or search results that we see. And there's a huge lack of transparency into the algorithms that are used to drive those displays. Even the government, which tried to do a little bit of investigation around this, was so inadequate at getting under the curtain and seeing what was there when they tried to investigate it. And then, the third prong here is centralization. The fact that, as I mentioned, some of these social media companies have gotten so big, there is an incredible concentration of power and data in so few companies these days, and the Federal Government has gotten bigger and bigger and it touches on and implicates many more aspects of our society. When the U.S. founding fathers set out to create our Constitution, the Constitution says that any powers not specifically delegated to the Federal Government are reserved to the states. And we've seen a huge evisceration of that principle, and one of the reasons that is there is they had seen, in other situations when governments got too big, a lot of bad things happen. I think that's where we are right now. And I think one of the quotes that I like that relates to this is that, "Power tends to corrupt. Absolute power corrupts absolutely." So, the bigger the government, the bigger a power center is, the more the ability for it to do things that are corrupt. Okay, so let's tie this back to the web and where we are. So, when we think about Web 1.0, it was very much what a lot of people describe as a read web, and what that meant was for the most part, there were relatively static websites where users would go and be able to obtain information that was published there by the so-called webmaster. I think that's kind of a cool term, webmaster, we don't hear that much more. But literally, that was the person in charge for a company of posting content to the site or managing the content that was posted. To a large extent, that was a very, as I said, passive experience for users and it was very much a one-way push of information from websites that were typically owned by a single company, talking about their products and services to the user. Then we get to Web 2, and that was much more what people refer to as read-write. It was much more of a two-way communication, people could still go to websites and get information about companies and their products and services, but there was a lot more user-generated content through social media platforms, through other platforms, creator economies, things like YouTube, and Roblox, and other platforms where users contributed a lot of the content. And there was a lot of two-sided marketplaces where there would be am intermediary between companies and their consumers, and they would provide a lot the intermediary services. So, we saw that and that was definitely a step in the right direction and it really led to the democratization of information and really shrunk the world in that, people could reach people from around the world through the internet, whether it's for selling goods or services to people around the world, or sharing information and thoughts with people around the world. So, there was advancements there but what we saw was, again, a very rapid centralization of power among a limited number of these intermediaries or platforms. And I won't call 'em out by name, but we know who they are, right? And that is the situation of where we are right now. So, when we look at Web 3, what are the key elements of Web 3? So, one is there's decentralization. So, we talked a little bit about what the problems are with centralization, and Web 3 tries to solve that through decentralization. Another component is, what a lot of people refer to, they say that Web 3 is trustless. I kinda quibble with that term a little bit. I think the concept that people try to convey is, you're not putting your trust in individuals or entities, like the situations that I highlighted before, but rather, there's much more of a network or community-based trust as far as what is validating processing and storing the transactions that we're talking about, and I'll talk about that a little bit more. And of course, there's a transparency. With public blockchains, a lot of the information, pretty much all transactions, are readily viewable by anyone that wants to view 'em. There's limited information about who the entities are that transacted, but the transactions are there. And through different means, it's possible to identify who the transactors were. But the important thing is these transactions are on a blockchain using block readers or other existing technology. You can see these technologies, you can see these transactions. And the last component which covers some of the things that are before, I mentioned the community aspect, you can see a lot more community-based governance and community-based projects. Blockchains in general, the decentralization results from multiple people, these node operators, validating transactions. Again, not a single entity. So, when we think about decentralization in the context of Web 3, what does this really mean? So, as I touched on a little bit, blockchain networks, they store data across distributed devices which are also referred to as nodes. They're just computers on a network. And they're under control of different people, so there's no central authority that governs decision-making or the validation of transactions, and nor is there a single server or one point of technology that controls or stores the data. Okay, so... If we look at the so-called tech stack for Web 3, you have a bunch of front end applications, just like in any other tech stack, that's the ultimate, what the user interacts with, and there's many different types of applications, including one of the things we'll talk about today, is metaverses. And underneath that, you have different layers, a lot of peer-to-peer networks, there's distributed autonomous organizations, which we'll talk about a little bit, there's commerce platforms, including exchanges which enable you to buy and sell digital assets, Dapps, or decentralized applications, and smart contracts. And those are some of the tools that enable the technology to work. And then, there's what's sometimes referred to as the relationship layer and how do you identify yourself to these networks and largely, there's what's called digital wallets, which we'll talk a little bit about, and what we're moving towards is a decentralized identity, and I'll touch on that again in a second. And underneath all of this and at the bedrock, the foundation of it all, is really blockchain technology, distributed ledgers, and other types of SmartChains. So, I mentioned identity, one of the things that is, I think, very interesting, and I think easily displays the progression where we've gone from Web 1 to Web 3 is just how you identify yourself to an online application. In Web 1, again, it was this one way you went to a website and you had to register, you put a username and password, and that entity had a password manager. If you lost your password, you could request a new link, you could get a new password, reset it, and you could sign in. When we went to Web 2, there was still a lot of password-based authentication to access websites, but instead of doing it with the site itself, in some cases, you still did, but the powerhouses that controlled all the data and knew everything about you, they created identity services. And so, you could use one of these services to actually log into a third-party site. So, they were authenticating you for these third-party sites. Again, they had this centralization of information and knowledge, and they used it to provide these services. With Web 3, you connect via wallet, and your wallet may maintain some level of anonymity about you, except when it's required that you go through a KYC process, but there's no intermediary. You hold the keys to your wallet, we'll talk about that, and you connect via your wallet to any of these online services. So, it provides a couple advantages. As a user, you don't have to share as much public information about yourself. And with respect to the companies that are looking to ensure they know who they're dealing with, you can log in without them having a lot of information that they now need to store and deal with a lot of data privacy type issues. So, this is one graphic I saw that summarizes some of this, and we're looking at the evolution of truth. We went from the Bernie Madoffs of the world where there was no truth, and you can see, as you go to the top right, as it went from Web 2.0 to Web 3.0, there's a greater ability to ensure that what you're seeing on a blockchain is accurate transaction information and it's transparent and reliable, for many reasons. We'll touch on some of those. Okay, so with that as a backdrop, the other question I think is important to understand is, why does blockchain matter? Why is it gonna be important? And why is it gonna, in my view, be a game changer? I think that blockchain technology will ultimately prove to be more impactful than the internet was. We've all seen how powerful the internet is and how ubiquitous it has become, and it is industry agnostic. Pretty much every industry in the world uses internet technology these days. How is blockchain like internet, and how is it different? So, when we think about the internet, it basically leverages TCPIP, which is an information protocol. So, the internet is a way of moving information around the world. Now, the information can be anything from news or weather, it can be transaction information, but the internet itself doesn't really process that transaction information, it just distributes it to the entities that process financial transactions. Blockchain is a transaction protocol. The blockchain technology, and there's many different blockchains, but blockchain is primarily about processing, validating, and storing transaction data. And when you think about the value of transactions versus the value of information, I believe that the value of transactions ultimately, will be greater than that of just information. And for that reason, I believe, and others, that blockchain technology will ultimately be more impactful than the internet. And just to state it another way, why I think it will succeed is that, as we looked at earlier, trust in big enterprises and governments has eroded. The truth has become really- Everyone has their own version of the truth, it's become very subjective. It's hard to find just factual information anymore without someone presenting it in a way that's advocating their position. And so, Web 3, which blockchain powers, is really about this concept of decentralization and community government, it's taking power away from big enterprises and government and shifting the focus of trust to the network and the communities that run them, where there's a greater level of transparency. And underlying this, as I mentioned, blockchain is the linchpin of Web 3 and that's why it is so significant. Now, a lot of people, our naysayers, which is fine, every new technology has their naysayers, I went back, I mean, I recall from the early days of the internet, people predicted it would fail. Here's just a couple of quotes from very reputable media publications, Newsweek, the actual inventor of Ethernet in an InfoWorld article, Wired Magazine and the associated press, all predicting the demise of the internet back in '95, '96 timeframe or so. And that's fine, I think a lot of people, when things are so new and different and many people don't understand it, they predict it's never gonna take off. And as we saw, obviously, those predictions were all wrong. And so, I think, a lot of the same arguments are being made now with respect to blockchain, that no one understands the technology, it's too complicated, bad people use it, all the same arguments that were advanced back in the early days of the internet are being recirculated today, and I think those will be, over time, proved to be false as well. Okay, so let's look a little bit more at what blockchain technology really is. So, blockchain is really a form of distributed ledger technology. It's like a database, but it's different, and I'll talk about how that is in a second. When you think about ledgers, we think about these old leather-bound books where each page had multiple lines and each transaction was written on a line of the page, and when you filled the page, you went to the next page, and when you filled the book, you went and you created a new ledger. With blockchain, the transactions are processed and validated, as I mentioned earlier, by what's called nodes, which are just computers that work on the blockchain network and they run the relevant protocol for that blockchain. So, you have this decentralization in that there's not a single entity that processes and validates the transactions. Each transaction is irrevocably written to the relevant blockchain. So, you hear the term immutable, once data is written to a blockchain, you really can't change it effectively, and I'll show you how that is in a second. And for each transaction, the transaction is appended to the blockchain, but there's multiple copies of the blockchain, so a copy of the blockchain can reside on multiple nodes. And so, we'll see how this decentralization and distribution of information differs from existing technology. So, where does the chain part come in? So, the blocks are basically like a page, they're analogous to the pages of a ledger. There's a certain amount of space, you put a certain amount of transactions in a block, and when that block gets validated, it gets written to the blockchain. So, a block is just an amount of space analogous to a page. Okay, what's the chain part? So, the blocks are actually chained together, and this is part of the power of blockchain technology, and the way they're chained together is that once block one is written to the blockchain, there's an algorithm run which is called a hashing algorithm, and you don't really need to know details about what it is, what it does though, it takes the contents of block one, and by running this algorithm on it it creates this unique string of characters, that is what's referred to as the hash value. And so, just a way of identifying through an algorithm, the contents of that block. And that hash value gets written to block two, so the hash value of block one gets written to block two. And what that does is it chains them together in a way such that, if someone were to go back and try to change the contents of block one, there would be a new hash value for that block and it wouldn't match the value that was written as the hash value of block one to block two. And you don't go back and change the hash values once they're written to the new chain. And if you ever tried to go back and change all that, it gets really complex because as you have thousands and thousands of blocks, you have to do a lot of changing to go back and try to fix it all, you have to really go back to block one, and it's really just not feasible. Additionally, because there's multiple copies of the blockchain, if one version of the blockchain gets out of sync with the other versions of the blockchain under control of different entities, it becomes an ignored chain. It's deemed to be invalid, so it gets disregarded. So, there's a lot of technology built-in to ensuring the integrity of the transaction data once it's written, and the decentralization of this information by it being under control of multiple different entities is part of what prevents one bad actor from taking activity that would change the data once it's been written. Okay. So, how do you transact on a blockchain? The way you transact is typically through a digital wallet or a crypto wallet, and the wallet is really just a piece of software. Think of it as like a browser in a way, you use the browser to interact with the internet, a crypto wallet is how you interact with the blockchain. And again, because it's primarily a transaction protocol, you're, for the most part, doing transactions through your wallet. So, the wallet has what's called a public key and a private key, and the public key, I'd say, is analogous to your email address. If I wanna send you a digital asset, I need to know your public key so I know how to address the transaction, just like addressing an email. And the difference though, is that there's also a private key, and for me to actually execute a transaction from my wallet, I need to apply my private key to show that I actually have control over that wallet. Just like I can send you an email, but I can't send an email from your account because I need your password to log in. So, if you keep your private key private, you're good to go and you have security there. And so, the way that the blockchain works essentially, is that there is digital assets including cryptocurrencies, and NFTs, and other types of tokens, and because it's a ledger-based system, you don't actually store assets in your wallet. The name wallet is a bit of a misnomer as we think about it, typically, a physical wallet, you store coins or cash, in this context, you don't, you just use it to transact. And what happens is, on the blockchain when there's a transaction, if I buy a Bitcoin, what happens is the ledger will show that my wallet, my public key of my wallet, owns a Bitcoin, and that shows up on a ledger. And if I go to want to transfer a Bitcoin to someone, it's gonna make sure I have a Bitcoin to transfer and then it'll validate the transaction and do it. If I try to transfer two Bitcoins and I only have one, that transaction won't be validated. Okay. So, when we think about the difference between fiat money and cryptocurrency, there's huge differences, right? They're digital currencies, the cryptos are, versus typically, fiat money is physical. They're basically represented by code as opposed to some physical metal or paper. With fiat money, the government can print pretty much an unlimited supply. With some cryptocurrencies like Bitcoin, there's a fixed cap on how many will ever be produced. So, it's one of the few currencies where there's an anti-inflationary provision put in. And of course, a big aspect of this is that it's decentralized, and so the government control of money, which in some situations has turned out to be a problem, with crypto, we have this decentralization and so, it's not. And with fiat money, it fluctuates a little bit based on various factors, but the government tries to maintain a value to a certain extent through monetary policy and fiscal policy, whereas with cryptocurrency, to a large extent, it's the value determined by supply and demand. Okay, so one of the other technologies that's important is smart contracts, and kinda like the term wallet, smart contract's a bit of a misnomer, they're not contracts nor are they generally particularly smart, they're very simple pieces of code often, that are used to execute some business logic. So, in a sense, it's like business process software, except that it runs on a blockchain and that brings certain advantages in that the transactions are typically recorded there and you can obtain data from different sources like IoT devices or other data sources through what's called oracles. And the oracles actually validate the data that's provided to a smart contract before it can be received by the smart contract, and so, again, there's another level of integrity there. And then, the smart contracts are basically, stored on and executed on a blockchain. Okay, so what are NFTs? NFTs are a type of crypto token, and there's two parts to it. There's really the token part, which is an evidence of ownership of something, and then there's the something, the second part is either typically an asset which could be physical or digital, or some other entitlement. So, I liken this to title to a car. When you buy a car, that's the asset, you get a title certificate that has the VIN number, the vehicle identification number of the car. And so, the VIN number references the VIN number of the car, it gets recorded in a traditional database at the Department of Motor Vehicles, and it shows that you own the car having that vehicle identification number. Taking a little bit deeper-dive into NFTs. As I mentioned, the way that you create an NFT is it's a token, and when it's created, there'll be a token ID that's unique, that uniquely identifies that token, and that's part of what distinguishes a non-fungible token from a fungible token. With fungible tokens, each Bitcoin is all the same, which NFTs, each token is different, has a unique token ID, and the token can represent some asset or entitlement that's different. And so, when you're creating the NFT, you add what's called metadata, and the metadata can be a variety of things, but typically, it'll be a reference to the asset or entitlement that the NFT relates to. And if it is a digital asset, typically, the asset is not stored on a blockchain, it's stored somewhere else, so the metadata will identify the file and the location of the file where it's stored, for example. And so, there can be other information in there, like if you want to impose a resale royalty on the token, you can put resale royalty data in, and a variety of other information. So, once all that information is there, you use a smart contract to mint the token, that just means to create it. So, the token ID comes into existence, the metadata gets associated with it. And when someone buys that NFT, the token ID gets associated with their wallet ID and that gets recorded on the blockchain, and that's how your ownership of an NFT is established. It's really as simple as that. The resale royalty that I mentioned is interesting in that if you program the smart contract when the NFT is minted to collect a resale royalty, each time that token is resold, the issuer can automatically get a portion of the proceeds of the sale sent to a digital wallet. And so, why is this important? So, there's a couple of instances where I think, it's a no-brainer. When you think about the music industry, you have music groups that go on tour to do a concert, you may have a ticket that has a $75 face value, and by and large, the scalpers get a hold of most of them before most of the public can even even buy 'em. And it may go up to $300 or more, and that delta between the face value and what consumers pay is going to the scalpers, they're not the ones that are creating the music or providing the entertainment but they're getting a lion's share of the profit. With these resale royalties, if you do NFT-based ticketing, which is already happening, you can program it so that a percentage goes back to the actual artist. Same thing in the context of a physical artist, so a lot of painters and other artists in the world start out and they sell their works at a very low amount just to make a living as they're trying to build a name for themselves, and as they become more popular over time, their works sell for more and more money, and for some of these artists, it sells for millions of dollars and they get typically, no share of the upside. With smart contracts, if you use those to manage the sale or resale of digital art or other types of artworks, the artists can get a share of that going forward. So again, there's much greater equity in how the monetary proceeds are distributed. One other key element of blockchain technology in Web 3 is what's called DAOs, and DAOs are decentralized autonomous organizations. And when you think about traditional companies, they're very hierarchical from the top down. So, you have a board of directors including the chairman of board, you've got the executive team below that, the CEO, CFO, the whole C-suite, and you have management, you have employees, and decisions and everything flows downward. With DAOs, it completely inverts that pyramid and it's very much a community-based governance structure. So, DAOs are really a set of smart contract protocols that define the rules of the DAO. So, DAO is like a company, but often, there's not a corporate structure. It is a set of governance protocols that are set for that particular DAO, and that specifies what the DAO can and can't do. And there's typically, a token associated with the DAO, and people who buy the token get a share of the voting rights in that DAO. And the protocol defines what kind of proposals token holders can make, and if it's a valid proposal, then the other token holders can vote on it, and if the vote is positive, then the DAO will implement whatever that action is that the community voted on. And all of these results to proposals, to voting, everything is stored on a blockchain, and so, there's again, greater transparency in everything that transpires. Okay, and so we talked about, from a UI perspective, one of the big directional aspects of this technology is things moving towards metaverses. So, what are metaverses? Metaverses are really, it's kind of a- There's many different metaverses first of all, and they're different, so it's kinda hard to give a specific definition, but here are some of the elements that are common among many of the metaverses. And it really is a mix of certain technologies and business models that come together to create a metaverse. At the core, many of them are a virtual world, so for those of you familiar with things like Second Life or other virtual worlds, you know that what they are essentially, is a shared, immersive, social space where users are typically represented by an avatar, that the avatar is actually in the space, and that avatar interacts with other avatars and other objects within the space. And so, instead of just looking at a computer screen, your avatar is in it and you are participating in what's there. And many of the metaverses will be 3D and/or VR, and you're seeing also, a lot of augmented reality, virtual reality, other forms of mixed reality, as a common display element. And so, that's part of the immersion part of virtual worlds as well. At a high level, they're a new form of social media. Or, it's not really maybe a new form, it's an extension of what virtual worlds were, but it is a very social media like thing because you're just interacting with other people in places through your avatar, as opposed to just through typing into a social media text box right now. Within the virtual world, for the most part, the platform operators sell land to users and the users build out the virtual world. They build the spaces, they build the experiences, so you have very much of a user-generated content-based approach. And there's a digital economy, and so, within the digital economy, people are selling goods, services, there may be currency that's sold through it, but it all hinges on having virtual land. And people say, "Well, why would I buy virtual land?" And that is because, in order to build something in a metaverse, you have to own land, or many times, people will buy land and lease their land to other people to build it, just like in the real world. And so, if you want to build, for example, a concert venue where people can gather and you can do digital concerts in a metaverse, you need land to build that concert venue. And underlying all of this again, is blockchain and NFT technology. Many of the assets, including avatars, some of the digital economy, like digital fashion that people will buy for their avatars, all of those will be represented by NFTs, and a lot of the information about what's going on will be recorded to the blockchain. So, if you are running a concert, you may sell NFT based tickets, people will buy the tickets, all that gets recorded on a blockchain. Okay, so let's get in- With that as a backdrop of the technology and the business models around this, let's get into some of the legal issues. So, one of the first things we'll note is that legal issues, the law and regulation that is, always lags behind new technology and new business models. So, one of the challenges we face as people who advise clients in this space is, in many cases, we're trying to fit a square peg into a round hole. Many of the laws and regulations that apply were created long before any of this technology was conceived. Having said that, a lot of the basic principles of these laws are definitely applicable. And so, what a lot of the regulators are doing is providing guidance on how they believe the existing laws and regulations apply to these new technologies. And so, between that and other case law precedent and prior enforcements, we can glean the applicability of law to these areas. And there's a whole bunch of areas you see listed out here that are some of the key areas to think about, but each blockchain-based offering can create many different, unique, different legal issues, so you have to really think about each one based on the unique facts and circumstances. These are just some of the common areas. So, the first is NFTs. NFTs are really one of the fastest growing classes of digital assets and will be pervasive, I believe, across many industries, not just for digital assets, we're seeing people tokenize real estate and other physical assets, I mentioned people tokenizing tickets, we're seeing carbon credits tokenized, there's all kinds of things that are happening across a diverse array of industries. So, what is the legal status of NFTs? What do you own? What are the property rights and IP rights? So, as I mentioned earlier, with NFTs, there's a token and there's typically an asset, and we'll focus for example, on digital assets for now, because that's predominantly what's happening, although, as I mentioned, there's other classes. So, with the token, you typically own the token, right? And again, all that means is there's a token ID associated with your wallet, and by owning it, it means you can buy and sell that token. But if it's a digital asset associated with the token, typically, you only have a license to a particular instance of that digital asset. And that asset is referenced in the token metadata, as I mentioned, and there'll be typically, specific license terms that say what you can and cannot do with that digital asset. And in many cases, there's a personal non-commercial license, which means you can basically display it. So, if it's like a profile picture or a collectible, that's pretty much the extent of it. We're seeing, in other cases, there's commercial licenses being granted like Bored Ape Yacht Club, and people are creating brands around the profile picture and using, in that case, their ape as part of a brand identifier. We've seen burger joints, we've seen coffee clubs, and other types of things be generated, as well as music publishing around bands that are created based on some of these apes, etc. Okay, so typically, the digital asset, the copyright owner retains copyright in the underlying work. And that's important because if- The digital asset of course, is a copyrighted work, if you're gonna use it, you only have a license to use what's expressly granted, and if you don't have rights to do certain things like make derivative works, then you can't do that legally without violating the copyright of the issuer. If you're selling NFTs, and just like any other time you're licensing digital works, you have to do a rights clearance. You have to ensure that you actually own the copyright or you have at least, a license or a right to be able to publish a digital work based on that. So, if you think about, take the token away for a second, if you were gonna license the digital asset in any other context, do you have the right to grant what you want to grant? And if so, then that's fine, if not, then you can't legally make that NFT. We're seeing a lot of disputes as to ownership, some are just blatant infringement where people are creating NFTs around other people's IP and they have no relationship to that IP. In other cases, there's legitimate disputes like who has the right. So, one of the cases going on right now between Quentin Tarantino and Miramax, Quentin Tarantino, apparently had some content he created around Pulp Fiction and Miramax says they own all the rights. He generated some NFTs based on what he believed he had rights to, and there's a lawsuit pending regarding that. It's important, just like in any other context, like Contracts 101, is if you're gonna have a license and you want it to be valid, there has to be a valid offer and acceptance. And to have an acceptance, typically, under electronic contracting, you have to have a user affirmatively accept the license in some way. So, there's different ways of doing this, but just like any other application on the web, one way to do it is when you're presenting the NFT, you can have a little checkbox that says "By buying this NFT, I agree to this NFT owner license," and you can have a link to the license right there, and the user may have to check that or some other affirmative action to indicate that they've accepted that agreement. So, that's helpful. Some of the platforms that sell NFTs, don't really have this flexibility to create custom licenses, that's something that's being worked on, but one way or another, you wanna make sure, so that may go into whether you decide to use that platform or not. Many of the platforms have a terms of service, and a lot of people think that that covers the license for the NFT. Sometimes it does, sometimes it doesn't, sometimes the platform terms of service, in most cases, is just governing the relationship between the user and the platform, not between the seller and the buyer. And so, the way that that manifests itself, as many terms of service will say, by buying an NFT, you're purchasing it from the seller, not us, and there may be additional license terms, but that's not our problem, we're not imposing the license, that's between you and the seller. So, you need to understand what the format of the license is and how you can apply it given the different marketplaces. It's also important to make sure that there's no one right or wrong scope of license. As I mentioned, things range from very restrictive, personal non-commercial licenses through commercial, and you need to identify as a business, what your business model is, what legal issues you're willing to take on with respect to your licensing, and then you need to craft a custom license based on those terms. There's a wide range of licenses, I strongly do not encourage people just to pick a license and go copy it. As successful as Bored Ape Yacht Club has been, their license, many people have noted, is probably deficient in many ways and could have been better written. So, those are some of the key things with NFT licensing. The last thing I'll mention is that, actually the last two things, one is, it's important to make sure from a consumer protection perspective and to avoid liability, is that you accurately describe what the NFT represents. As I mentioned, you own the token, you have a license to the digital asset. There's a lot of people that are saying you can own a unique digital asset in describing an NFT, and that's not accurate, and we've seen situations in the past where that has led to lawsuits. So, you don't want to misrepresent, even if it's unintentional, you need to properly inform a consumer of what they're getting. And the other issue that comes up with NFT licensing is, okay, so you can control the initial sale of the NFT and you can ensure that the buyer affirmatively accepts the license, but how do you ensure that subsequent purchasers are bound by the license? There's a number of things that you can do in the license with a conditional transfer, you can put the license in the metadata of the NFT or a link to it. Again, that's helpful, not dispositive, but this is an area of evolving best practices and requires careful thought. There are companies like MINTangible that are working on technology solutions to integrate a licensing infrastructure layer into the NFT ecosystem that will try to automate some of this. But in the interim, it requires careful consideration from a legal perspective. As I mentioned, there's a lot of infringement, so how do you detect and enforce infringement in this space? So, many of the traditional principles apply to the digital asset. If it's copyright or if there's trademark information in there, you're gonna have traditional claims that you can make. One of the things I would say though, is in this context, is that it's really important to monitor and act early if you are enforcing IP rights, and the reason for that is when something is listed on a marketplace, if there's an NFT that represents a digital asset on a marketplace, when we sent DMC take down notices to the marketplaces, they've been very compliant, and you can get the NFT taken down to prevent a sale via that marketplace. And so, the DMCA process is very helpful. The other thing though, that goes one step deeper than that is taking an NFT down from a marketplace doesn't disable the NFT. As I mentioned earlier, the file typically resides somewhere else, and what you see on the marketplace is really just an image, typically a low res image, that shows what the NFT represents, but it's not the actual file. So, for example, if the file is a video clip like a top shot moment, that video clip will reside somewhere else. When you go to buy the video, that may just have a still image, for example, and that is all you really see. So, what this means is from a DMC take down perspective, if there's infringing content, you want to think about going to the source of where the file is stored and get the file taken down, because if you do, then you've disabled the NFT and there's nothing really to resell going forward. You can use UDRP for trademark misuse within domain names, and again, we've seen a lot of companies pop up sites that use a brand's domain with some variation and try to sell NFTs that look like they're coming from the brand. We've been successful in getting control of those domains. But you have to be aware that there's certain domains like .eth and some others that are not subject to UDRP, and so for those, you need to use alternative methods to take down the domains. And so, as I mentioned, as far as the monitoring and acting early, one of the reasons it's important is that once it's sold, as I mentioned earlier, the NFT gets associated with a user wallet but you may not know who that user is, and so it gets harder to enforce at that point. Okay, so there's a lot of regulation, a lot of different agencies, that have a say in regulating crypto related assets, the SEC is one of the ones that have been most active. And as you can see from this chart here, what's interesting is that different agencies have classified digital assets in different ways, and it creates this regulatory uncertainty. So, the SEC has classified many crypto assets as securities, FINCEN has said it's like money, OFAC treats it like a currency, the IRS has said its property, and the CFTC has said that many digital assets are a commodity. And you can see here on this slide, some of the different issues that these agencies deal with, and many of them, you're probably familiar with. So, we'll take a little closer look at some of the big regulatory issues here. So, I mentioned the SEC, with the exception of Bitcoin and Ether, they've found that most cryptocurrencies and tokens, they believe are securities. They haven't squarely addressed NFTs yet, but they have indicated that there are situations where NFTs may be securities. We'll talk about that in a second. And they also regulate securities exchanges, so if you're operating in marketplace and what is being sold is a security, then you you may be subject to the securities exchange rules. The SEC has issued a few, what's called no-action letters, where people have submitted a fact scenario and said, "If we do this, do you agree you won't take action against us?" And the SEC has agreed. Those are very limited in the context of digital assets, but it's worth reading the few that are out there. And probably, the most relevant guidance is the, what's called the framework for investment contract analysis of digital assets. It's kind of a mouthful, but that's like the SEC guidance on how they're applying the test for whether something's an investment contract to digital assets. FINCEN, which is the Financial Crime Enforcement Network under Department of Treasury, they're responsible for administering the Bank Secrecy Act, which deals a lot with anti-money laundering. They issued guidance back in 2013 and then updated it in 2019, on the applicability of those laws and regulations to convertible virtual currencies, which they define as, in the guidance. But if you think about tokens that can be sold and resold on an exchange, those are gonna be as an example of what a convertible virtual currency is. The FINCEN is getting stricter about enforcing the AML rules against crypto asset companies that are subject to these rules. There's been a bit of a lackadaisical attitude on the part of some, and it's led to money laundering and other types of issues, so FINCEN's been more stringent in their enforcement. And somewhat related is OFAC, which is the Office of Foreign Asset Control, and they deal with ensuring sanctions compliance and minimizing sanction avoidance issues. They've issued guidance on how digital art, or art in general, but digital art also, including in some cases, NFTs, are being used as a way to avoid sanctions, and they've actually taken some actions, do you need to be mindful of that component if you're dealing particularly with high value NFTs. The IRS has issued guidance on the taxation of convertible virtual currency. They basically treat and tax it as property. And so, when you acquire it, if you acquire cryptocurrency, for example, in connection with performing goods or services, that's gonna be income just like any other time you receive value for goods or services. But one difference is that if you hold that cryptocurrency and it appreciates when you go to sell it, or convert it, or use it, under the guidance currently, then you may have another gain attributable to the increase in value from the time you acquired it, so there's many other tax implications, but those are some of them. And we're seeing a lot of issues around gambling, there's just a growing use, and particularly one of the areas we see a lot is in certain games and chance-based applications. And so, there's a growing scrutiny on some of the chance-based mechanics. In the traditional game world, there's a lot of use of loot boxes, there's some social casino games, and other methods that have been very lucrative and profitable for the publishers of those games. There's been a number of lawsuits relating to them. And in most cases, the game companies have prevailed, with the exception of one notable situation in Washington State for some of the social casino game companies. The problem is it's hard to use chance-based mechanics when you're dealing with NFTs or cryptocurrencies, in part, because one of the reasons that the game companies have been successful in overcoming these lawsuits is that the courts have found that with most in-game assets, if the terms of service prohibit the sale of those assets outside the platform, then those are deemed to have entertainment value only and the use of them in connection with chance-based mechanics don't meet the test for gambling, which essentially is, if people pay money as chance-based outcome and people win something of value as a result of it, if you have those three components, then it's gambling. That argument often doesn't apply with NFT-based assets or other digital assets because if what people win is an NFT and they paid money for a chance to do that, then that NFT, because it can be traded on a secondary market, it has value. And so, what we're seeing is a lot more play-to-earn and other types of models within blockchain-based games that are not as much chance-based. Okay, going back to securities laws, just a little bit deeper. I mentioned this investment contract. So, the definition of securities, one of the components of it is an investment contract, and that is- There's a Supreme Court case from the 1940s called the Howey Test that identifies when something is an investment contract. And basically, if there's an investment of money and a common enterprise, there's a reasonable expectation of profits and that profit is based on the effort of others, then you typically have a security. And the SEC has said that in most cases, the cryptocurrencies that have been issued fall into that definition because people invest money, everyone rises or falls together, and typically, the issuer keeps some of the crypto, people are buying it 'cause they're trying to make money, and whether they do or not, in large part is based on whether the issuer builds the platform that they're trying to build, that the currency will be usable on. Okay, so for that reason, the SEC views many cryptocurrencies as securities. There's this concept of initial coin offering where it's initial release of a cryptocurrency that someone may offer, if the platform in which it's gonna used is not yet built and the funds that are raised from that sale are used to build the platform, then that's the classic example of where there'd be a security, at least according to the SEC. A lot of people think NFTs can't be securities, that's not necessarily true. In most cases, NFTs probably won't be a security, if they do represent a single asset and there's a single owner, arguably, there's no common enterprise, arguably, the profits are not from the efforts of others. If the NFT is just a collectible, it may be due just to the market value, greater demand. But each case is fact specific, there are some scenarios where NFTs could be securities. If you tie a revenue right to the NFT, that may cause it to be a security. If you do a presale of, let's say an in-game item where the item is not usable yet because the game hasn't been built and you use the proceeds to fund the platform that the game will be operated on, that may be a security. And the SEC has talked about fractionalization as an area where there might be securities as well, if we take a high valued asset, create multiple NFTs to represent a share of the ownership. The DAO, the legal issues with DAOs can be very complicated. The leading jurisprudence to read on this is- The SEC issued a report on what was called The DAO, which was an early VC-based DAO, and the report of investigation found that the tokens issued there were likely securities based on the fact that they weren't truly decentralized. I encourage you to read that if you wanna learn more about that. FINCEN, as I mentioned, has issued guidance on convertible virtual currency and the guidance goes through various elements of what is a virtual currency and talks about how labels don't matter, people try to say something is a utility coin, really, the facts and circumstances matter. If you are involved in money transmission by any means, then the Bank Secrecy Act may apply to you, which means you may have to develop AML processes and procedures. Crypto exchanges, they may qualify as bunny transmitters under the BSA, according to the guidance. And you see a whole host of other activities listed out here, I won't go through in detail, each of which can raise issues according to FINCEN, of compliance with the Bank Secrecy Act. I mentioned sanctions, so OFAC administers this. So, one of the implications if there's a sanction is that U.S. persons cannot interact with whatever the designated actors or property is. And OFAC took action recently against for engaging in certain financial transactions that were deemed to facilitate money laundering. They designated the exchange and specific crypto wallets as designated property, which means that if you are a U.S. person and you're operating in exchange, you can't interact with those wallets, for example. So, that's deemed to be blocked property. So, you need to exercise a level of diligence to make sure that you're not violating the sanctions rules. The CFTC, they have regulation over futures, options, derivative contracts, and related activities. They try to prevent fraud and manipulation in markets. They've issued various guidance, as you see here on this slide. I encourage you to read that. They've classified many cryptocurrencies as commodities and subject to their oversight and the marketplaces where they're traded, and they've successfully taken action against some companies for violating the commodities laws. And here's just some examples of some of the prohibited activities. We're seeing some wash trading and other types of price manipulation, those are some of the types of things that they look to avoid. So, just in the few moments left here, with the metaverses, there's a ton of legal issues, there's gonna be a lot of IP issues because there's so much user-generated content. A lot of the traditional issues apply. Governance is a big thing, within metaverses, you have a platform and typically- Well, first of all, you have real world law that applies. Real world law applies even though it's a metaverse. People think because it's this ethereal thing, that laws don't apply, they do, just like any other website or online property. Then you have the platform and they typically have their terms of service. And then, within the metaverse, you may have different lands, and people that own land can impose their own set of rules and restrictions with respect to what can happen on that land. A very simple example is you may have to be over 18 to participate. It gets a lot more complex than that. And so, there's layers of governance issues with metaverses that are important. And because blockchain, and NFTs, and DAOs underpin a lot of the activity in the metaverses, it's important to understand all the legal issues we just talked about, and potentially more, when dealing with blockchain-based DAOs, metaverses. And here's just a list of some other issues that arise, I won't go through them in all detail today. Last thing I'll just say is, as you can tell from the way I did the lead-in, I'm very bullish on Web 3. I think there's a lot of advantages to it, a lot of benefits, I think it'll overcome a lot of the abuses that have happened. But just to do a reality check, I am realistic and I don't think we're gonna jump right to Web 3.0. I think what we're gonna see and what we are seeing is really more of a Web 2.5, which is kind of a bridging between social media and Web 2.0 to Web 3. There's still a fair amount of centralization, even in some of the bigger blockchain-based platforms in order to ensure integrity and some other things, in the short run. I do think over time, we'll move more towards Web 3, but just like eCommerce was envisioned from the early days of the internet, and it really didn't become a significant part of the commerce world until just really, a few years ago. It had been growing slowly and steadily, it took almost 20 years. I don't know how long it will take to get to Web 3 but I think we will get there, but it's just not gonna be overnight. So with that, I want to thank you all for tuning in, I hope you found this informative. If you have questions, always happy to have conversations with people around these topics. We have a blog called Law of the Ledger, that covers a lot of the topics here in more depth, and we cover breaking stories, and we actually just launched a podcast as well, called the Legit Ledger, trying to help you keep things legit if you're dealing with distributed ledger technology. So with that, I wanna thank you all, and I hope you enjoyed.

Presenter(s)

James Gatto
Partner
Sheppard Mullin

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