by Danny O’Neill

With a strong background in music, corporate and general IP law, team member Danny O’Neill has been working closely with our artist and technology clients to find creative solutions to the complex legal issues that arise as a result of working at the intersection of art and Web3. Danny has been lead counsel on matters related to Royal.io, the new streaming platform that sells music rights as limited digital assets and works closely with our founder, Vivek Jayaram, on all aspects of the firm’s NFT and Web3 practice. Here, he gives us a glimpse into the intersection of how new technology is reshaping the music industry.

If you have been on the internet in the last year, you will likely have seen the term “NFT”, which stands for “Non-Fungible Token.” NFTs have become extremely pervasive in business and popular culture as of late, but for people outside the wild world of Web3, it may not be so apparent why these funny looking .jpeg images have amassed such widespread notoriety and adoption.

At a high level, NFTs are essentially a form of verification to show that you actually own something—like a deed to a house. When you buy a house, you gain ownership via a signed, written legal document that we as a society all agree is sufficient and permanent evidence to verify your ownership. The blockchain takes this idea one step further, and allows you to create, or “mint”, a unique identification number (the “token”) that represents a real world item (usually digital art) onto the blockchain itself. The blockchain functions as a publicly available forum or ‘ledger’, which shows who owns a particular token at a specific time. 

The token displays the identification information of the then-current owner (aka the “wallet ID”), and when that owner sells the token, the next owner’s information shows up on the next “block” in the “chain”. Once minted, the token cannot be changed or altered in any way, nor can it be exchanged for another token, regardless of the value (hence, it 

is “non-fungible”).

This technology has proven to be very useful to artists for many reasons. For example, NFTs can not only verify the authenticity of a particular work, but also carry access to additional benefits (think of it as a VIP ticket to a concert with backstage passes). The other, even more revolutionary element of NFTs is that, via the smart contract (part of the underlying code embedded in the NFT), each time the NFT is sold, a portion of that sale can automatically and instantaneously go back to the original holder, which is normally the artist.

This is important because, prior to NFTs, if an artist (e.g. a painter) sold their work to a gallery for $1,000, then the gallery sells the same artwork for $1,000,000, there is no law, statute, rule or industry practice to ensure that the artist receives any portion of the secondary sale. If the artist’s work is represented by an NFT, however, they can build in a mechanism into the smart contract to automatically grant them a portion of that secondary sale, and each subsequent sale, in perpetuity (aka forever).

Overall, NFTs represent ownership, authenticity, and instant royalty payments. These three things are incredibly important for all types of artists, and especially for musicians and music companies, who have been at the forefront of the development of NFTs and related technology. Let’s look at the landscape of NFTs specifically as they relate to music.

HISTORICAL CONTEXT FOR MUSIC NFTS

Believe it or not, the first instance of the sentiment of what a technology like NFTs could do for musicians first came about when David Bowie created the concept of “Bowie Bonds”. Purchasers of Bowie Bonds received a security interest to a portion of the revenues derived from Bowie’s catalog of music.

Unluckily for David Bowie, at the time he predicted this concept, the term “digital asset’’ had not been coined nor was there a blockchain available (though perhaps he traveled to the future in order to gain this knowledge). The biggest limitation for Bowie Bonds was that they were undoubtedly subject to securities regulation, thus limiting the pool of purchasers to those who qualified under the relevant exemption.

To date, we have seen NFTs play out in the music space a little differently than how Ziggy Stardust envisioned, but the concept of buying into an artist’s anticipated revenue from their creations has become increasingly more prevalent in this space.

WHAT ARE THE LEGAL AND BUSINESS ISSUES INVOLVED WITH MUSIC NFTS?

NFT sales come with a variety of legal and business considerations. 

It is important for people using this technology to always keep in mind intellectual property (“IP”) 

rights, royalty administration (especially for music NFTs, which is slightly more complicated), and regulatory related concerns. A few of the important issues we see are:

1 INTELLECTUAL PROPERTY

In any NFT sale, the purchaser does not receive any IP or other rights to the underlying digital asset without express contractual authorization from the rightsholder. The most common example of this came about when Dapper Labs created the “NBA Top Shot” NFTs in 2021. These NFTs contained short video clips of NBA highlights, the rights to which belonged to ESPN. In these very early days of NFTs, there was some confusion as to whether or not selling the NFTs absent the requisite permission violated ESPN’s rights, and what the purchasers could do with those clips.

In short, Top Shot users do “own” the NFT, but the NFT is subject to a license from Dapper Labs (via ESPN) that allows the users to do a limited number of things, such as buying, holding and selling the digital highlight in personal, non-commercial settings. Violating the terms of this NFT agreement could have serious consequences, such as termination of the Top Shot account, rendering the value of the NFT worthless.

Music is no different in this regard. If a musician mints an NFT with the song as the underlying digital asset, then they are not inherently granting ownership of the song to the purchasers. Purchasers of NFTs buy the token itself, and any additional rights to the underlying asset must be granted through a separate contract outlining the specific nature of those rights.

Companies in the NFT space such as the controversial Bored Ape Yacht Club (“BAYC”) have been taking leaps with respect to intellectual property rights, going as far as granting rights to NFT holders that would allow purchasers to freely create their own businesses using the IP in the digital asset of the NFT that they purchased, as well as other broad commercialization rights. However, as innovative as this idea is, this grant of rights is all carefully outlined in the terms and conditions on their website, which functions as the contract subject to which purchasers take the NFTs.

2 ROYALTIES

For those of us working in the music industry, we all know that one of the biggest pain points is tracking down music royalties owed to the artists and other collaborators who contribute to a song’s creation. The breakdown of music royalties and how they are paid out could be a stand alone article, so we will keep it high level for now; but as a basic concept, it is pretty easy to understand that when a song gets played (e.g. on Spotify), the artist gets paid a certain amount.

The tricky part is, the artist is not the only person and/or organization responsible for the song’s creation. The artist performs the song when they record it, but there are a variety of people that also contribute to the final recording. Someone also needs to produce the song, mix the song, promote the song, write the song, the list goes on (not to mention record labels, who typically take a percentage of the future royalties on an artist’s work in exchange for their services)—and all these people need to get compensated for their contribution.

Music royalty administration is carried out by organizations that aggregate and distribute the royalties to the people that own rights to the music. On the ‘master’ side of the royalty (which is calculated based on monies earned from the final recording of the song itself), organizations like SoundExchange calculate and administer the royalties. On the publishing side, PRO’s (or “performance rights organizations”) do the same, but for songwriters credited as such on the record. If that’s confusing, think of it like this: the master royalties go to performers on the record, and the publishing side goes to the songwriters. 

WHAT DOES THIS ALL MEAN FOR AN ARTIST LOOKING TO MINT AN NFT OF THEIR SONG? 

Whether signed to a label or independent, the artist typically retains ownership over a percentage

of their rights to the music. In most record deals, payment to additional rights holders with respect to the recording come out of the artist’s share of the royalties, not the label’s. An artist signed to a deal with a label may not be able to grant rights into the overall song, but they are typically free to administer their own portion of the royalties via contractual assignment.

A very innovative company in the space and longtime firm client, 

Royal.io, has devised a way for artists to capitalize their administration rights with respect to their royalty percentage utilizing the blockchain. Working with artists directly, they provide a platform which allows artists to mint NFTs and hold them for sale. Purchasers of these NFTs receive a contractual right to receive a percentage of the artist’s share of the royalties. The artist directs a lump sum of royalties to Royal.io, who then further distributes those royalties via data contained in smart contracts.

Having done NFT drops with the likes of Nas and The Chainsmokers, Royal.io

encountered some interesting challenges navigating royalty allocations. Ultimately, the artists using Royal.io’s platform, even if signed to iron-clad, multi-year record deals with major labels, still had sufficient discretion to assign a portion of the royalties they controlled with respect to the music. In this way, Royal.io was able

to facilitate the particular artist’s desire to utilize blockchain technology to more closely engage with their fans. Ideally, this concept will inspire emerging artists to continue to expand the direct connection with their communities by leveraging Web3 technology, ultimately allowing fans to directly impact the success of their favorite artists.

FINANCIAL REGULATION

Owning NFTs that allocate a percentage of the royalties of someone’s favorite artist or grant other additional benefits has expanded the connection between the artist and fan in a way that has never been done before, and NFTs are a great way for an artist to build and engage their community. However, operators and purchasers of NFT technology need to be aware of potential securities issues and other regulations when it comes to using blockchain technology and selling digital assets.

As laws around the financial regulation of NFTs and cryptocurrency continue to develop, companies in the space need to work diligently to ensure compliance with relevant legislation regarding securities and commodities laws. Under current legislation, NFTs are typically not inherently deemed securities; however, this isn’t to say that NFTs can’t be securities at all. Whether an NFT is a security is a case-by-case analysis that cannot be applied generally to a particular industry, including music.

The Howey Test is the general standard to determine whether a particular asset class is subject to SEC regulation. This is a three-part test in which the Supreme Court determined that an investment contract exists when there is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others. If an asset does not meet all three parts of the test, it is not an investment contract, and not a security. If the Howey Test is satisfied, then the issuance of the asset must be registered with the SEC, or be eligible for an SEC exemption. So far, we have not seen music NFTs that were not intended to be sold as securities come under SEC scrutiny. 

In general, the main argument that music-related NFTs are not securities is based on the fact that the value these NFTs create is not that of a typical securitized investment contract, but is rather tied to the personal connection that the fan has with the artist’s work. Therefore, the NFT itself does create an expectation of profit, but rather creates the opportunity to allow artists and fans to connect in meaningful ways that were not possible before this technology.

Whether an NFT is deemed a security is one of many considerations that those engaging with the technology need to keep in mind. Other financial regulatory issues that arise when dealing with these types of assets include Financial Crimes Enformcement Network (FinCEN) issues, Know Your Customer (KYC) and Anti-Money Laundering (AML)-related concerns and, most recently, developments in Office of Foreign Assets Control (OFAC) and Commodity Futures Trading Commission (CFTC) regulations. Having legal strategies in place to mitigate risk is a key part of a successful drop.

THE TAKEAWAY

The most important things to remember about NFTs are that they represent ownership, authenticity, and instant royalties for artists, and that they are an innovative way for artists and their communities to support one another. The benefits of widespread adoption of NFTs and blockchain technology are vast and exciting, and for the first time in the industry, artists are leading the way. Whether or not the institutional players in the music industry—for example, major labels—will work hand in hand with artists and technologists in this field to do so, remains to be seen.

Much like online streaming, the impact of blockchain technology on the music industry is here to stay, and innovative artists and companies in the space are creating exciting ways for consumers to engage with the technology every day. With this innovation, like any other, it is important to pay close attention to emerging legislation and always understand the potential legal risks when buying, selling or creating NFTs.

With any NFT transaction, getting a clear understanding of (i) the IP rights granted (or not granted) in the sale, (ii) how royalties will be paid out (either via a smart contract or, with respect to music NFTs vis-à-vis Royal, how those royalties are allocated to new rights holders), and (iii) any potential regulatory implications is key to ensure this technology is leveraged effectively and legally. And in the end, collaboration is key. Artists, technology developers, and lawyers need to have clear lines of communication and collaboration established across the board to make sure everyone involved is adequately protected from any potential legal exposure.

The post From Obscurity to Mass Appeal How Music NFTs are Impacting the Creator Economy first appeared on Jayaram Law.