We have previously discussed the
thorny intellectual property implications of non-fungible
tokens (“NFTs”), units of data stored on a blockchain
that signify ownership of a unique digital media item. But another
emergent issue facing the NFT market is what, if any, application
federal securities laws have on the offer and sale of NFTs. This
issue recently came to a head in a 64-page federal court decision
in
Friel v. Dapper Labs, Inc., No. 21 CIV. 5837 (VM), ECF No.
43 (S.D.N.Y. Feb. 22, 2023). Defendant Dapper Labs is the
creator of a popular set of NFTs made in partnership with the NBA
called “Moments”: unique and non-fungible video
highlights of NBA games, each with their own serial number, and
each recorded on Dapper Labs’ own Flow blockchain. The Court,
in a first-of-its-kind decision, denied Dapper Labs’ motion to
dismiss, finding that Plaintiffs had adequately alleged that
Moments were not simply collectibles equivalent to sports trading
cards, but were, in fact, securities and should have been
registered as such. Importantly, the Court did not make a
determination that NFTs are necessarily
“securities,” but rather found that, assuming
Plaintiffs’ allegations to be true, Moments in
particular had characteristics of a security. The basis for
the Court’s decision, including that Dapper Labs fully
controlled Moments’ secondary market and that Moments were
promoted by tweets with emojis invoking imagery of
return-on-investment, provides a useful cautionary tale for other
NFT sellers seeking to mitigate risk.
Plaintiffs’ Allegations that Moments are an
“Investment Contract” and Should Have Been
Registered
The Amended Complaint in Friel makes
allegations that would be run-of-the-mill in cases involving the
buying and selling of stocks, but seeks to chart new territory for
NFTs: that they were improperly sold as unregistered securities. In
a nutshell, the named plaintiff, on behalf of a purported class,
alleges that he purchased Moments. Plaintiff further alleged that
Moments were in actuality a type of security known as an
“investment contract,” which is created where there is
the investment of money, in a common enterprise, with reasonable
expectation of profits to be derived from the efforts of others.
According to Plaintiffs, the Moments should have been, but were
not, registered as securities with the SEC before sale, that is,
Dapper Labs should have made detailed public filings describing,
among other things, risk factors and financial information.
The Parties’ Briefs Debate Whether Moments are Securities
or Simply a Digital Trading Card or Collectible
In its motion to dismiss, Dapper Labs came out
swinging, arguing in their opening lines that “Plaintiffs are
trying to make a federal securities case over basketball cards.
Basketball cards are not securities. Pokémon cards are not
securities. Baseball cards are not securities.” It argued that
aside from their digital nature, Moments are no different than
physical basketball cards, rare coins, or fine art-all of which are
well-established under federal securities law to not be
investment contracts. Plaintiffs, in opposing the motion, naturally disagreed with
this analogy, arguing that, unlike a trading card which could be
sold anywhere, including eBay, Moments could only be sold
on a secondary marketplace that Dapper Labs controlled, and as such
“Plaintiffs are not improperly importing the securities laws
to trading cards; Dapper Labs has capitalized on trading cards by
turning them into securities.”
The Court Agrees with Plaintiffs and Finds that Moments are
Adequately Alleged to be Securities
In its February 22, 2023 order, the Court generally
agreed with Plaintiffs and denied Dapper Labs’ motion to
dismiss. While recognizing that “it is a close call and the
Court’s decision is narrow,” the Court found that,
assuming everything alleged in the Amended Complaint is true,
Plaintiffs adequately alleged that Moments were not simply trading
cards or collectibles, but in fact were unregistered
securities.
In determining whether an “investment contract” was
created, the Court applied factors from the “Howey
Test,” named for the seminal 1946 Supreme Court case SEC
v. W.J. Howey Co., which, in the context of citrus orchards
looked to whether the purchase of the purported security involved
all of the following three factors (1) the investment of money
(which was not disputed), (2) a common enterprise, and (3)
expectation of profits.
Importantly, the Court found, in determining the “common
enterprise” factor, that Moments, once purchased, could only
be sold in a secondary market controlled by Dapper Labs, and thus,
unlike fine artwork or trading cards which is not tethered to an
artist remaining alive or a trading card company staying in
business, “if, hypothetically, Dapper Labs went out of
business and shut down the Flow Blockchain, the value of all
Moments would drop to zero. That is the critical causal connection
that other collectibles cases lack, and which is alleged
here.”
Another important consideration by the Court, in determining the
“expectation of profits” factor, was that Plaintiffs had
alleged that Defendants’ public statements and marketing
materials “objectively led purchasers to expect profits,”
including, notably, tweets by Dapper Labs with emojis depicting
rocket ships, stock charts, and money bags, which “objectively
mean one thing: a financial return on investment.”
Takeaways from the Dapper Labs Decision
The Dapper Labs decision is notable in finding that an
NFT could be an unregistered security. Taking a page out of the
Friel’s playbook, on March 9, 2023, a plaintiff filed a
putative federal securities class action alleging DraftKings Inc.
illegally sold unregistered securities when it released NFTs
through its own marketplace. Here, the Dapper Labs
decision can be credited with the assist, as the complaint against Draftkings alleges
“[i]ndeed, DraftKings NFTs are dependent upon the success of
DraftKings because it controls the DK Marketplace. If DraftKings or
DK Marketplace cease to exist, the Marketplace NFTs will be
worthless.” This language mirrors the Dapper Labs
decision’s discussion of Moments only being available on Dapper
Labs’s “Flow” blockchain.
It’s still too early to see how this game will be played
out. Still, it should be noted that the Dapper Labs
decision does not stand for the proposition that every digital
asset is, in-and-of-itself, an investment contract that would flunk
the Howey test. Rather, the Court focused on the
particulars of how Moments worked, including their lack of a
secondary market not tied to Dapper Labs’ own proprietary
blockchain and the promotion of Moments to suggest an expectation
of profits. Furthermore, it is important to remember that the Court
was simply denying a motion to dismiss, and as such was required to
assume all of Plaintiffs allegations were true-not making a
determination on the merits of Plaintiffs’ claims. Even so, the
Dapper Labs decision will likely provide a template for
enterprising plaintiffs going forward, especially for NFTs that are
tied to the success and failure of the company that mints them, as
opposed to an NFT recorded on a separate blockchain such as
Ethereum. Furthermore, companies offering NFTs should take care
that their public statements-including even their choice of
emojis-can and will be used against them in future securities
litigation, and be guided accordingly.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.