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Although the emergence of virtual “real” estate in the metaverse presents a unique opportunity for the commercial real estate industry, there are risks associated with virtual real property.
In our previous alert, Real Estate in the Metaverse: What Is Virtual Real Estate? Why Does It Matter?,[1] we provided a brief overview of what the metaverse is and why the commercial real estate industry should take notice. This alert discusses four risks that investors should consider before purchasing virtual real property.
Risks to Consider
The unique nature of virtual real estate presents inherent risks that investors should be aware of. In addition, the novelty of the metaverse has allowed scams to flourish. We have summarized four risks that we believe all investors should be aware of before transacting in the metaverse.
1. Platform Operators Control Virtual Real Property Rights
There are some obvious differences between traditional real estate and virtual real property that create unique risks for investors. Physical land and improvements are directly perceived by our senses, while virtual real estate can only be perceived through a medium. In other words, virtual real property can only exist on a platform. Therefore, should a platform’s operator restrict an owner’s access to the platform or delete the platform entirely, owners of virtual real property in the platform would be left with no property rights and little, if any, recourse.
A platform operator can draft terms of use how they see fit, as virtual real property owners must accept terms as is. Indeed, most metaverse platforms incorporate terms of use that insulate the operator from liability and enable the operator to exert influence over virtual real property rights with broad discretion. As noted in our previous alert, the current market is saturated in four primary platforms, including The Sandbox, Decentraland, Cryptovoxels and Somnium. Under Decentraland’s[2] terms of use, the platform’s operator has no continuing obligation to ensure the platform’s longevity and “may cease to operate . . . in the future, at its exclusive discretion, with no liability whatsoever in connection thereto.”[3] Likewise, the operator of The Sandbox[4] may, “in its sole discretion” and at any time, block an owner’s access to the platform and terminate an owner’s rights to create and upload content.[5] The Sandbox’s terms specify that a banned or restricted owner retains title,[6] but its rights of ownership are severely restricted.
Virtual real estate is not safeguarded by constitutional restrictions that protect owners of traditional real estate. For example, under the Fifth and Fourteenth Amendments to the United States Constitution, governments that take real property outright or indirectly by regulations that eliminate any economic utility may only do so for a public use and must provide just compensation. However, private entities, such as platform operators, are generally unrestricted by the Constitution. This means that virtual real property can be deleted and its access permanently blocked for any reason and without any compensation. Indeed, Decentraland’s terms of use limit the platform’s liability to the greater of (a) the amounts actually paid by the user in the 12-month period preceding the claim arose or (b) $100.[7]
Therefore, platform operators wield more influence over virtual real property rights than do their government counterparts over traditional real property rights. The result is that virtual real property owners inherently have fewer property rights. Furthermore, little regulation enables platform operators to act with broad discretion with little liability, thereby increasing the likelihood of bad behavior. This risk is also unavoidable, as the lack of an insurance industry for virtual real property makes it impossible for owners to shift the risk to another party.
Nonetheless, owners may be able to reduce risk by demanding market terms of use that contain owner friendly provisions. One of the most common trends is the emergence of Decentralized Autonomous Organizations (“DAOs”).
2. DAOs Are Useful but Create More Complexity
Some platforms, including Decentraland, are organized as DAOs, which are community-driven entities with no centralized authority. Decisions are made by votes of the DAO’s members (commonly referred to as “token holders”) based on governance protocols and executed by rules within smart contracts. In the context of metaverse platforms, DAOs can be seen as onchain analogs to homeowners’ associations by giving token holders input over a platform’s rules and regulations.[8]
Accordingly, DAOs decentralize the influence that would otherwise be consolidated in a platform operator. This reduces the risk that an owner’s rights are limited, as rulemaking requires cooperation, which allows owners to lobby their interests. However, lobbying may increase the costs of virtual real property ownership and the added layer of complexity may result in inefficiencies.
3. Smart Contracts Provide Security at the Cost of Flexibility
Virtual real estate transactions in the metaverse utilize smart contracts. Smart contracts are self-executing consensus protocols, which operate by a series of if-then statements agreed upon by the parties, which are written into code on a blockchain.[9] These smart contracts are used to facilitate purchases and sales of virtual real property.
Smart contracts associated with non-fungible tokens (“NFTs”) also function as a deed. Once the sale is executed, the NFT is recorded on the blockchain, which is distributed in real time to all other nodes on the subject blockchain and provides evidence of the purchaser’s ownership of the virtual real property.[10] Because smart contracts are linked to the blockchain, any adjustments to the code or protocols requires an affirmative vote of the DAO.[11]
Although smart contracts provide security to virtual real estate transactions, they also reduce flexibility. For example, once a purchase is added to the blockchain, it is final and there is no opportunity to amend or restate the terms without the consent of the DAO.[12] Accordingly, there is no room for error in negotiating the terms of a virtual real estate transaction. Furthermore, the law on smart contracts is undeveloped, and some purchases could ultimately be unenforceable.[13]
4. Phishing and Other Scams
The metaverse is new and most consumers know little about it. Bad actors are taking advantage of this by creating fake links to the most popular metaverse platforms. Once the link is activated, the scammer has access to the consumer’s virtual wallet and can transfer its consents through a smart contract. As a result, the transfers are almost impossible to amend, which means the stolen cryptocurrency is essentially impossible to retrieve. Cryptocurrency-based crime equaled $14 billion in 2021.[14] Indeed, fraudulent metaverse links are so lucrative that many of these links are readily available for sale on the dark web.[15]
To prevent these scams, virtual real estate investors should incorporate two-step authorization to better protect their virtual wallets.[16] Some blockchain-based businesses are beginning to incorporate features that allow cryptocurrency to be reported stolen, which disables the reported cryptocurrency from being able to be bought or sold to discourage phishing scams.[17]
Conclusion
Before purchasing virtual real property, investors should be aware of certain structural risks, such as the broad control a platform operator has over virtual real property rights. As DAOs become market, virtual property rights will become more complicated. Investors should also be mindful of the immutable nature of smart contracts and cryptocurrencies and be careful to completely negotiate terms and to avoid scams.
FOOTNOTES
[1] Robert B. Koonin et al., Real Estate in the Metaverse: What is Digital Real Estate? Why does it Matter?, ArentFox Schiff (May 2, 2022), available here.
[2] As of the date of this Alert, Decentraland is one of the most popular metaverse platforms for digital real property ownership. Id.
[3] Terms of Use, Decentraland, available here. (emphasis added) (last visited June 19, 2022).
[4] As of the date of this Alert, The Sandbox is one of the most popular metaverse platforms for digital real property ownership. See supra note 2.
[5] Terms of Use, The Sandbox, available here. (emphasis added) (last updated October 26, 2021).
[6] Id.
[7] See supra note 4.
[8] Decentralized Autonomous Organizations (DAOs), Ethereum, available here. (last visited June 19, 2022).
[9] Id.
[10] Id.
[11] Stuart D. Levi & Alex B. Lipton, An Introduction to Smart Contracts and Their Potential and Inherent Limitations, Harv. L. Sch. Form on Corp. Governance (May 26, 2008), available here.
[12] Id.
[13] Craig de Ridder & Robert Howard, Investing in Metaverse Real Estate: Mind the Gap Between Recognized and Realized Potential, JD Supra (Apr. 21, 2022), available here.
[14] Crypto Crime Trends for 2022: Illicit Transaction Activity Reaches All-Time High in Value, All-Time Low in Share of All Cryptocurrency Activity, Chainalysis.com (Jan. 6, 2022), available here.
[15] Eamon Javers et al., Cybercriminals target metaverse investors with phishing scams, CNBC (May 26, 2022), available here.
[16] Id.
[17] Id.