NFTS

The challenges of cryptocurrency, NFTs, and smart contracts on litigation

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This article was first published in World IP Review, February 2022.

In the Bitcoin whitepaper, Satoshi Nakamoto detailed a “purely peer-to-peer version of electronic cash” using timestamps to form a chain of transactions to keep a “public history of transactions”.

The central concept was decentralization, users transacting with each other without the need for an intermediary such as a bank or agent. This was possible only through the uniqueness of keys used to operate each transaction and the public nature of the chain.

The paper laid the foundation for blockchain technology and now, 14 years later, we have a cryptocurrency market estimated by Bloomberg to be worth £2.2 trillion, an NFT market of £29 billion, and contracts that can use this technology to perform themselves without human intervention.

The boom of this new decentralized world brings with it unique challenges for litigators. This article considers the current scope of cryptocurrency litigation and commercial disputes relating to cryptocurrency, NFTs, and smart contracts.

Interim orders

Although cryptocurrency transactions are necessarily publicly recorded, anonymity is central to their operation. In fact, Nakamoto advised that users create a new key (ie a new code) for each transaction to prevent different transactions from being attributable to a single owner.

It is therefore unsurprising that cryptocurrency is particularly vulnerable to fraud, given that the currency can be held by anyone without any verification of identity. AT report by Chainalysis in January 2022 found that illicit addresses already hold $10 billion worth of cryptocurrencies, the majority of which is associated with crypto theft. A common difficulty for victims of crypto theft and fraud is therefore uncovering the identities of their defrauders.

To address this, UK courts have harnessed the wide powers of interim orders. In Fetch.AI Limited v Persons Unknown [2021], the claimants’ crypto accounts were hacked and their bitcoin was traded at an undervalue. They bought claims of breach of confidence, unjust enrichment, and an equitable proprietary claim against an indeterminately wide range of potential defendants, referred to as “Persons Unknown”.

In the case, the Commercial Court confirmed the view that cryptocurrency is an intangible form of property, such that a proprietary injunction could be ordered. To tackle the wide net of the relief sought, Judge Pelling QC broke the categories of “Persons Unknown” into three: (i) the fraudsters, (ii) those receiving the bitcoin at an undervalue, and (iii) innocent receivers paying full price for the bitcoin.

The worldwide freezing order was granted against those directly involved in the fraud or knowingly receiving its proceeds and the proprietary injunction was restricted to only innocent receivers who knew, or reasonably ought to have known, that the bitcoin did not belong to the fraudsters. Such categorization allowed the judge to grant the relief sought while protecting, as far as it could, innocent crypto users from unnecessary intervention with their assets.

The claimants also sought disclosure orders against the cryptocurrency exchange Binance, in particular, its Cayman Islands holding company and its English registered company. Pelling concluded that the lex situs, ie the applicable law, for crypto cases is of the place where the cryptocurrency owner resides or is domiciled. This is particularly important for cases involving crypto, which often transcend different jurisdictions, as it gives English courts the gateway to accept jurisdiction to make interim disclosure orders.

The judge granted a bankers trust order against the Cayman entity, requiring it to disclose confidential information to trace the misappropriated bitcoin, and was satisfied that the order could be served out of the jurisdiction. A Norwich pharmacal order, which requires a party to disclose information that can identify the ultimate wrongdoers in a case, was also granted against the English entity on the basis that Binance was mixed up in the fraudsters’ wrongdoing by administering their crypto accounts, and were “certainly likely to be able to provide information necessary to enable the ultimate wrongdoer to be sued”.

The case shows the court’s willingness to use tools in their power to help victims of crypto-fraud. In fact, the court’s approach in the case of Mr Dollar Bill Limited v. People Unknown [2021] that followed shortly after, was a step more accommodating.

Justice Trower granted both a bankers trust order and a Norwich pharmacal order against two crypto exchanges that held wallets into which misappropriated Bitcoin was traced, even though these were based outside of the UK. Mr Dollar Bill shows the Court using Norwich pharmacal orders “to facilitate the further tracing exercise that may be required” in crypto cases.

The decision suggests that there could be a shift in attitude to service out of the jurisdiction and such disclosure orders, necessitated by the very fast dissipation of cryptocurrencies between jurisdictions. The application was, however, granted without representations from the foreign crypto exchanges, and the UK courts are yet to make a final, binding decision on the interplay between such disclosure orders and challenges to jurisdiction and service in cryptocurrency cases.

Commercial disputes

In November last year, JRR Tolkien’s estate filed a complaint against the cryptocurrency “JRR token” for infringing the author’s trademark and using the misleading domain name “jrrtoken.com”.

As far back as 2014, the cryptocurrency “Coinye”, featuring a half-Kanye West and half-fish image, was discontinued after a legal battle with the American producer/rapper. These examples illustrate the ongoing challenge for brands to protect their rights in the virtual world, including cryptocurrencies but also other forms of blockchain technology, in particular NFTs.

NFTs, or non-fungible tokens, are digital ledgers. Unlike cryptocurrencies, they do not have inherent monetary value and can’t be exchanged like money. Instead, they represent a digital asset, such as artwork, a song, or other digital property, and record when that asset was minted (ie created) and how it has been traded. In practice, this verifies ownership to the asset, much like a deed to a plot of land.

The validation of ownership that NFTs provide has recently made them explode in the art and branding worlds. Christie’s sale of “Everydays – The First 5000 Days” by Beeple made its creator the third most valuable living artist in the world after its £50 million sale last year. Dolce & Gabbana’s first NFT collection sold for 1,885.719 ETH, equivalent to almost $4.2 million.

However, problems can arise for brands when NFTs in the virtual world are intertwined with IP rights in the physical world without proper consent. For example, in January 2022, luxury fashion brand Hermès filed a lawsuit in the New York Southern District Court against the artist Mason Rothschild for using images of Hermès’ iconic Birkin bag, which sells for £7,000 to £360,000, in NFTs without their consent .

Rothschild’s NFTs incorporating images of the bags have traded for 200 Ether (around £493,310.79); however Hermès claim that the virtual assets infringe their trade mark and the sales amount to dilution of their brand.

Minting NFTs that incorporate existing IP exposes artists and minters like Rothschild to disputes and indeed litigation involving disgruntled brand-owners. For brands, difficulties with monitoring and preventing infringing activities online is exacerbated by NFTs because of the fast-moving pace of this market and because there are far fewer practical barriers to minting an NFT as compared with manufacturing and distributing physical infringing products.

The NFT market is also likely to give rise to commercial licensing disputes. In the US, Quentin Tarantino is seeking to auction NFTs of handwritten screenplay extracts from the 1994 cult classic “Pulp Fiction”; however, he faces an ongoing legal battle on whether the rights to mint such NFTs were assigned to the studio Miramax before the film’s release or retained by Tarantino as part of his reserved right to print publication. Such disputes will require courts to characterize the act that minting a particular NFT within the context of a licensing agreement agreed long before this type of digital asset and exploitation was commercialized or even invented.

In a similar vein, in September 2021 art collector Amir Soleymani filed a High Court case in the UK against NFT platform Nifty Gateway for freezing its account and blocking access to his assets. The dispute concerns Nifty’s contractual terms to a ranked auction for another of Beeple’s NFTs, “Abundance”, which Soleymani claims were unfair and not properly communicated. This is one of the first cases involving an NFT sale in the UK and will bring legal questions of contractual interpretation and consumer rights into the current “wild-west” of NFTs.

These licensing and commercial disputes highlight the need for greater clarity in the NFT world, which is currently unregulated. Litigation will be fueled if NFT minters, platforms, and consumers do not agree on the exact scope of NFTs, the terms of their sales, and how neighboring rights are affected.

smart contracts

Smart contracts use blockchain technology to automate commercial contracts. They are commonly described as “self-executing transactions”, meaning that they use computer programs to automatically perform contracts obligations, without any manual work required.

Examples of use cases include running transactions on cryptocurrency exchanges, managing supply chains, monitoring service level agreements, real estate, insurance, and decentralized finance.

On 25 November 2021, the Law Commission published a report titled “Smart Legal Contracts: A Summary” to analyze how existing UK law applies to smart legal contracts. The report assesses the application of key contract law principles on smart contracts, from contract formation to interpretation to remedies such as mistake and breach.

It concludes that the current legal framework in England and Wales is able to facilitate and support the use of smart legal contracts. It notes the scope for some uncertainties but considers the “flexibility of our common law” sufficiently robust to address these.

One particular development that the Law Commission considers necessary but feasible to apply existing laws to smart contracts involves contractual interpretation. The principles of contractual interpretation have become second nature to most commercial litigators—how a reasonable person, with all the necessary background knowledge of the parties at the time of the contract, would understand the language of the contract. However, smart contracts may require courts to interpret not only the meaning of natural language but also the meaning of code.

The Law Commission suggests adopting a test of a “reasonable coder”, namely “what a person with knowledge and understanding of code would understand the coded term to mean”. Its suggestion is to use an “expert” coder to translate the coded language to the court and give their opinion on what the code appeared to instruct the computer to do.

Such suggestions show the Law Commission adapting traditional contractual principles in order to keep up with blockchain technology, recognizing their increasing use but also the need to cater for potential uncertainties.

The paper ends with an appendix summarizing a list of issues that the Law Commission encourages contracting parties to consider in advance of entering into a smart contract. This includes agreeing on a jurisdiction clause to mitigate the uncertainties caused by the multi-jurisdictional nature of blockchain.

The new wave of technology that blockchain has bought has revolutionized the consumer, financial and digital worlds, but lawmakers and regulators are catching up. The unique challenges posed by cryptocurrency, NFTs, and smart contracts are being recognized and accounted for by UK judges as well as regulators but further legal and regulatory development in this area is likely to be seen in the coming months and years.

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