AML on Fractionalized Art Market: Compliance Questions of Digitized (Physical) Work of Art

November 1, 2023

By Filip Radzikowski

Fractionalized ownership is not a novel idea. The legal, financial and social ramifications of this investment scheme were extensively analyzed in various fields, including the art market. However, only recently has it experienced an exceptional surge in popularity in Asia and the Middle East^[1] and recently it is getting footing in European and US markets. Fractional ownership gained popularity in the mid-80’s and was originally employed in the context of business jets, later migrating to real estate. The early 2010s welcomed this form of investment with open arms in the fine arts, with numerous newly established companies drawing on the contemporary art market returns exceeding the S&P 500 in the same timeframe.^[2] The significance of fractional ownership lies in the variety of modes it can take, seemingly disrupting traditional forms of investment. A prior article written by the Center for Art Law on the share-buying in LLCs’, most notably offered by Masterwork, should provide our readers a valuable insight into legal considerations of a more traditional fractionalization scheme. Nevertheless, the digital realm attracts an increasing number of players in the fractionalized art investment market. The advent of blockchain technology and the tokenization process has disrupted the markets, including for fine arts. Undoubtedly, these present revolutionary solutions to investors. On the other hand, their vulnerabilities are already viewed as exploitable for illicit financial operations, of which both the Department of the Treasury^[3] and Financial Action Task Force (FATF) are cautious in their recent (2023) Anti-Money Laundering (AML) and Countering the Financing of Terrorism (CFT) studies.^[4]

Art investment, and blue-chip art in particular, usually require onerous financial backing, which for many interested in capitalising on the art market, constitutes an unattainable threshold.^[5] Therefore, fractional art ownership is a rapidly expanding field and a “natural outgrowth of the financialization of the art market.”^[6] Making headlines, companies like Particle Collection or recently launched Freeport had seen fractionalizing tokenized art as a growing investment opportunity, digitising the ownership claims and dividing works of Banksy or Andy Warhol. Artemundi, a US-based art investment company with over 30-year’s worth of experience, in partnership with Swiss bank Sygnum had notably bought Picasso’s Fillette au beret painting to be fractionalized into 4000 pieces of the Art Security Tokens (AST)^[7]; another joint undertaking between Rubey and Tokeny had the same idea for introducing the tokenized claims to custodied assets, while the painting (Carnaval de Binche by James Ensor) is being loaned long-term to the Royal Museum of Fine Arts in Antwerp.^[8] Tokeny also partnered with Artory on bringing permissioned tokens under code-name T-rex to increase transparency and compliance with the current AML regime.^[9] Considering AML rules as a jurisdiction bound regime, the digital sphere transcends these boundaries which makes fractionalized art especially complex subject to regulation, especially as there is no uniformity in the digitization process.

How are Physical Artworks Being Tokenized?

NFTs, having made a splash on the art market scene and since having dropped in price and popularity^[10] are discussed at length in a number of articles by the Center, most notably a case study of insider trading, a review of a headline NFT ownership dispute case involving Sotheby’s, as well as general analysis of NFTs on the art market. For the purposes of this paper, they work as a proof of title to digital or physical assets that are registered on a blockchain or other Distributed Ledger Technology (DLT), which is an encrypted database serving the purpose of the irreversible and incorruptible public repository of information^[11]. But NFTs are only one of the sub-groups that crypto-assets subscribe to in the general scheme of “digital representations of value or of rights that have the potential to bring significant benefits to market participants.”.^[12]

There are few different schemes of operations that companies offering fractionalized art ownership employ; Ventures such as Freeport or Masterworks offer prospective^[13] buyers a purchase of class A shares under Securities and Exchange Commission (SEC), which are subjected to ordinary securities AML rules. Another notable enterprise on the fractionalized art market is Particle Collection, which uses the Ethereum Network for the purposes of issuing their NFTs as a representation of the ownership claim to a particular fraction of artwork’s title. The “Particulization Process” results in ‘Particle’ shares (in the form of asset-backed NFTs referred to as ‘Digital Reference’) being disseminated between investors, while the physical artworks are being loaned on the perpetual basis to the Particle Foundation for the purposes of displaying, preserving and insuring the object.^[14] Nevertheless, the company explicitly excludes these ‘Particles’ as security offering or any other form of financial product. Consequently, the question of applicable AML rules arises. While the rules applicable to the traditional art market have in recent years become more stringent, the precariousness of AML procedures applicable in the process of purchasing these virtual claims not only allows for plausible circumvention of AML regime, but also hinders the orderly development of the market.^[15] Ranging from the traditional securities through blockchain-based securities, ending with the purely NFT-based claims, the regimes for fractionalized assets are diverse, lacking common core and in many instances their applicability is a cause for a headache.

Freeport, like Masterworks, do not tokenize the objects themselves; Rather, they set up series LLC who acquires an artwork, via affiliated Freeport Curation LLC, which then becomes the series LLC’s primary asset and subject to investment under Tier 2 Regulation A of the Securities Act.^[16] The tokens registered on the blockchain are just a corresponding visual representation of the ownership interest to a particular series, not conferring any rights that the share itself would. The characteristics of such investment mode create difficulties in the legal and practical dichotomy of the digital asset class it could be subscribed to. More and more common is thus to consider such investment scheme as Security Token Offering (STO), which can be described as the “digital representation of the investment product” registered on the DLT^[17], but might in itself also constitute this product.^[18] This type of tokenisation is opted for by partnership between Artemundi and Sygnum Bank, which refers to it as “Art Securities Tokens”.^[19] Rubey and Artory also make use of STOs by partnering with Tokeny’s technology of permissioned tokens (ERC-3643 or the T-Rex Protocol), which allows for identity management, falling in the Know-Your-Client AML requirements and by using ONCHAINID platform for the implementation of ERC-734^[20] protocols to provide a standard for verifiable credentials that meet the AML standards.^[21]

What this should portray is the complexity of navigating the AML and CTF rules applicable to digital assets applicable stems from the multitude of forms these assets may take and the context in which they are traded.

United States

Under the US rules applicable in 2023, characterising digital assets, including fractionalized NFTs (f-NFTs) under the term’s umbrella, as securities under the Securities Act of 1933, and more specifically an investment contract, seems to be achievable by applying conditions set out by the Howey test (SEC DLT Framework).^[22] The applicability of the requirements Howey introduced to fractionalized ownership scheme without digital dimension had been analysed in an article available here, and the f-NFTs are likely to be considered to fall within the purview of securities.^[23] That said, the issuers of f-NFTs or STOs (and thus ASTs as well) should be considered a financial institution, and specifically a broker or dealer in securities, pursuant to 31 CFR 1010.100(t).^[24] Therefore, the companies that offer tokenized ownership claims to fractionalized artworks must comply with the rules of Bank Secrecy Act 1933, as well as amendments in respect to AML made by the Patriot Act 2001. The Customer Due Diligence and client screening under Section 326 of the Patriot Act, as well as transaction monitoring and reporting requirements (that should result in suspicious activity monitoring and reporting mandated by Section 356 of the Patriot Act^[25]). Further, companies such as Particle or Freeport should comply with the Anti-Money Laundering Act 2020 and specific AML rules under Code of Federal Regulations (§ 1023.210 – for broker-dealers) and Finra Rules on money laundering (Rule 3310).^[26] Although fractionalized art ownership, digital or otherwise, for now seems to be generally subjected to rules of securities and thus the AML rules for the dealers and brokers in securities under the BSA, the legislative landscape for digital assets is scattered and not tailored to the needs of investment and ownership in the digital environment.

European Union

Subjecting fractional ownership investment schemes to rules of AMLD5^[27] requires discussion on whether the material scope of the Directive allows for interpreting the said tokens as falling in the brackets of the “virtual currencies”, and thus whether it subjects any entities considered by the act to the obligations set therein. Analysis by Haffke et al. of whether STOs, or as the authors coin it “investment tokens”, should be considered as such finds that this from of tokenization should, in strict interpretation, be excluded from the heading of “virtual currencies”; with authors at the same time calling for the more overarching interpretation that EU Member States to be used when implementing provisions of the Directive.^[28] This is not the case with the UK standards, where the implementation took into consideration the FATF standards, and set up criteria that security tokens are most likely satisfying.^[29] Nevertheless, fractionalized digital assets are not left in the EU’s regulatory limbo. The legislative landscape for crypto-assets and DLT had been supplemented recently by the new EU Regulation (2023/1114; MiCAR), and insofar as the European institutions excluded NFTs from being subjected to rules contained therein, the intricacy lies in including fractionalized tokens under Recital 11 of the said Regulation to being bound by its rules, as shared ownership introduces the fungibility (p. 328^[30]). In the context of AML, MiCAR-subjected issuers of digitized assets, and thus companies offering tokenized and fragmented ownership of physical art works, must meet the application requirements prior to authorisation of offering (Art. 16 MiCAR) such as these stemming from Article 18 ((2)(g) – “a description of their internal control mechanisms and procedures to ensure compliance with the obligations in relation to the prevention of money laundering and terrorist financing under Directive (EU) 2015/849”). Consequently, for companies minting and fractionizing NFTs, MiCAR’s scope should consider these falling within the definitions of issuers or crypto-asset service providers (CASPs) (Article 3(15) and (16)), whose application under Article 62 also requires setting up AML mechanisms ((2)(i)); Security tokens on the other hand are most likely to be regulated under the traditional EU securities framework governed by Directive 2014/65/EU (Markets in Financial Instruments Directive; MiFID II), exemplified by Germany, Spain^[31] or Estonia.^[32] Nevertheless, there is a divergence in both the extensiveness of the regulatory framework, and its applicability to fractionalized ownership in the digital sphere among European jurisdictions.

Final Thoughts

The advent of digital technologies on the art market paves the way for new investment opportunities, as well as necessitates the question of regulatory solutions. .Another article available to our subscribers on practical solutions offered by emerging DLT technologies and the practical solutions which art market participants can benefit from, including these relating to AML, available here. Although the vulnerabilities of decentralised digital space in the art trade should not be trivialised, the market for fractionalized art shows emerging technologies’ capacity for addressing at least some of those. With the noble aim of democratising the art market, supporting institutions and promoting culture, as well as solving some of the intricacies of the art market, which prospective investors found disincentivizing, the digitization and fractionalization enables the art world to enter into the modern era of investment. Although these advances are not necessarily welcomed by every player on the art market, there are good reasons to anticipate both an increased interest of various (prospective) stakeholders in this novel art market setting and a proliferation of legal challenges that will certainly emerge with time, stretching beyond the compliance sector. Concluding, tokenization engenders a promising future for art investment and promises a solution to at least some of the issues that have been considered inherent to the art market. Nevertheless, novel approaches pose novel challenges, and for the art market ‘going digital’ the necessity of regulatory changes is rather uncontested^[33] and deserving of more comprehensive discussion.

About author:

Filip Radzikowski, A graduate of Bachelor of Laws at Maastricht University’s European Law School, currently completing his Master’s in International and European Trade and Investment Law at the University of Amsterdam. Passionate about arts and art markets, he is looking forward to further his professional development on the nexus of these interests and the academic legal background, contributing to addressing the future challenges and participating in the popularisation of art and law.

Sources:

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2. Yussuf Yasin, Blockchain can democratise $1.7trn art market, says Tokeny CEO, Delano, May, 6th, 2023, https://delano.lu/article/tokeny-technology-to-unlock-1- (last visited Jun 1, 2023). ↑
3. U.S. Department of the Treasury, Study of the Facilitation of Money Laundering and Terror Finance Through the Trade in Works of Art (2022), available at: https://home.treasury.gov/system/files/136/Treasury_Study_WoA.pdf. ↑
4. Financial Action Task Force, Money Laundering and Terrorist Financing in the Art and Antiquities Market (Feb. 27, 2023), available at: https://www.fatf-gafi.org/en/publications/Methodsandtrends/Money-Laundering-Terrorist-Financing-Art-Antiquities-Market.html. ↑
5. Adriano Picinati di Torcello, Why should art be considered as an asset class, p. 18. Available at: https://www2.deloitte.com/content/dam/Deloitte/lu/Documents/financial-services/artandfinance/lu-art-asset-class-122012.pdf. ↑
6. Artnet News Intelligence Report, Kazakina, Katya, Fractional Art Ownership Is Turning Art Into Stocks – But Not Everyone Stands to Make Profit (2022), available at: https://artemundi.com/wp-content/uploads/2022/04/2022_Artnet-Spring-Report-P-26-33.pdf. ↑
7. Joy Dumasia, Sygum Bank and Artemundi tokenize a Picasso artwork on the blockchain (July 16, 2021), IBS Intelligence, available at: https://ibsintelligence.com/ibsi-news/sygnum-bank-and-artemundi-tokenize-a-picasso-artwork-on-the-blockchain/ (last visited Jun 1, 2023). ↑
8. The KMSKA museum tokenizes a million-euro masterpiece with ERC-3643 Standard, Tokeny (2022), https://tokeny.com/the-kmska-museum-tokenizes-a-million-euro-masterpiece-with-erc-3643-standard/ (last visited Jun 26, 2023). ↑
9. Luc Falempin et al., Whitepaper: T-REX (Token for Regulated EXchanges) (Apr 29, 2020), Tokeny solutions, available at: https://tokeny.com/wp-content/uploads/2020/05/Whitepaper-T-REX-Security-Tokens-V3.pdf. ↑
10. Olga Kharif & James Tarmy, NFTs, Once Hyped as the Next Big Thing, Now Face ‘Worst Moment’, Bloomberg, June, 19, 2023. Available at: https://www.bloomberg.com/news/articles/2023-09-01/nft-hype-fades-in-crypto-market-as-sales-volume-plunges#xj4y7vzkg (last visited Oct. 9 2023). ↑
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12. Regulation (EU) 2023/1114 of the European Parliament and of the Council of 31 May 2023 on markets in crypto-assets, amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/EU and (EU) 2019/1937, Recital 2. ↑
13. For more information, please check Masterworks’ and Freeport’s Offering Circulars filed with the SEC. United States Securities and Exchange Commission, Masterworks 001 LLC. Filing, File No. 024-10876, available at: https://www.sec.gov/Archives/edgar/data/1738134/000149315219006830/form253g2.htm, & United States Securities and Exchange Commission, Freeport Holding Series, LLC. Filing, File No. 024-12099, available at: https://www.sec.gov/Archives/edgar/data/1946910/000182912623003143/freeportholdings_253g2.htm#a_001. ↑
14. Particle collection, https://support.particlecollection.com/hc/en-us (last visited Jun 26, 2023). ↑
15. Anna Mosna & Giulio Soana, NFTs and the virtual yet concrete art of money laundering (September 25, 2023). . Computer Law and Security Review (51). Available at: https://www.sciencedirect.com/science/article/pii/S0267364923000845?ref=cra_js_challenge&fr=RR-1, p. 10. ↑
16. United States Securities and Exchange Commission, Freeport Holding Series, LLC. Filing, File No. 024-12099, available at: https://www.sec.gov/Archives/edgar/data/1946910/000182912623003143/freeportholdings_253g2.htm#a_001. ↑
17. Thomas Lambert et al., Security Token Offerings (June 25, 2021), available at SSRN: http://dx.doi.org/10.2139/ssrn.3634626 ↑
18. Clifford Chance, Secuirty Token Offerings – A European Perspective on Regulation (October 2020), available at: https://www.cliffordchance.com/content/dam/cliffordchance/briefings/2020/10/security-token-offerings-a-european-perspective-on-regulation.pdf. ↑
19. Rubey, What are Art Secuirty Tokens?, available at: https://www.rubey.be/en/what-are-art-security-tokens. ↑
20. Luc Falempin et al., Whitepaper: T-REX (Token for Regulated EXchanges) (Apr. 29, 2020), Tokeny solutions, available at: https://tokeny.com/wp-content/uploads/2020/05/Whitepaper-T-REX-Security-Tokens-V3.pdf; also see: Onchainid, Whitepaper: ONCHAINID – The identity system for compliant digital assets, available at: https://uploads-ssl.webflow.com/60ed5607a0d4556dd864b950/619367fe1ca0963a9bcb2edf_OID%20Token%20-%20Whitepaper%20-%20V%201.0%20.pdf ↑
21. Tom Barbereau et al., Tokenization and Regulatory Compliance for Art and Collectibles Markets: From Regulators’ Demands for Transparency to Investors’ Demands for Privacy. In: Lacity, M.C., Treiblmaier, H. (eds) Blockchains and the Token Economy. Technology, Work and Globalization. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-030-95108-5_8, p. 224. ↑
22. Roberto Anello, Digital Art May Be Next in the SECs Crosshair, Forbes, July, 15, 2021, available at: https://www.forbes.com/sites/insider/2021/07/15/digital-art-may-be-next-in-the-secs-crosshairs/?sh=7dc440b832df (last visited Jun 26, 2023). ↑
23. Brian Elzweig and Lawrence J. Trautman, When Does a Nonfungible Token (NFT) Become a Security? (March 11, 2022). 39 Georgia State University Law Review, 295 (2023), Available at SSRN: https://ssrn.com/abstract=4055585 p. 329. ↑
24. 31 C.F.R. § 1010.100 (2023). ↑
25. USA PATRIOT Act of 2001, Pub. L. No. 107-56, § 356 (2001). ↑
26. United States Securities and Exchange Commission, Anti-Money Laundering (AML) Source Tool for Broker-Dealers (May 16, 2022), available at https://www.sec.gov/about/offices/ocie/amlsourcetool#1 (last visited Jun 1, 2023). ↑
27. European Parliament and Council Directive 2018/843, 2018, O.J. (L 156/43). ↑
28. Lars Haffke, Mathias Fromberger & Patrick Zimmermann, Virtual Currencies and Anti-Money Laundering – The Shortcomings of the 5th AML Directive (EU) and How to Address Them (May 18, 2020). Journal of Banking Regulation (21) 2, pp. 125-138, available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3328064. ↑
29. Clifford Chance, Secuirty Token Offerings – A European Perspective on Regulation (October 2020), available at: https://www.cliffordchance.com/content/dam/cliffordchance/briefings/2020/10/security-token-offerings-a-european-perspective-on-regulation.pdf. ↑
30. Brian Elzweig and Lawrence J. Trautman, When Does a Nonfungible Token (NFT) Become a Security? (March 11, 2022). 39 Georgia State University Law Review, 295 (2023), Available at SSRN: https://ssrn.com/abstract=4055585. ↑
31. Johannes Writz et al., Road to MiCAR: The European Crypto-assets Regulation The Bird & Bird Guide to the European Union’s Regulation on Markets in Crypto-assets (MiCAR), Bird&Bird, June 2023, available at: https://www.twobirds.com/-/media/new-website-content/pdfs/2022/articles/road-to-micar_en.pdf. ↑
32. Finantsinspektsioon, Security Tokens (November 17, 2022), available at: https://www.fi.ee/en/finantsinspektsioon/innovation-hub/security-token (last visited Jun 27, 2023). ↑
33. Max J. Heinzle, Security Token Offerings: Anatomy and Context, Part 3: Secondary Markets for Security Tokens, 21finance, March 2022, available at: https://21.finance/wp-content/uploads/en-sto-101-secondary-markets-whitepaper.pdf. ↑