The Ethereum Merge: what does the hard fork mean for my NFT licenses?

Abstract building - red

Intellectual Property and Technology Alert

By:

Proclaimed to be “the most significant upgrade in the history of Ethereum,” the long-awaited Ethereum Merge is finally slated to occur in mid-September. The existing execution layer of Ethereum will transition from a proof-of-work protocol (POW) to a proof-of-stake protocol (POS), which is intended to improve the blockchain’s energy efficiency and increase its transaction throughput.  

The consensus protocol is the core element of all blockchains: since it determines the “correct” block in the blockchain, it confirms what data and transactions should be added to the blockchain record.

However, despite the expected benefits of POS many miners who have kept the Ethereum blockchain running in the years since its inception have invested significant resources in the POW model – resources that will be devalued in a POS model.

If a significant number of Ethereum users continue using the POW model, the blockchain could fork into two separate blockchains – ETHPOS and ETHPOW (the Ethereum Merge will not directly affect the existing Ethereum Classic blockchain, which uses POW).

Post-Merge hard fork

If a hard fork does occur on Ethereum, it would raise unique questions for many token ecosystems built on top of Ethereum such as governance tokens; non-fungible tokens (NFTs) and tokens linked to real-world products. Here, we will focus on the effect on NFTs because Ethereum is the dominant chain for most NFT issuances. 

Blockchains have experienced forks in the past, but the Ethereum Merge is unique in many ways because of the many applications built on top of it. For example, the original, and largest, blockchain, Bitcoin, has forked innumerable times since its launch in 2008. However, the Bitcoin blockchain does not have NFTs based on it. And while Ethereum underwent a major fork in 2016 due to a hack that drained The DAO of 3.6 million ether, creating Ethereum and Ethereum Classic, NFTs had not yet become a major application on the Ethereum blockchain.

When a hard fork occurs, the blockchain is duplicated, and every transaction prior to the fork is the same on both blockchains up to the fork. Then, like a tree branching out, future transactions on the separate blockchains diverge and are determined by each blockchain’s separate protocol.

While many people buy NFTs to own an avatar, an artwork, or an event ticket, in reality purchasers are usually receiving a tokenID (stored on a blockchain) and metadata that refers to a form of storage where the artwork resides (such as AWS or IPFS). In a fork, the tokenIDs the purchaser received before the fork duplicate and continue to exist on each blockchain. So, in the case of any fork that occurs after the Ethereum Merge, new NFTs will either be minted on the ETHPOW blockchain or the ETHPOS blockchain, but any NFTs that existed on the Ethereum blockchain prior to the Merge will duplicate and exist on both ETHPOS and ETHPOW.

Questions about NFT licenses in a hard fork

Although US copyright law does not automatically grant buyers of artwork the right to reproduce, adapt or even publicly display the artwork, often NFT creators will license such rights to purchasers when they buy an NFT. But some interesting questions arise in the event of a hard fork and the subsequent duplication of the then-existing Ethereum NFTs and their continuing co-existence on the divergent Ethereum blockchains, which NFT holds the license to the artwork that was granted to the purchaser when they bought the NFT from the creator? Does the license exist on the ETHPOW blockchain or the ETHPOS blockchain? And who decides? The NFT creator? The NFT holder? If the NFT holder sells the NFT to a buyer on the ETHPOW blockchain, but continues to hold the NFT on the ETHPOS blockchain, does the license remain with the holder or transfer to the new purchaser?  

Since licenses are not applied consistently across projects, the answers to these questions depend on the license agreement entered into between the NFT creator and the original purchaser. In the absence of clear guidance from the license agreement, however, the ownership of the license may be ambiguous and disputes may arise between the parties. The recent CryptoPunks License Agreement from Yuga Labs is an interesting example: the agreement expressly permits Yuga Labs to “designate” which NFT on which chain holds the license agreement. This approach was also followed by Can’t Be Evil template licenses published by a16z (DLA Piper participated in drafting those licenses).

Indeed, there exists legal precedent allowing blockchain service providers to delineate their responsibilities in the event of a fork. In Archer v. Coinbase, a California appellate court affirmed summary judgment in favor of a cryptocurrency exchange against a user who had claimed that the exchange was obligated to provide him access to all forked versions of the Bitcoin he had in his exchange account. The court reasoned that the exchange’s user agreement contained no term obligating the exchange to support all forks. Following Archer, blockchain asset trading platforms (including NFT trading platforms) often expressly provide in their terms of service that they retain the right to determine which of any blockchain forks they may support.

As a matter of best practice, NFT issuers should provide clear guidelines on how they will deal with forks in their license agreement to avoid disputes later on. 

Learn more about the implications of the Ethereum merge and potential hard forks by contacting one of the authors.