Connect the DOTs

All the hype around crypto art raises concerns about fraud and counterfeiting in an unregulated market. NFT experts Joshua Chu and Julian So explain how digital ownership tokens shield the creator and owner from such threats

As virtual assets made a comeback in 2021, one new edition in the spotlight was non-fungible tokens (NFTs). Crypto sceptics commonly argue there is no tangible property associated with NFTs, so they are just hype with no value.

However, with acknowledgment that intangible assets such as intellectual property have been traded for centuries, the real overlooked issue is whether traders are aware of the underlying value of the asset they purchase, namely, ascertaining what they are buying and its value, with due diligence.

NFTs are not interchangeable, and unique as a collectible digital or physical item. They can be a single edition or a limited number to ascribe a rarity value.

The most common problem with NFTs early on was storage location, in a centralised or decentralised server. Underlying smart contracts in NFTs are merely computer codes that facilitate the settlement of a sale and purchase transaction, including the payment of fees, but do not convey any legal rights.

Unless the NFT takes the form of a hybrid smart contract, with specific natural-language terms built into the code, it can’t be deemed a legally binding agreement.

Without purchasers and subsequent vendors having a basis of assessing fair value of the underlying asset to their NFTs, value significantly risks fluctuating unpredictably, as its foundation is based completely on emotion.

Digital ownership tokens

A digital ownership token (DOT) is created by utilising blockchain and NFT technology tools available on blockchain platforms, with a unique identifier to reflect the digital ownership title to a tangible or an intangible asset.

A DOT embeds legally binding ownership documentation into its metadata and secures such metadata on a blockchain.

The underlying asset of a DOT will usually be accompanied by the following documents:

• A sale and purchase agreement acquiring the underlying asset from the owner;
• A representation from such owner that it is the legal and beneficial owner of such underlying asset, and has the power to make the sale;
• A transfer deed that transfers the underlying asset to the holder of the DOT;
• A third-party independent valuation or appraisal report on the underlying asset, where appropriate; and
• All associated legal documents.

Therefore, DOTs solve the issue with most NFTs, namely, identifying what the purchaser is in fact buying, assignment of legal rights, and ascertaining the value of the underlying asset.

DOTs will also satisfy requirements by regulators when it comes to virtual assets.

This was echoed by the Monetary Authority of Singapore in 2022, which stated: “Blockchain, tokenisation and cryptography can be deployed together to enable the fractionalisation of high-value assets and monetisation of previously un-monetised assets. This will in turn help to unlock new economic value, enhance financial inclusion, and enable more seamless and efficient provision of financial services.”

While regulators have expressed concerns over “blank virtual assets” (virtual assets with nothing within), they have also shown interest in DOTs.

Some DOTs will include metaverse integration features and augmented reality features. For example, imagine having an antique or painting with a museum curator explaining how it is genuine, its history and historical value, all built into the metadata of the DOT.

The benefits of DOTs will therefore carry forward, both in the virtual and physical realities.

For example, a hybrid DOT, also known as a H-DOT, will include the following legal instruments embedded into its metadata and secured on a reliable blockchain: sale and purchase agreement; evidence or warranty of ownership; transfer of sub-licence detailing holder rights; and image, video, music or other file.

H-DOT owners can confirm ownership and/or licensing rights from the legal documents minted into them. A QR code is usually employed pointing to all related legal documents.

Legal rights

A DOT can resolve the issue of unauthorised copying of NFTs as a legal contract by specifying the intended contracting parties. It contains terms of ownership, licence and rights, and available legal recourses if third parties breach any of them.

Currently, under common law, the foundation of any contract includes the pillars of privity of contract, and offer, acceptance and consideration.

While NFT bootleggers will be able to copy pure codes containing hyperlinks to where a virtual asset is stored, the same cannot be done against a DOT because of the prevailing contract law principle.

For example, the doctrine of privity of contract provides that a person cannot acquire and enforce rights under a contract if not a party, and a person who is not a party cannot be made liable under it. This doctrine is enshrined in The Hong Kong Contracts (Rights of Third Parties) Ordinance (cap 623).

Therefore, an NFT bootlegger cannot simply clone a DOT, as they have no privity to the legal instrument in the DOT. Accordingly, only a legal owner of DOTs can enforce their legal rights.

Conversely, contracts that are embedded into the tokens of DOTs can also address the issue of proper offer, acceptance and consideration.

In the past, intellectual property rights to NFTs were at times only an afterthought, as there was no assignment of these rights at the time of issuing the initial NFT. Problems arise when intellectual property rights are merely “granted” retrospectively via centralised terms and conditions; contract conditions of offer, acceptance and consideration for such intellectual property rights are not present.

It should be noted that attempts by many NFT issuers to rectify earlier issues of not assigning rights by amending and issuing a centralised set of terms and conditions betrays the very notion of blockchain, which enshrines decentralisation.

Consideration is also essential where one side gives up something in return for an expected return, and should comprise the following criteria:

• Through negotiation where terms are laid out by both parties;
• Mutual exchange is accomplished, where both parties gain something; and
• The exchange must be of value in some way (it is not the court’s place to determine the value).

As such, it cannot be said there exists proper consideration of a right that is retrospectively assigned to a buyer. Prior attempts by NFT projects to retrospectively assign intellectual property rights to token holders may have ended up ineffective owing to the failure to comply with basic criteria for contract and consideration.

Legally speaking, the only way for proper ratification of various past NFT projects is to simply re-issue tokens with all the proper new contracts embedded. However, this is logistically difficult because many tokens have already been assigned via secondary sales, where the initial issue of a privity contract will return to haunt new NFT holders.

Only the real owner of a DOT will be able to take the necessary legal action, as stipulated in the legal contract, against breach of that owner’s digital ownership rights. DOTs can adequately protect token holder’s rights under Hong Kong laws and common law.

Seamless and paperless

One of the greatest complaints against the legal profession is how environmentally unfriendly it has become. Not only is a paper transaction unsustainable, it also takes time. A typical paper transaction will encounter substantial lag time if going through lawyers preparing relevant transaction documents – sometimes taking months to complete.

The current state of a secondary market for untokenised assets is akin to stock market trades in the ’90s before the internet, where a broker is called to manually complete a transaction, as opposed to using an automated market maker today. It is highly doubtful that traders would accept a full day’s delay for trade in today’s stock market.

By tokenising assets into DOTs, secondary trade can be transacted digitally, achieving both the commercial goals of quick transaction and sustainability objectives. The DOT to commercial papers is therefore akin to an automated market maker, enabling far greater transaction scale.

The legal framework to enable seamless, instantaneous and paperless property transactions in Hong Kong already exists, found in the Conveyancing and Property Ordinance (cap 219), Land Titles Ordinance (cap 585, not yet in effect), and Electronic Transactions Ordinance (cap 553).

But despite passage back in 2004, the Land Titles Ordinance has stalled owing to competing interests of paper-based conveyancers and technology resistance.

The result, sadly, is that conveyancing transactions still require substantial time to complete, averaging no less than six months, while parties are at the mercy of market uncertainties, with the slightest shift in markets seeding potential disputes.

The introduction of DOT technology is the last piece of the puzzle that will finally propel conveyancing in Hong Kong to the modern age.

By seamless and paperless transactions, not only will Hong Kong’s economy benefit from increased transaction volume with plentiful completion. Billings can also potentially, one day, become a passive and automatic income stream, freeing lawyers to focus on lawyering again, instead of being bound by billing hours.