September 22, 2022

Borrowing and Renting in the Metaverse: The Disputes Are Yet to Come

Holland & Knight Masters of the Metaverse Blog
Andrew J. Soven
Masters of the Metaverse Blog

Second Life, which was brought to virtual life by Linden Lab in 2003, is widely acknowledged as the first "metaverse" in which individuals could acquire, build on and, if they wished, sell virtual land. Coming to life long before the advent of cryptocurrency, the coin of the realm was the U.S. dollar, and land could be acquired through auctions held by Second Life. In 2006, Second Life concluded that an avatar named Marc Woebegone had found a way to hack into an auction and acquire a property below market value. Second Life took back the land, and all other virtual land owned by Woebegone, with the flip of a switch, effectively accomplishing the first ever non-judicial virtual foreclosure. Bragg v. Linden Lab, 487 F. Supp. 2d 593 (E.D. Pa. 2007). The matter eventually settled.

Almost 20 years later since Second Life welcomed its first avatar residents, it seems inevitable that if the metaverses succeed to the degree that J.P. Morgan and many others hope, virtual land disputes will only become more common. For example, TerraZero Technologies, founded in 2021, promotes that it "owns, acquires, leases and develops real estate within multiple Metaverses" (including Decentraland, where there currently are roughly 200 properties), while also providing "a full service real estate experience, including buying, leasing, construction, tenant representation and white-glove brokerage services." TerraZero rents and sells its land to individual consumers and businesses alike.

Interestingly, TerraZero deliberately attributes its properties with many of the characteristics of traditional real estate, i.e., "LAND is a non-fungible digital asset maintained in an Ethereum smart contract … divided into parties are referenced using unique x,y Cartesian coordinates," and "each LAND token includes a record of its coordinates, its owner and a reference to a content description file or parcel manifest that describes and encodes the content the owner wishes to serve on his or her land." In other words, just as in real life, the land purports to be unique and has a title resembling that found in a traditional deed. Unlike Second Life's owner, which claimed, "You have to remember this stuff isn't real. It's a game on a computer," TerraZero and others consider their land as more than just a game. Evans v. Linden Research, 2012 WL 5877579, at *2 (N.D. Cal. Nov. 20, 2012).

Indeed, TerraZero will loan U.S. dollars to individuals and businesses to allow them to buy property. To secure these loans, NFTs are given by the borrower as collateral. Once the debt is paid, TerraZero returns the NFTs to the borrower. It is unclear clear from the website whether an owner can sell the land subject to a mortgage or whether the owner can borrow against the property further and grant a security interest to a third party, which potentially would have its own remedies rights in event of default.

Not the Same

Presumably, there will come a time when a TerraZero borrower defaults and disputes the forfeiture of its collateral and the loss of its rights to the property. Despite "land" being given the attributes of traditional real estate, it is difficult to believe that a court will deem the land so similar to virtual real estate as to require TerraZero to initiate the notice and other procedures associated with either judicial or non-judicial foreclosures, given that there the property does not exist in particular state and that the rules behind traditional foreclosure would be hard to bend to sensible application in the virtual world.

But it is a much closer call as to whether the requirements of Uniform Commercial Code (UCC or Code) Article 9 should be followed if TerraZero flips the switch, extinguishes its borrower's rights and declares ownership of the NFTs it holds as collateral. Do any of the Code's notice requirements (which differ depending on whether the borrower is a consumer or a business), redemption requirements and collateral sale rules apply? It is only a matter of time before these arguments are made, and although in traditional contracts some elements of the UCC can be waived by agreement, the applicable statutes are generally non-waivable under state law.

Equally certain is the possibility of a dispute if TerraZero decides that a tenant has breached its lease and "evicts" (again, by a flip of a switch) its tenant. Would the higher protections, such as laws barring debt acceleration, offered by many states to individual tenants in the real world apply? Would a persistent coding error violate a virtual implied covenant of habitability? And at an even more basic level, will leases be subject to the numerous requirements (font size, etc.) that apply in the real world?

It seems likely that virtual property owners, landlords and brokers will argue that despite the nomenclature resembling real estate in the non-virtual world, their arrangements are subject to their Terms of Service, and the state laws that govern selling and renting real estate simply do not apply. However, numerous questions remain unanswered, including whether terms of service need to distinguish between consumer and commercial entities in the manner often required by Article 9. But as the housing market in Decentraland and other metaverses similar to it heats up, it likely will not be long before a brick-and-mortar court weighs in.

How We Can Help

Holland & Knight's Metaverse Strategy Team includes experienced attorneys who are recognized thought leaders in the field. The Metaverse Strategy Team represents dozens of clients, including Fortune 500 companies to technology startups, as these businesses navigate the metaverse landscape.

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