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When is an NFT drop not an NFT Drop? When it’s an Illegal Lottery

Rare Monsters

An increasingly popular feature of NFT drops is a delayed reveal of the art behind an NFT, typically known as a “Mystery Drop”. In a Mystery Drop, it is only after you buy the NFT (normally for a set price) that the NFT (and its art) is revealed to you. The allocation of NFTs to buyers is purely by chance.

Mystery Drops seek to emulate popular trading card games such as Pokemon, where you buy a pack of cards, not knowing its exact contents, and it is only upon opening the pack that you discover if you have a super rare character card, or a less unique one. The rare trading cards typically attract a higher price on the aftermarket, and the same is true with Mystery Drop NFTs.

How it often works in a Mystery Drop is, out of all the NFTs in the drop (typically thousands), there will be a small number of unique or rare NFTs that will be more sought after and therefore valuable, than others. Mystery Drops are therefore very attractive to speculative buyers.

Sounds like a Gamble…

In the UK, a Mystery Drop runs a high chance of being classed as a lottery.

So, what is the problem with that?

Lotteries in the UK are illegal unless they fall within a special category of legal lottery, under the Gambling Act 2005. Unless they fall within an exemption, lotteries may only be operated under licence from the Gambling Commission.

Why is the Mystery Drop likely to be a lottery?

In the UK, a “lottery” is a type of gambling, which has three essential elements:

    1. you must pay to enter the game;
    2. there is at least one prize; and
    3. prizes are awarded purely by chance.

With a Mystery Drop, it can be said that buyers are on notice of the lottery element of the drop at the time of purchasing the NFT; buyers know they are paying to enter into a game. By purchasing a Mystery Drop NFT, you are automatically entered into a prize draw. The first element (a) of the above is therefore present.

The second (b) and third (c) elements are likely also present in a Mystery Drop, as there are some more highly prized (valuable), rarer NFTs, and they are awarded purely by chance.

Most Mystery Drops therefore run a high risk of being classified as lotteries in the UK.

Avoiding a Lottery

It may be possible to avoid being caught by gambling regulation if a Mystery Drop can meet the criteria of a “Prize Promotion” (which is not regulated by the Gambling Act). To avoid regulation, prize promotions are commonly run as follows:

    • A free prize draw (which removes the requirement to pay to participate); and
    • A prize competition (which removes the determination of winners by chance).

Satisfying the above for a Mystery Drop is however likely to be very difficult, as it is necessary to buy an NFT to enter: the NFT is the purchase price, such that the prize draw is not free. The second “competition” element of a Prize Promotion will also not be satisfied if there is a random allocation of (rare) NFTs.

Plagued by Problems

The Mystery Drop also presents a risk from a consumer and contract law viewpoint.

There is a serious concern that selling something to a consumer where they do not know what they are getting is a breach of consumer rights. Further, the sale of an NFT is a contract for sale, however where the goods the subject of the sale (the mystery NFT) are unknown, it creates uncertainty which can allow the contract to be set aside. In other words, a buyer could make a legitimate demand for the return of their purchase monies in the future.

Conclusion

We have seen that it is easy for a Mystery Drop to be classed as an illegal lottery in the UK, risking legal intervention and prosecution from the authorities; the Gambling Commission and FCA both have said NFTs are squarely in their sights.

There are also consumer and contract issues to consider, which could leave NFT sales open to future legal challenge.

There have already been cases in the US, challenging Mystery Drops for the above reasons, and it is foreseeable that litigation and regulatory enforcement will follow in the UK.

A common question is often whether an NFT project creator can put visible warnings in the associated whitepaper and/or smart contract to disclaim any uncertainty or regulatory liability on their part: the answer is unfortunately, no.

Recommendation

Our recommendation is to approach an NFT project from a logical and strategic standpoint, taking into account the regulatory backdrop and other legal considerations before you promote and market your project.

We consider in further detail the key legal elements of an NFT project, for review here.

If you would like to discuss this further, please contact our Head of Intellectual Property Will Charlesworth.

Will Charlesworth

 

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