Tokenization is the process of taking real-world assets and having them represented by digital tokens that can be traded on a blockchain. Tokenization can be a valuable tool for automating business processes and facilitating investment in fractional portions of an asset. However, the success of any tokenization project depends on the laws applicable to the asset being tokenized and the terms and conditions governing the project. Contrary to what some might think, rights in the asset represented by a token do not generally transfer to a buyer on the sale of the token.
Background
Any value or right can generally be represented through a unique token that may be transferred and stored electronically using blockchain or similar technology. The process of mapping values (including real-world assets) to a token is commonly referred to as tokenization. Tokenization is expected to be leveraged in all kinds of assets, such as real estate, equities, and bonds. Unlike certificates, for example, tokens can be transferred between users globally without any intermediary involvement, which can reduce transaction time and costs. Blockchain-based transfers also make it easier to track ownership and automate the transfer of assets, leading to more liquidity, transparency, and accessibility.
Some tokens represent assets that are readily interchangeable (e.g., fiat or crypto currencies). These tokens are considered fungible in that they are identical to each other and can be traded for equivalent value. Due to their high fungibility, these tokens can have a financial use and activities surrounding them may be regulated. Other tokens are unique and not fungible with other tokens, e.g. because they represent digital pieces of art or physical assets. These tokens are commonly referred to as non-fungible tokens (“NFTs”). Their value is attributable to the unique characteristics of the asset underlying each token and the utility it gives to the token holder.
Transfer of Ownership Rights in the Underlying Asset
Ownership of an NFT does not necessarily amount to ownership of rights in the underlying asset that the token represents. For example, physical objects are subject to ownership rights. When a token represents a physical asset (e.g., a piece of fine art), ownership in the physical asset does not necessarily transfer to the buyer on transferring the token. Some legislation has addressed the disconnect between physical objects and their digital token twins. For example, under Art. 7(1) of the Liechtenstein Token Act, the transfer of the token equates to the transfer of the right embodied in the token provided that transfer is lawful and contractually permissible. Similar clarity does not exist in other jurisdictions yet.
Businesses should therefore carefully consider what they want to sell or acquire when they engage in tokenization projects. This is especially true when it comes to real estate tokenization, which is the process of fractionalizing real property into tokens. Since the transfer of ownership in real estate typically requires other actions such as notarization (which cannot be substituted by the transfer of the token), it simply will not be possible to transfer ownership in real estate assets with the transfer of the token. Real estate tokenization projects may even have securities law implications—for example, when a token represents a right to share in the profits generated by real property.
Licensing of Intellectual Property Rights
Some NFTs may represent assets subject to protection by IP rights (e.g., digital art). As with ownership rights, rights to use and exploit the asset (e.g., to display and commercialize the art) do not necessarily transfer on sale of the NFT. Rather, the extent to which rights are transferred will depend on the terms and conditions stipulated in the smart contract or elsewhere. As a default, the sale of an NFT does not include commercial use rights that vest in the underlying asset. So a buyer would only be able to use the asset for personal, non-commercial use (e.g., display in a virtual gallery or as an avatar). To avoid legal disputes over what rights are granted as part of the sale, the terms of sale of the NFT and/or the smart contract encoded in the NFT should clearly set out what is permitted and what is not with respect to IP rights.