Hainan Province takes the lead, NFT directly faces the first "regulation" of the new year

Author: Xiaoza Legal Team

It is reported that the Market Supervision Administration, Publicity Department, Cyberspace Administration, Ministry of Industry and Information Technology, Ministry of Culture and Tourism, Ministry of Commerce, Public Security Department, Financial Bureau, and Taxation Bureau of a southern province jointly issued the "Notice on Strengthening Risk Supervision of Digital Collectibles" (hereinafter referred to as the "Notice") to enhance the supervision of digital collectibles risks within the province.

Looking through the entire Notice, we can summarize three points: 1. Digital collectibles belong to the digital economy and will not be subject to a "one-size-fits-all" approach; 2. There are frequent irregularities in digital collectibles, posing risks of illegal activities; 3. Regulatory authorities will adopt a "proactive supervision" strategy. Now, let’s study the Notice together and break it down.

1. License Management

The digital collectibles industry should obtain different licenses based on their specific business types. The Xiaoza team previously wrote an article on this topic; please click the link "Heavyweight Open Class | What Licenses Are Needed for NFT Platforms in Our Country?" for more details. Over time, our team believes that some licenses have changed, and different provinces and cities have updated their licensing policies. It is recommended to consult the local licensing authorities directly.

Engaging in business without obtaining the necessary qualifications incurs two types of legal risks.

One type is the crime of illegal business operations, which usually constitutes a serious disruption of market order. Specifically, there are four categories: (1) Operating specialized or restricted items without permission as stipulated by laws and administrative regulations; (2) Trading import and export licenses, certificates of origin, and other licenses or approval documents as required by laws and administrative regulations; (3) Illegally engaging in securities, futures, or insurance business without approval from relevant national authorities, or illegally engaging in payment and settlement services; (4) Other illegal business activities that severely disrupt market order. In judicial practice, if digital collectibles are deemed to be securities or futures products, then operating without a license carries a significant risk of illegal business operations.

The other type is administrative violations. Operating digital collectibles without the relevant administrative licenses will incur administrative violation risks. Regulatory authorities can regulate or penalize such actions according to the "Administrative Measures for Art Trading," "Auction Law," "Internet Information Service Management Measures," etc. Do not think that administrative penalties are merely about paying fines; the industry and market regulatory authorities can revoke the business licenses of enterprises operating without a license and in serious circumstances, depriving them of the ability to continue their business activities, which is the most severe administrative penalty for enterprises.

2. Connection Between False Advertising and Criminal Law

To be honest, given the prolonged stagnation of the digital collectibles market, various platforms and service providers have tried every means to attract users. Some use the results of football matches for promotions, some combine online and offline methods to gain traffic, and some stimulate consumption through gambling practices, creating a chaotic scene.

In the past, the handling of such irregularities mostly involved criticism, exposure, or revocation of business licenses, with operators remaining unperturbed. The Notice specifically emphasizes "strengthening the connection between criminal and administrative law, and resolutely cracking down on false advertising crimes." So, what specific crimes are involved in false advertising? How many years can one be sentenced?

According to Article 222 of China's Criminal Law: The crime of false advertising refers to the behavior of advertisers, advertising operators, and advertising publishers who violate national regulations and use advertisements to falsely promote goods or services, with serious circumstances. Based on the Xiaoza team's experience in handling illegal fundraising cases, if an advertiser violates national regulations and uses the name of digital collectibles to falsely promote illegal fundraising, and meets any of the following conditions, they will be convicted and punished for false advertising: (1) The illegal income exceeds 100,000 yuan; (2) Causes serious harmful consequences or adverse social impacts; (3) Has received administrative penalties for false advertising twice or more within two years; (4) Other serious circumstances.

It is important to note that both individuals and entities can constitute the crime of false advertising. For individuals, the penalty can be imprisonment for less than two years or criminal detention, and a fine may also be imposed; for corporate crimes, a "dual penalty system" is adopted, imposing fines on the entity and holding the directly responsible managers and other directly responsible personnel criminally liable in accordance with individual criminal liability.

3. Fraud and Illegal Fundraising

The Notice specifically names behaviors such as "whitelists, regular buybacks, and cash rewards." The Xiaoza team particularly reminds: Buybacks, cash rewards, and similar actions are sensitive behaviors in the current digital collectibles industry, and these actions primarily face the criminal law risks associated with illegal fundraising.

Taking buybacks as an example, as a special sales method, buybacks can generally be a legal business practice. However, in the actual situation of the digital collectibles industry, this buyback method is often used by criminals as a means of illegal fundraising. In fact, it is not just digital collectibles; other products can also be exploited as gimmicks and tools for illegal fundraising. Judicial authorities have confirmed this through judicial interpretations. The newly revised "Interpretation of Several Issues Concerning the Application of Law in the Trial of Criminal Cases of Illegal Fundraising" issued by the Supreme People's Court in 2022 explicitly lists product buyback behavior as a common method of illegal fundraising.

According to the second article of this judicial interpretation, if the actor does not have the genuine content of selling goods or providing services, or does not primarily aim to sell goods or provide services, and engages in illegal fundraising through methods such as product buybacks or consignment sales, they can be recognized as committing the crime of illegally absorbing public deposits, thus facing criminal penalties. In practice, there have been cases of using liquor and jade as targets for buybacks to absorb funds.

Although digital collectibles are not physical items like liquor or jade, if a platform agrees in advance with users that it will buy back at a price higher than the original selling price by a certain percentage when the platform ceases operations, and explicitly or implicitly promotes that the digital collectible products are investment products that can yield fixed returns, then considering that users can only view their collectibles through the platform after purchasing, this business model is not significantly different from the aforementioned liquor buyback model, thus also carrying a high likelihood of constituting illegal fundraising.

4. Copyright Infringement Issues

Copyright infringement is a long-standing issue for the digital collectibles industry. The Notice uses the term copyright, which actually refers to "copyright" under Chinese law, prohibiting any organization or individual from using others' works to mint or create digital collectibles without authorization.

In practice, the most challenging aspect is UGC platforms. The first major case that caused a stir last year was actually a user infringement case on a UGC platform. Without discussing the controversies of the case, today we mainly want to tell readers how to minimize infringement issues.

We recommend:

• Platforms need to establish a relatively complete rights review mechanism to prevent the minting of infringing works. In practice, the Xiaoza team suggests that platforms require uploaders to provide documents such as proof of creation and authorization; on the other hand, there needs to be a comprehensive verification mechanism. For example, when it comes to image-based digital collectibles, multiple professional image recognition tools can be used to review uploaded images, and dedicated personnel should verify the results to prevent infringing works from being minted as digital collectibles to the greatest extent possible.
• Establish smooth user reporting and complaint channels. This is important for early detection and handling of infringing works, and it is also a key aspect for regulatory authorities to assess the compliance of platforms.
• Limit users' freedom to set prices and monitor abnormal transactions. The Xiaoza team has found in practice that currently only some UGC platforms allow users to set prices freely, leading to frequent occurrences of absurdly priced collectibles on the platform. Such collectibles carry significant risks of money laundering and wash trading, making them easy tools for malicious actors to exploit for criminal activities, and platforms need to be cautious.
• Exercise caution when charging commissions and gas fees. In current judicial practice, courts believe that UGC platforms directly derive significant economic benefits from user-uploaded content, thus requiring them to bear a higher duty of care to prevent infringement. Therefore, the industry needs to rethink traditional charging standards and profit models, clearly distinguishing between on-chain costs and platform commissions to prevent risk exposure.

5. Secondary Market Issues

The Notice clearly states: "Illegally established exchanges will be resolutely banned," and that the management measures for trading venues in Hainan Province should be implemented to ensure proper entry management, daily supervision, statistical monitoring, and risk disposal for exchanges. Currently, there are no high-level laws or administrative regulations explicitly defining the nature of establishing a secondary market for digital collectibles in China. However, from the perspective of maintaining financial security and social stability, Chinese regulatory authorities generally hold a negative attitude towards private secondary trading venues.

To be frank, the value of digital collectibles lies in their liquidity. Without trading channels, it is difficult to claim that digital collectibles have value. The Xiaoza team believes that the gradually established "cultural trading centers" across the country provide a good idea for addressing liquidity issues. As comprehensive cultural property trading venues approved by national financial regulatory authorities, which trade in property rights, debt rights, equity, and intellectual property (copyright), they have a deep connection with digital collectibles.

In Hainan Province, the Hainan International Cultural and Artworks Trading Center (referred to as "Haiwen Trading") is the only joint-stock enterprise in China approved by the Hainan Provincial Local Financial Supervision Administration that has both online and offline qualifications for art trading. Although there is currently no direct opening of a secondary market for digital collectibles, there is certainly great potential for the future. We recommend that platform operators closely monitor the latest developments of cultural trading centers in various regions.

6. Strengthening Joint Credit Enforcement and Enhancing Public Education

The establishment of a credit system required by the Notice is essentially a blacklist system. The Hainan regulatory authorities will promptly collect administrative penalties and other credit information of digital collectibles operating enterprises and publicly disclose them, listing untrustworthy market entities in the abnormal operation directory or serious illegal credit list.

This practice will have a significant impact on various untrustworthy and illegal operating enterprises. It will not only cause enterprises to lose their market foundation but may also have adverse effects on the main responsible persons of the enterprises for a long time, such as restrictions on employment. The Xiaoza team believes that referencing the blacklist system implemented in the financial industry will explore a regulatory system in the future that involves more interaction with enterprises and stricter supervision, significantly increasing the legal costs for enterprises and their actual controllers, which requires extra attention.

In Conclusion

We are pleased to see that the recognition of the legality of digital collectibles in this province is relatively high. However, regarding the chaos and risks brought by digital collectibles, various departments have understood the situation and prepared response plans. What impressed us the most is the "connection between criminal law and administrative law" concerning false advertising, and we look forward to its shocking effects, hoping that enterprises do not rush headlong into it.