Impediments In Regulation of Different Types of NFTs: Inadequacies in the Indian Statutory Framework

The authors are Aditya Singh and Parth Kanthak, second year students at NLSIU, Bangalore.

Introduction

Non-Fungible Tokens (NFTs) have exploded in the digital asset market. It, however, has not been all rosy for the buyers. NFTs, being a new occurrence in the digital assets market, have their share of drawbacks due to lack of regulation. Cases such as the arrest of Nathanael Chastain, a former employee of OpenSea, for insider trading, wire fraud etc as he used the special knowledge to purchase NFTs going to be listed on the platform beforehand, have shown how potential pitfalls such as price manipulations, money laundering, wire frauds, tax evasions etc, that were earlier speculated, are indeed real and possible. But the larger problem is the difficulty that the law enforcement agencies might face in holding them accountable for the same. Although isolated cases lying at the fringes of the existing legal framework could be solved, this is not a sustainable long-term approach towards a quick, compliable and decisive regulation.

In this article, the authors shall attempt to analyse how the existing legal framework is inadequate to accommodate NFTs, in turn, hinting towards the need to consider NFTs as a sui-generis asset class and creating special regulations for them. To that end, we will firstly, look at the jurisprudence around the Sale of Goods Act, 1930 and whether different types of NFTs can be incorporated within its purview as therein lie the basic rights of buyers and sellers. Secondly, we will first refute the positions taken by pre-existing literature on categorization of NFTs as derivatives and securities and also lay down our stand on the same as regulating NFTs under the Securities Contracts Regulations Act, 1956 (“SCRA”) will bring it under SEBI’s jurisdiction.

Sale of Goods Act, 1930 (“SOGA”)

For something to be under SOGA’s domain, it has to be a ‘good’ under S. 2(7) of the act. Now, in the context of NFTs, there are two conflicting sets of jurisprudence. The first, according to which an NFT can be brought into consideration as a good, is a three-pointer test laid and developed collectively in the cases of TCS v. State of Andhra Pradesh and BSNL v. Union of India. The Supreme Court held in these cases that what has to be looked at is firstly, the item’s utility, secondly, its merchantability and thirdly, whether it is transferable, storable and deliverable. Applying the same in the context of NFTs would require a consideration of the fact that different types of NFTs have different uses. While a very popular one is digitalization of artworks and memorabilia to enable collection with an underlying aim of reselling with appreciation in price. Certain NFTs are used by companies for loyalty programmes because of their traceability and ability to be operated via a blockchain. These can be used to give customers access to various activities on metaverse and Web 3.0 which will, in turn, fetch rewards such as hidden discount codes for them. The latter does not have utility, similar to that of a good. Hence, reinforcing the point that if rights contained in SOGA are to be given to buyers and sellers of every type of NFTs, a separate statute or regulation mandating the same is required. The second criterion i.e., merchantability, depends on the clauses of the smart contract in which the token is encapsulated. If it permits further buying and selling, then this criterion is fulfilled.

Of the three conditions in the last criterion, storability is satisfied by every NFT as they are stored on different blockchains. However, the water muddies with deliverability and transferability. One issue is that the two terms have been used interchangeably in the judgement and neither of the terms have been defined, creating a lot of ambiguity. However, to reconcile, we will consider the two together and see the item, the possession of which has been delivered and the title that has been transferred with it. Now, after the implementation of the first criterion, what's left with us are NFTs that are or are of similar nature to art or memorabilia, NFTs which have utility similar to that of goods. Even in this, in case of most NFTs, the buyer does not get the title to the artwork but to that particular token with a unique id and metadata encapsulated in a smart contract.

This gives way to the other side’s arguments that NFTs may not actually be goods at all. To go back to the definition of NFTs, they are cryptographic representations of ownership of a digitalized item wherein the process involves tokenizing, for example, a digital art. Hence, it is deriving its value from something else. This is also reflected in another form wherein scholars have opined that NFTs are derivatives as it is a contract deriving its value from something other than itself. Whether it is a derivative under the SCRA is a separate debate but it can be said that its broad nature is that of a ‘derivative’. In the case of R.D. Saxena v. Balaram Prasad Sharma, the court considered this as one of the criteria in not holding property papers etc as goods. Even in the instant case, that token is merchantable because something is backing their valuation. There was a similar holding in the case of Sunrise Associates v. Govt. of NCT of Delhi in context of tickets wherein it was held that it is a “memoranda evidencing the transfer of certain rights”. To conclude this line of thought, we fully acknowledge that there is an argument to be made from both sides that NFTs may or may not be categorized as goods. However, as we have shown, the scope is still limited to one use case of NFTs. This in no way creates a scope for uniform standards of efficient enforcement guaranteeing buyers and sellers a minimum standard of rights across NFTs with different use cases which is multiplying with time.

Securities Contracts Regulations Act, 1956

With the entry of small investors and possibilities of price manipulation by creating false demand through circular trading, pumping and dumping by wealthy investors or accumulating profits by insider trading, it is the need of the hour that NFTs be subject to similar standards of scrutiny as conventional securities and derivatives. While a strand of the circulating opinion on the subject has been that NFTs are derivatives, we argue that they may be derivatives in general economics parlance, however, that is not the case going by the SCRA. Going by the wordings of S 2(ac)(A), an NFT firstly has to be a security as per the standards defined in S 2(h), hence, it being derived from a risk instrument is immaterial and as per clause (B), the smart contract is required to derive its value from the price of an underlying security which is not the case here.

We also differ from the other strand that NFTs are not securities as they are ‘non-fungible’ but NFTs that bestow ownership may be categorized as securities because firstly, to apply the test of ejusdem generis, in order to classify an instrument as ‘other marketable securities of like nature’, the common elements of the pre-stated instruments need to be considered. The elements that shares, scrips, debentures etc have in common is that they are instruments evidencing something such as ownership or other parties’ liabilities, issued to the public at large with scope for appreciation/ returns or depreciation, hence, ownership and non-fungibility do not appear to be relevant criteria in this context. In our opinion, another relevant criterion which has not been considered by this school of thought but is pertinent to note is that the instruments have to be of an “incorporated company or a pooled investment vehicle or other body corporate” but NFTs do not have management or administrative structures like these corporate bodies.

One scenario through which NFTs can be classified as securities is under S 2(ib) as a ‘collective investment scheme’ if the structure of consideration is such that money of multiple people has been collected and invested across one or multiple NFTs. This mode of investment in NFTs is gradually gaining traction with NFT marketplaces allowing partial or fractional purchase and a silver-lining of this is that regulatory protection can be offered to vulnerable investors with limited corpus, market access and information as such paths of investment are normally used by the above-described investors. Despite this, most of the NFTs are free from regulation as securities or derivatives and the need for the contrary has sufficiently been outlined.

Conclusion

Through the course of this article, we have attempted to situate NFTs within the existing Indian statutory framework. As is evident, it has yielded mixed results. Although one could situate NFTs within the framework of SOGA, these operate on the fringes offering only a temporary solution and even in this, there are substantial arguments available on the contrary leading to various drawbacks such as creating room for inconsistencies and making enforcement inconvenient. Secondly, even in case of SCRA, very limited types of NFTs can be regulated and the scope to accommodate the other types does not even lie at the fringes.

Hence, to comprehensively regulate NFTs and restrict its detriments, specific legislation containing aspects such as granting basic rights to buyers and sellers, prohibiting insider trading and penalizing various methods of price manipulations should be enacted across all NFTs with different use cases.