The Second U.S. NFT Property Is Ready To be Auctioned | Sheppard Mullin Richter & Hampton LLP

Propy has announced that the second US NFT-backed property (see our blog about the first NFT sale here in which we discussed blockchain technology, and specifically how the sale works) is set to be auctioned, with a starting price of 185,000 USDC. USDC is a stablecoin backed by the United States Dollar (we previously discussed stablecoins here).

As discussed in our first blog, this transaction is similar to Propy’s first NFT real property sale in that ownership of the property is transferred by the seller into an LLC that was formed by Propy, and then ownership of that LLC is minted on the blockchain as an NFT. The NFT will then be auctioned on the Propy Marketplace. The NFT itself, which is stored on the blockchain, provides the holder of the NFT with full ownership of the LLC that owns the subject property.

To participate in the auction, the bidder must complete a Know Your Customer (KYC) form. The KYC form requirement is a critical step, both from a regulatory standpoint and from a practical standpoint, as it helps Propy fight against potential financial crime, money laundering, and assists the company with customer identification and verification. This second auction is further evidence that NFT-backed real estate will continue to emerge as a trend with staying power, and it appears evident we are only at the beginning. While this trend is exciting, as with any NFT, there are several legal considerations market participants should be aware of. The following is a non-exhaustive list of potential legal issues an NFT-backed real estate sale may present.

NFT Legal Issues

As we have previously discussed here, here, here, and here, NFT enforcement now seems to be more in focus than ever. According to a recent report, the SEC is probing whether NFTs are being utilized to raise money like traditional securities. The SEC has reportedly sent subpoenas related to the investigation and is particularly interested in information about fractional tokens (such as NFTs). While Propy has been clear that these NFT based real property transactions are not fractional ownership, fractionalization of real property ownership is another emerging trend in the blockchain and real estate space. Fractionalization will likely result in significant legal hurdles that owners, developers, and holders need to be aware of as these transactions become more commonplace.

Other recent regulatory activity relating to NFTs has been occurring at a rapid pace, including a study published by the Department of the Treasury on money laundering and terrorist financing through the art trade, including NFTs (see our blog on the study here). Additionally, the Treasury Department’s Office of Foreign Assets Control (OFAC) sanctioned a Latvia-based digital asset exchange and designated 57 cryptocurrency addresses (associated with digital wallets) as Specially Designated Nationals (SDNs) (see our blog on the sanctions here). These designations appear to be the first time NFTs have been publicly impacted as “blocked property” – as one of the designated cryptocurrency addresses owns non-fungible tokens (NFTs). See our report on this here.

The Propy website also states that the NFT issued in connection with the second NFT-backed real property transfer is a “DeFi asset that can be borrowed against.” Decentralized Finance (DeFi) certainly has benefits, but investors should be aware of the risks this relatively new technology presents, particularly in DeFi lending. On a DeFi platform, lenders allow users to offer cryptocurrency loans in a permissionless manner without an intermediary. Financial institutions are required to follow anti-money laundering (AML) and Know Your Client (KYC) laws. Both AML and KYC obligations require the financial institution to conduct prerequisite due diligence which requires the institution to know their customer’s identity to ensure that they are not on any sanction lists, etc. Additionally, the SEC has recently expanded its campaign against crypto lending and indicated that it may constitute a security under the Howey test.

There are many other legal issues NFTs and tokenized real estate assets may raise depending on what they represent and their use.

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