Bankrupt in the Metaverse

Companies are pouring capital into the metaverse, often on expectations of outsized future returns. Investment in the metaverse more than doubled in 2022, and industry experts have projected that the metaverse could generate as much as $5 billion in value by 2030.^[1]

But innovation involves risk, and not every innovator makes it to the promised land of reward. Just as in real life, it is inevitable that some of the players that are building and operating in the metaverse will face challenges that will force them into restructuring or bankruptcy. In fact, what was just recently a booming metaverse real estate market has shown significant signs of softening, with investors wondering if the metaverse housing bubble is about to burst.

As metaverse assets (including real estate) are largely comprised of digital assets and intellectual property, questions regarding ownership of those assets will be central to any bankruptcy or restructuring efforts.

As recent crypto bankruptcy filings illustrate, legal ambiguity about the ownership of digital assets can create costly litigation between creditors and estate fiduciaries over what constitutes “property of the estate” — the pool of assets that make up the bankruptcy estate and that are used to satisfy the claims of creditors.^[2] Creditors may believe they hold certain property rights, only to find out that property belongs to the debtors’ estate that will be shared pro rata among the debtors’ creditors.

As the metaverse expands, and content created in and for the metaverse proliferates, the tension over ownership between platforms and users will inevitably increase, particularly in metaverse-related bankruptcy filings.

Three central elements of metaverse platforms

Complications related to ownership in the metaverse largely depend on how the rules apply to the three elements central to many emerging metaverse platforms: fungible digital tokens, non-fungible tokens (NFTs), and content.

• Fungible digital tokens are cryptocurrencies such as Bitcoin. Some metaverse platforms issue their own tokens and store them on-platform. If tokens stored on-platform are commingled and not held in custody for a specific user, it is likely that such tokens could belong to the platform and not the user in a platform bankruptcy, even if they were purchased by the user or obtained as payment for virtual property, services, or experiences.
• NFTs represent unique digital assets such as works of art, land, or buildings (and can serve as property titles). NFTs purchased outright are almost certainly owned by the purchaser, with little room for ambiguity. But complications can arise when an NFT is used as collateral, as discussed below.
• Content includes anything that is created or built in the metaverse, such as music, digital clothes, or virtual real estate. Who owns the content on any given platform depends on the platform’s terms of use, as discussed in more detail below. The question of ownership gets more complicated when the content is purchased with a loan that requires collateral, often an NFT.

Ownership of Content

Most issues about what constitutes property of the estate are likely to be rooted in questions about ownership of content. As noted above, ownership of content depends on each platform’s terms of use. But of course, terms vary. Some platforms’ contracts clearly state that users own the content they create. Other platforms use language that suggests that the platform could have some ownership claim over user-generated content.

Where content has value, a bankrupt platform operating as a debtor in possession would be motivated to assert ownership over such content to increase the value of the bankruptcy estate and the pool of assets available for monetization and distribution to creditors. Likewise, any creditors’ committee appointed in a platform bankruptcy would be keenly focused on determining whether contract language would allow the debtor to assert ownership rights to metaverse content.

As metaverse platforms become interoperable, allowing users to bring property with them from one platform to another and potentially developing the property along the way, the claims to ownership could get even more complex.

Ownership of Secured Property

Late 2021 and early 2022 saw investors clamoring to buy up metaverse real estate, with each record-setting sale topping the next. A cottage market for metaverse mortgage loans has sprouted, with lenders offering secured financing through metaverse loan mortgages, which use the underlying non-fungible tokens (NFTs) that represent the land as collateral. With distress hitting the metaverse real estate market, questions will arise as to whether such secured metaverse property belongs to the platform, the borrower, or the secured lender.

One approach to metaverse mortgage lending that has emerged is for a mortgage lender to lend digital tokens to a borrower to finance the purchase of virtual land. Before the loan is paid off, the NFT representing the land is held by the lender, which grants the borrower full deployment rights over the land, similar to a license. This arrangement allows the user to access the land and improve it with user-generated content.

The law has not been tested as to whether, in such a scenario, the metaverse mortgage lender, who has possession and control of the NFT representing the land, owns that NFT until the underlying loan is paid in full. Does the mortgage lender have legal and beneficial ownership of the NFT while it is in the lender’s possession, or is the lender merely holding it in trust for the borrower until some future trigger event occurs? Until the law is settled, significant risks exist for a metaverse mortgage borrower in a platform bankruptcy, not the least of which is that the metaverse mortgage lender, not the borrower, could be considered the owner of the land with sole standing to enforce rights and make decisions vis-à-vis the land in the bankruptcy.

Adding another layer of complexity, if the borrower is considered a licensee of a non-bankrupt mortgage lender, it may not be afforded key bankruptcy protections typically available to direct licensees in licensor bankruptcies (including the right to retain the benefit of the license for the pendency of the lease term).

While some of these issues will get clarified through jurisprudence, many will be clarified through statutory and contractual developments, including a newly promulgated Article 12 of the Uniform Commercial Code and the development and evolution of “smart contracts” in metaverse mortgage lending.

Article 12, which has already been adopted by some states, provides that a digital asset such as an NFT may be perfected either by filing a UCC-1 financing statement or by control of the actual NFT. Perfection of NFTs via control would permit the metaverse mortgage lender to have a first priority security interest in the collateral, and the ability to foreclose on that collateral in the event that certain trigger events have occurred. Much like control over a bank account, control would not equal ownership until the lender forecloses on its collateral.

Metaverse mortgage lending smart contracts, which incorporate coded rules triggered when specified conditions have been met, would dictate the timing of the foreclosure — which could be immediate. In such cases, if the metaverse mortgage borrower defaulted under its metaverse mortgage, the ownership of the collateral — here, the NFT — could be coded to transfer immediately to the mortgage lender, resulting in the loss by the mortgage borrower of its rights in and to the metaverse land. As we write today, it is unclear whether smart contracts will support concepts like forbearance, amendment, and workout.

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Bankruptcies will be part of the metaverse just as they are in every other part of economic life. Participants may be able to protect themselves from unexpected shocks by drafting contract language that clarifies ownership rules at the outset and appropriately pricing their risk. But participants will need to understand the risk to do so, and they will have to watch the space closely to be sure they understand how the rules evolve as disputes are adjudicated. We certainly will.

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^[1] “A CEO’s Guide to the Metaverse,” McKinsey (Jan. 2023).
^[2] The filing of a bankruptcy petition creates a bankruptcy estate that includes all of a debtor’s legal and equitable interest in and to property as of the filing of the bankruptcy petition and commencement of the bankruptcy case. 11 U.S.C. §54l (a)(l); Fowler v. Shade, 400 F.3d 1016, 1018 (7th Cir. 2005).