Introduction
Since gaining popularity in early 2021, Non-Fungible Tokens (“NFTs”) are finding a new use in property transactions. NFTs are digital assets created on a block chain usually in the form of an image or short video. A block chain is a digital ledger facilitating peer-to-peer transactions. In 2021, the first recorded NFT property transaction on the Ether block chain involved the sale of an apartment in the Ukraine through an auction. The company facilitating the transaction, Propy, Inc., (“Propy”) explained that ownership of the property was actually held and recorded in Ukraine as a U.S. Limited Liability Company (“LLC”). The auction winner became the owner of the NFT that granted the rights to the LLC, with the owner signing proprietary-developed legal papers for NFTs to transfer ownership to all future buyers. The auction winner purchased the NFT evidencing ownership in the LLC, and by extension, became the owner of the property held by the LLC. Propy recorded the physical deed under Ukrainian law with a reference to the LLC’s NFT address.
On February 10, 2022, in Florida, Propy facilitated the first successful U.S. based NFT property sale for 210 Ether or $652,289.40 using NFT and block chain technology. Propy used essentially the same method used in the Ukraine to conduct the property transaction in Florida. Propy also completed a second NFT property sale in April 2022, selling a condominium for 185,000 USDC in Florida using NFT and block chain technology. This article explores banking considerations in light of NFT evidenced property transactions becoming more frequent, specifically how a bank can foreclose on property evidenced by an NFT.
NFT Property Transactions
As the use of NFTs in property transactions continues to grow, banks will confront many novel issues relating to NFTs. Because an NFT is a digital asset existing on a block chain, an NFT has attributes similar to a cryptocurrency, which also exists on a block chain. Like a cryptocurrency, an NFT can be controlled by a smart contract, which controls the functionality of an NFT. An NFT can be coded to be fractionalized into separate individual tokens that each alone represent a portion of ownership in an NFT. A fractionalized token has implications for ownership, financing and governance. The person or entity who controls a fractionalized token can obtain financing by offering fractionalized tokens as collateral for a loan. A property sold as a fractionalized NFT could also have many owners since each fractionalized token would represent ownership. NFT smart contracts can be coded to include voting rights based on a fractionalized token holder’s proportionate holdings (i.e., one token equals one vote). NFT smart contracts also can be coded to require commission be paid to the original seller and listing agent at every subsequent sale. These are a few examples of the possibilities NFTs offers in property transactions.
However, these possibilities are not necessarily new. Voting rights and fractionalized ownership are concepts currently used in the stock market. The difference here is these transactions are conducted using the block chain, which is completely secure and public. In a property context, fractionalized tokens evidencing property ownership make it easier to facilitate many owners of a property and easier to track ownership because all the transactions are publicly available on the block chain. If voting rights were coded into a smart contract, fractionalized token holders could vote on property related decisions including whether to sell or make improvements and repairs.
Because the block chain is public and cannot be altered, the block chain would be a substantial improvement for property transactions. If implemented, block chain technology eliminates many transactional barriers and would reduce the need for certain paperwork.
The block chain also eliminates the need for title insurance because the transactions are almost instantaneous and public. Anyone can find transactions and verify ownership on the block chain with an NFT’s corresponding unique address. This would substantially cut down on fraud because the unique NFT address cannot be changed or copied to another NFT. Block chains can be searched through certain websites, similar to a search engine, depending on which block chain the transaction occurred on (i.e., Ether or Bitcoin block chain), to verify ownership. Furthermore, the block chain cannot be edited. Once a transaction is completed no hacker or scammer can enter the block chain and change content on or about an NFT.
While property records can currently be searched online through County Recorders’ websites. Using the block chain could limit the need for government involvement in property transactions. If block chain technology could be adapted as a safe, secure and public method of conducting property transactions, it would remove the need for certain government responsibilities. However, the likelihood of limiting government involvement in property transactions is low. If block chain technology rose to prominence enough to curtail government involvement in property transactions, it is more likely the government would create its own platform on the block chain to facilitate property transactions. Then require citizens to maintain their NFTs evidencing property transactions on the government’s block chain to be valid and enforceable. In the immediate future, it is more likely a government will recognize NFT deeds as binding and enforceable, and make NFT deeds subject to the same or similar laws as current physical deeds.
One example in the U.S. of NFTs being officially recognized by a government is in South Burlington, Vermont. The city is experimenting with the implementation of NFT deeds, including uploading deeds onto the block chain, allowing for deeds to be transferred electronically and allowing the municipality to recognize the deeds on the block chain as valid. South Burlington will serve as an example for how governments can implement NFTs.
NFT Implementation Barriers
While the block chain presents many property transaction opportunities including more easily facilitating common ownership and removing costly barriers, the practical application is uncertain. Most courts in the U.S. have yet to recognize an NFT evidenced deed as binding and enforceable, except to the extent Vermont recognizes the validity of NFT evidenced deeds. When Propy sold the apartment in the Ukraine, Propy recorded the LLC’s ownership of the NFT on the block chain and a physical deed with the government in the Ukraine. The transaction has yet to be challenged by the Ukrainian government. Because Propy recorded a physical deed, the transaction likely would be considered legally binding and enforceable under Ukraine law. Until a state or the federal government of the U.S. recognizes NFT deeds as binding and no longer requires physical deeds, it is best to follow Propy’s example. It is unlikely a paper deed system will cease due to the sheer amount of work to code existing recorded deeds onto the block chain in each jurisdiction.
Another issue for NFT property transactions is its ease of use. The block chain and NFTs are complex technology, to properly use the technology a person must understand coding, smart contracts, contract addresses, digital wallets and fees, known as gas fees, among other concepts. Even though NFT property transactions may remove certain transactional barriers, removing those barriers may not be a benefit for some. While third party intermediaries increase the transactional cost, they also serve as liaisons to assist consumers in the process of buying or selling property. Most consumers will likely need third parties to assist them in the buying or selling of property using the block chain because of its complexity. Just as in the financial industry where most consumers seek out financial advisors because of the complexity of financial markets. Consumers will seek out block chain real estate professionals to facilitate the sale or purchase of property. Inevitably, third party intermediaries will appear to assist consumers in buying or selling property on the block chain. Proponents of implementing block chain and NFT technology into property transactions claim it will remove the need for third party intermediaries. However, in practice, it will only shift the market for the same third party intermediaries to aid in the process of property transactions through the block chain.
As shown by the increased acceptance and popularity of cryptocurrencies, NFT deed adaptation could quickly occur. However, it is unlikely in the U.S. to occur soon in light of questions regarding the enforceability and complexity of the technology. If NFT property transactions could be adapted to be similar to ordering food on a mobile app, the technology would be integrated and accepted quicker by the public and governments around the world. For example, Coinbase created a user-friendly and simple interface to purchase, sell and exchange cryptocurrencies. Companies who want to be the industry leaders in NFT property transactions must find a way to adapt the technology for simpler, faster and easier use.
NFT Foreclosures Procedures
Based on the current state of NFTs in property transactions, banks must consider what steps to take in a foreclosure action of an NFT evidenced property transaction. Even though NFT property transactions will be rare, it is still an issue banks will inevitably encounter. Banks first need to consider how the transaction was conducted. If a property was purchased following Propy’s example, then a bank will need to consider if the mortgagor is an owner of an LLC that actually holds ownership in the property. A bank may then need to foreclose on a property as if foreclosing on property owned by a business.
Another consideration is whether or not NFT deeds are recognized in the jurisdiction of the foreclosure. If NFT deeds are recognized, then it is important to consult with local counsel regarding the procedures under applicable law to foreclosure on property evidenced by an NFT deed. Whether or not NFT deeds are recognized by the relevant jurisdiction, a bank should require a mortgagor to transfer an NFT evidenced deed to a digital wallet owned and controlled by the bank in accordance with any applicable banking laws and regulations. Even if NFT deeds are not enforceable as of the date of the foreclosure, they may be in the future. Requiring the mortgagor to transfer the NFT to the bank avoids raising the issue of its enforceability in a court while eliminating the future possibility of ownership confusion.
If a bank asks a mortgagor to transfer an NFT deed, the bank should be prepared to pay the gas fees for the transfer. The mortgagor’s property is likely being foreclosed on because of the mortgagor’s financial difficulties, it is unlikely they could afford the gas fees to transfer the NFT deed to a bank. Another option is to add a gas fee provision in mortgage contracts that upon default would require a mortgagor to pay gas fees. If a mortgagor failed to provide the gas fees, then a bank could include the gas fees as the total amount owed in foreclosure. However, as of the date of this article, no court has determined the validity of a gas fee provision in a mortgage contract. Gas fee provisions also could be subject to state law fee restrictions. A bank should follow all applicable federal and state foreclosure and mortgage laws when conducting a mortgage transaction and foreclosure. Additionally, a bank should consult relevant regulatory guidance before acquiring an NFT.
Conclusion
While the process used by Propy seems underdeveloped and the validity and practical use of NFTs is still uncertain. Propy’s example shows that emerging NFT technology will eventually play a larger role in property transactions. Many companies are already integrating block chain technology for business purposes. Banks must consider what affect these technologies will have on their business activities, especially foreclosures, and prepare for NFT and block chain technology becoming part of normal business activities.
The author, Nathan D. Copeland, is an associate with Dreher Tomkies LLP.
