1. Industrial Metaverse Algorithm Market: Regulatory & Legal Challenges, Drivers & Observations

Regulatory and legal drivers that shape this emergent market space specifically relevant to algorithms include:

• Algorithms Treatment & Protection Under First Amendment
  Any words or pictures that would be speech under the First Amendment if produced entirely by a human are equally speech if produced via a human-created algorithm.  So long as humans are making the decisions that underlie the outputs, a human is sending whatever message is sent.  Treatment as speech requires substantive editing by a human being, whether the speech is produced via algorithm or not.  If such substantive editing exists, the resulting communication is speech under the current jurisprudence.  For example, like newspapers, Google algorithms are protected by the First Amendment making them hard to legally regulate them.  Indeed, even Netflix has argued that its recommendation algorithms are protected under the First Amendment.  (The First Amendment and Algorithms - Stuart Minor Benjamin Introduction, 2021), (Lobo, 2018), (Schlott et al., 2021)

• Algorithms Potential Treatment as a Trade Secret in Financial Accounting
  A trade secret is any practice or process of a company that is generally not known outside of the company. Information considered a trade secret gives the company a competitive advantage over its competitors and is often a product of internal research and development.  To be legally considered a trade secret in the United States, a company must make a reasonable effort in concealing the information from the public; the secret must intrinsically have economic value, and the trade secret must contain information. Trade secrets are a part of a company's intellectual property. Unlike a patent, a trade secret is not publicly known. (Frankenfield, n.d.)

• Algorithms Treatment as Trade Secrets and Valuation in Financial Accounting
  The valuation method that works best for trade secret assets is the net present value of future cash flows. This is a method of valuing a trade secret asset using the concept of the time value of money. The estimate of future cash flows is discounted to a present dollar value by a present value discount rate.
  
  Net present value of a future cash flow requires an evaluation of three factors:

• The total amount of future cash flow

• The discounted basis of that future cash flow as a present value

• The probability that the future cash flow will occur

  If accurate values can be assigned to these three factors, then the economic value of a trade secret can be calculated by multiplying these three factors together.  (Halligan, 2022)

• Algorithms in the context of Trade Secret Protections under Law
  In the United States, trade secrets are defined and protected by the Economic Espionage Act of 1996 (outlined in Title 18, Part I, Chapter 90 of the U.S. Code) and also fall under state jurisdiction. As a result of a 1974 ruling, each state may adopt its own trade secret rules. (Frankenfield, n.d.)

• Algorithms & Challenges of IP Patent Protection
  In general, for something to be patentable it must be useful. To be considered useful, it must fall into one of four categories:

  • Machine

  • Process

  • Manufacture

  • Composition of Matter  

Moreover, the invention must also not be:

• An abstract idea

• A natural phenomenon

• A law of nature

That poses the question, “Can an algorithm be patented based on these criteria?”  The problem algorithms run into in meeting these patent criteria is that, on their own, algorithms are abstract ideas.  When standing on their own, courts consider algorithms foundational tools for scientific work, rather than patentable ideas.  However, if the algorithm can be broken down into a series of mathematical steps and procedures that mechanize a process, then the algorithm shifts from “abstract idea” into the patentable “process” category.  While an algorithm cannot be patented, you can patent the series of steps that lead to your algorithm.

An algorithm is not patentable if it falls into one of three categories:

• Mathematical concepts

• Methods of organizing human activity

• Mental processes

To have a patentable algorithm, one must break down the algorithm into a series of steps and explain how it solves a real-world problem.  

In Alice Corp. v. CLS Bank, the Supreme Court ruled that because abstract ideas, natural phenomena, and laws of nature “are the basic tools of scientific and technological work”, it was concerned that granting patent rights for these types of tools might impede innovation rather than promote it.  Alice Corp. Pty. Ltd. v. CLS Bank Int’l, 573 U.S. 208, 216 (2014).

Alice, and another related legal opinion Mayo Collaborative Servs. v. Prometheus Labs., Inc., 566 U.S. 66, 71 (2012), established a test referred to as the Alice/Mayo test.  This patent law test is as follows:

• Is the claim at issue directed to a “judicial exception,” such as an abstract idea? If so then:

• Do the claims contain an element or combination of elements to ensure that the patent in practice amounts to significantly more than a patent upon the [ineligible concept] itself?  (Weifan, n.d.)

• Algorithms & Guidance of Patent Subject Matter Eligibility
  In addition to the terms "laws of nature," "natural phenomena," and "abstract ideas," judicially recognized exceptions have been described using various other terms, including "physical phenomena," "products of nature," "scientific principles," "systems that depend on human intelligence alone," "disembodied concepts," "mental processes," and "disembodied mathematical algorithms and formulas."  (2106-Patent Subject Matter Eligibility, n.d.)

• Algorithms & Filing of Patent Applications, Statistics of Past Patent Applications
  Machine learning is the dominant artificial intelligence (AI) technique. It is found in 40% of all AI-related patents studied and the technique grew at an average rate of 28% every year from 2013-2016.  Mentions of deep learning in patent filings grew annually at an average rate of 175% from 2013-16. Mentions of neural networks grew annually at an average rate of 46% over the same period.  Computer vision, which includes image recognition (critical for self-driving cars, for instance), is the most popular functional application of artificial intelligence (AI). It was mentioned in 49% of all AI-related patents and grew annually at an average rate of 24% over the period 2013-16.  The other two top areas in functional applications are natural language processing (14% of all AI-related patents) and speech processing (13%).
  
  Top 3 application fields in which AI-related patents are filed:

• (1) Telecommunications: 51,273 patent applications (15%)

• (2) Transport: 50,861 patent applications (15%)

• (3) Life & Medical Sciences: 40,758 patent applications (12%)

Companies represent 26 out of the top 30 artificial intelligence (AI) patent applicants. Most of these are multinational firms active in consumer electronics, telecommunications or software.

Acquisitions are relatively common, with 7 out of the top 20 companies having acquired AI firms. Among them, Alphabet has acquired the largest number (18) of AI companies. 

Most AI-related patent filings are made at the patent offices in the United States of America (152,981 filings) and China (137,010). Both countries combine a high number of innovations in AI and potential as a market for AI-related inventions. Filings under WIPO's Patent Cooperation Treaty (PCT System) represent 20% (67,662) of the total number of AI-related filings.  (The Story of Artificial Intelligence in Patents, n.d.)

Regulatory and legal drivers that shape this emergent market space specifically relevant to cryptographic assets include:

• Cryptographic Assets as Securities, Commodities, or Investments
  Crypto assets can be viewed as securities.  An NFT that has been marketed as an asset that will give a return on investment due to the efforts made by others, it is a security.  (Dorsey, n.d.)

• Cryptographic Assets & Treatment in Financial Accounting
  Holding of digital assets on company balance sheets whereby US GAAP and IFRS dictate that digital assets including cryptographic assets be treated as intangible assets.  While ROI cannot be directly booked on an intangible asset (i.e. investment gains, monetization streams), it can be accounted at fair value.  Intangible assets can be accounted for at cost and subject to subsequent impairment can be written down, but the converse is not true, the value of an intangible asset cannot be written up.  

• Cryptographic Assets & Treatment in Intellectual Property Observations
  Usually, the seller of the NFT determines the rights accompanying an NFT.  Metadata associated with an NFT tells about the corresponding assets to which the token is bound.  NFT intellectual property rights regarding the underlying asset of an NFT are created by whoever owns the asset.  The owner of the intellectual rights determines what rights to grant to the NFT buyer.  These rights might include the right to use, copy, modify, and display the content.  When an issuer of an NFT intellectual property obtains content from a creator, the issuer only holds the specific rights granted to them by the creator and can license only the limited rights to the buyer.  NFT transactions may involve issues such as proper licensing language and assignment.

Examination & Treatment of Smart Contract NFTs - Security, Commodity, or Investments 

• Increasing Precedence to treat NFTs as Securities 
  Classifying an algorithm within a smart contract for purposes of treatment as an asset class for transactable exchange and monetary gains of underlying value represent an NFT classification as a likely security, and therefore regulation under SEC and US securities law.  The SEC v. W.J. Howey Co. case in the U.S. Supreme Court put in place a test — “the Howey Test” — to determine what constitutes an investment contract. The Howey Test is a major criterion reflecting the U.S. government’s stance on NFTs.

  The US Supreme Court, in the SEC v W.J. Howey laid down four elements to determine whether digital assets such as cryptocurrencies or NFTs could be considered a “security” or “investment contract”:

  • An investment of money

  • Into a common enterprise

  • In which investors expect to profit

  • From the efforts of third parties
    (Hoppe & Hoppe, 2022), (Dorsey, n.d.)

• NFTs as Asset Classes & SEC Regulation
  NFT platforms facilitating the sale and secondary trade of the asset may need to register with the SEC as a broker-dealer/exchange/alternative trading system. An alternative trading system is a loosely regulated trading venue that matches buyers and sellers for transactions.  (Hoppe & Hoppe, 2022)

• Responsible Financial Innovation Act
  Guardrails are proposed to be placed around the growing industry of digital assets. The Responsible Financial Innovation Act, spearheaded by Senators Kristen Gillibrand and Cynthia Lummis, proposes that the vast majority of digital assets (including NFTs) be classified as commodities (such as wheat, oil or steel) rather than as securities. Oversight responsibility would be on the shoulders of the Commodity Futures Trading Commission (CFTC), not the Securities and Exchange Commission (SEC).  (NFTs as Commodities: Proposed Senate Bill Signals Regulatory Guidelines, 2022)

Accounting Examination of Intangible Assets, Information & Knowledge Assets, Digital Assets, Cryptographic Assets, and IP

• Information & Knowledge Assets 
  Information relevant to an enterprise’s business function, including captured and tacit knowledge of employees, customers or business partners; data and information stored in highly-structured databases; data and information stored in textual form and in less-structured databases such as messages, e-mail, workflow content and spreadsheets; information stored in digital and paper documents; purchased content; and public content from the Internet or other sources. (Definition of Information (Knowledge) Assets, n.d.)

• Intangible Assets 
  An intangible asset is an identifiable non-monetary asset without physical substance. Such an asset is identifiable when it is separable, or when it arises from contractual or other legal rights. Separable assets can be sold, transferred, licensed, etc. Examples of intangible assets include computer software, licenses, trademarks, patents, films, copyrights and import quotas.

  FASB intangible asset categories (each intangible asset is actually an established right of usage, an intangible asset is usually a right that helps the owner to generate revenues):

  • Artistic-related (such as copyrights)

  • Technology-related (patents)

  • Marketing-related (trademarks, trade names)

  • Customer-related (customer relationships, database of customer information)

  • Contract-related (franchises)

  • Goodwill

  • Definite-lived intangible assets 

  • Indefinite-lived intangible assets
    (IFRS - IAS 38 Intangible Assets, n.d.)

• Cryptographic Assets 
  Cryptographic assets are transferable digital representations that are designed in a way that prohibits their copying or duplication. The technology that facilitates the transfer of cryptographic assets is referred to as a ‘blockchain’ or distributed ledger technology. Blockchain is a digital, decentralized ledger that keeps a record of all transactions that take place across a peer-to-peer network and that enables the encryption of information. Cryptographic assets and the underlying technology provide opportunities to digitize a variety of ‘real world’ objects. (Leopold, n.d.)

• Intellectual Property 
  Intellectual Property (IP) refers to the ownership of unique intellectual goods such as inventions, logos, brand names, and product designs.

  IP only refers to something that you’ve created; as such, ideas themselves are not intellectual property. To be considered intellectual property, they must be realized in a more physical way. For example, an idea for an invention isn’t intellectual property, but the patent would be.

  Intellectual property can:

  • be sold or transferred to another owner

  • have more than one owner

  • belong to individuals or businesses

  In accounting, intellectual property is considered an intangible asset, and, when possible, should be recorded as such on the balance sheet.  Copyrights, trademarks and patents should be recorded on the balance sheet and other financial statements at or below, cost price. Internally developed IP (such as trade secrets) shouldn’t be recorded on the balance sheet as they don’t have direct costs or a clear market value. (Intellectual Property - What Is Intellectual Property?, n.d.)

• Trade Secrets 
  Trade secrets are a form of intellectual property. A broad range of information can be considered trade secrets, including for example formulas, processes, designs, production methods, customer lists and business plans.  Many companies opt to classify an algorithm as a trade secret as a first line of defense.  Information will only be protected by a trade secret if it is confidential (known to relatively few people and not publicly disclosed) and if the holders of the trade secret took reasonable steps to maintain its secrecy.  Trade secrets must also have economic value, providing a competitive advantage or having industrial or commercial application.  There is no set expiry date for trade secret protection – the information will be protected for as long as it remains a secret.  (Protecting Trade Secrets in Canada: Things to Know and Do, n.d.), (Collett, 2020)

• US GAAP 
  Currently there are no US GAAP accounting standards that specifically address the accounting for digital assets. In practice, the accounting treatment under US GAAP is to account for cryptocurrencies as intangible assets. The Financial Accounting Standards Board (FASB) has decided not to add a project on accounting for cryptocurrencies. For those reasons, a company’s accounting function must draw on various pertinent sections of US GAAP to facilitate accounting for digital assets.  (Cryptocurrency: Understanding the Basics and Accounting Challenges, 2022), (Corporates Investing in Crypto, n.d.)

• IFRS
  In June 2019, in response to a request from the International Accounting Standards Board (IASB or the Board), the IFRS Interpretations Committee (IFRS IC or the Committee) published an agenda decision on how an IFRS reporter should apply existing IFRS standards to its holdings of cryptocurrencies, a subset of crypto assets. The Committee observed that a holding of cryptocurrency meets the definition of an intangible asset under IAS 38 Intangible Assets as it is capable of being separated from the holder and sold or transferred individually, and is not a monetary asset, i.e., does not give the holder a right to receive a fixed or determinable number of units of currency. The IFRS IC concluded that holdings of cryptocurrencies should be accounted for under IAS 38 unless they are held for sale in the ordinary course of business, in which case IAS 2 Inventories would apply.  

  IFRS IAS 38 defines an intangible asset as ‘an identifiable non monetary asset without physical substance’. An asset is identifiable if it is separable or arises from contractual or other legal rights. An asset is separable if it ‘is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability’.  (Holdings of Cryptocurrencies | IFRS Developments, n.d.)

• SEC
  The SEC defines a digital asset as “an asset that is issued and transferred using distributed ledger or blockchain technology.” Though the security laws in the United States do not explicitly define digital assets, these may be deemed “digital asset securities” in certain circumstances. 

  Disclosure requirements within ASC 350, Intangibles – Goodwill and Other, apply to the digital assets held as an investment.  Additional disclosures under ASC 820, Fair Value Measurement, would be required for the nonrecurring fair value measurement used to determine impairment of those digital assets. To the extent the company sells digital assets or uses them in its business transactions, additional disclosures would be required.  (Corporates Investing in Crypto, n.d.), (Dorsey, n.d.)

• Legal Examination of NFTs & Intellectual Property Rights Determination 
  An NFT is a digital cryptographic way of proving the ownership and authenticity of an underlying asset.  They are non-fungible because they are indivisible, unique, irreplaceable and can be anything from certification of an asset’s ownership, intellectual property rights, utility, etc.  

  Smart contracts are a crucial component of the NFT agreement. In the same way that we would read the fine print of a contract, significant attention should be paid to the coding embedded in the NFT, such as the royalties or commission on the future resale of the token.

  Usually, the seller of the NFT determines the rights accompanying an NFT.  Metadata associated with an NFT tells about the corresponding assets to which the token is bound.  NFT intellectual property rights regarding the underlying asset of an NFT are created by whoever owns the asset. The owner of the intellectual rights determines what rights to grant to the NFT buyer.  These rights might include the right to use, copy, modify, and display the content.

  When an issuer of an NFT intellectual property obtains content from a creator, the issuer only holds the specific rights granted to them by the creator and can license only the limited rights to the buyer.  NFT transactions may involve issues such as proper licensing language and assignment.  (Dorsey, n.d.), (A Beginner's Guide on the Legal Risks and Issues Around NFTs, n.d.)

References