We have previously discussed the difficult intellectual property rights implications of non-fungible tokens (“NFTs”), units of data stored on a blockchain that signify ownership of a unique digital media item. But another emerging issue facing the NFT market is what, if any, application federal securities laws have on the offering and sale of NFTs. This issue recently came up in a 64-page federal court decision in Friel v. Dapper Labs, Inc., No. 21 CIV. 5837 (WC), ECF No. 43 (SDNY Feb. 22, 2023). Defendant Dapper Labs is the creator of a popular set of NFTs created in collaboration with the NBA called “Moments”: unique and non-fungible video highlights from NBA games, each with its 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 the plaintiffs had sufficiently alleged that Moments were not merely collectibles akin to sports trading cards, but were in fact securities and should have been registered as such. Importantly, the Court did not make a decision that the NFT is necessarily “securities,” but rather found that, assuming the plaintiffs’ allegations were true, Moments special had characteristics of a security. The basis of the court’s decision, including that Dapper Labs fully controlled Moments’ secondary market and that Moments was promoted by tweets with emojis that invoked images of return on investment, provide a useful warning to other NFT sellers seeking to mitigate risk.
Plaintiffs’ claims that moment is an “investment contract” and should have been registered
The Amended Complaint i Friel makes allegations that would be current in cases involving the purchase and sale of shares, but seeks to chart new territory for NFTs: that they were mistakenly sold as unregistered securities. In a nutshell, the named plaintiff, on behalf of a purported class, alleges that he purchased Moments. The plaintiff further argued that Moments was in fact a type of security known as an “investment contract”, which is created where there is an investment of money, in a joint venture, with a reasonable expectation of profits to be derived from the efforts of others. According to the plaintiffs, Moments should have been, but was not, registered as securities with the SEC before the sale, that is, Dapper Labs should have made detailed public filings describing, among other things, risk factors and financial information.
The parties’ cards debate whether the moments are securities or just a digital trading card or collectible
In its motion to dismiss, Dapper Labs came out swinging, arguing in its opening lines that “Plaintiffs are trying to make a federal securities case about basketball cards. Basketball cards are not securities. Pokemon cards are not securities. Baseball cards are not securities.” It argued that aside from their digital nature, snaps are no different than physical basketball cards, rare coins or art — all of which are well-established under federal securities law. not be investment contracts. Plaintiffs, who opposed the motion, naturally disagreed with this analogy, arguing that unlike a trading card that could be sold anywhere, including eBay, Moments could just sold on a secondary marketplace that Dapper Labs controlled, and as such “Plaintiffs do not improperly import trading card securities laws; Dapper Labs exploited trading cards by turning them into securities.”
The court agrees with the plaintiffs and finds that moments are sufficiently alleged to be securities
In its February 22, 2023 order, the court generally agreed with the plaintiffs and denied Dapper Labs’ motion to dismiss. Although the court acknowledged 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, the plaintiffs sufficiently alleged that moments were not merely trading cards or collectibles, but were in fact unregistered. securities.
In determining whether an “investment contract” was created, the Court used factors from “Howey Test,” named after the landmark 1946 Supreme Court case SEC v. WJ Howey Co .which, in the citrus orchards context, looked at whether the purchase of the purported security involved all of the following three factors (1) investment of money (which was not in dispute), (2) a joint venture, and (3) expectation of profit.
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 artwork or trading cards unrelated to an artist remains alive or a trading card company remains in business, “if, hypothetically, Dapper Labs went bankrupt and shut down the Flow Blockchain, the value of all Moments would drop to zero. It is the critical causation that other collectibles cases lack, and that is alleged here.”
Another important consideration by the court, in determining the “expectation of profit” factor, was that the plaintiffs had alleged that the defendants’ public statements and marketing materials “objectively led buyers to expect profit,” including, in particular, tweets from Dapper Labs with emojis depicting rocket ships, stock charts and money bags, which “objectively mean one thing: a financial return on investment”.
Takeaways from Dapper Labs Decision
The Dapper Labs the decision is notable in finding that an NFT can be an unregistered security. Taking a page out of Friel’s playbook, on March 9, 2023, a plaintiff filed a putative federal securities class action alleging that DraftKings Inc. illegally sold unregistered securities when it issued NFTs through its own marketplace. Here, it Dapper Labs the decision can be credited to the assist, as the complaint against Draftkings alleges “[i]in fact, DraftKing’s NFTs are dependent on the success of DraftKings because it controls the DK Marketplace. If DraftKings or DK Marketplace ceases to exist, the Marketplace NFTs will be worthless.” This language mirrors Dapper Labs the decision’s discussion that Moments are only available on Dapper Labs’ “Flow” blockchain.
It’s still too early to tell how this game will play out. Nevertheless, it should be noted that Dapper Labs the decision does not stand for the proposition that any digital asset is itself an investment contract that will repudiate Howey test. Rather, the court focused on the details of how Moments worked, including the lack of a secondary market unrelated to Dapper Lab’s own proprietary blockchain and the promotion of Moments to imply an expectation of profit. Furthermore, it is important to remember that the Court simply denied a motion to dismiss, and as such was required to assume that all of the plaintiffs’ allegations were true – not make a decision on the merits of the plaintiffs’ claims. Nevertheless, it Dapper Labs the decision is likely to provide a template for enterprising plaintiffs going forward, especially for NFTs that are tied to the success and failure of the company that creates them, as opposed to an NFT registered on a separate blockchain like Ethereum. Furthermore, companies offering NFTs should be aware that their public statements – including their choice of emojis – can and will be used against them in future securities litigation, and be guided accordingly.
