April 24, 2023 - Earlier this year, in a 64-page decision, Judge Victor Marrero of the U.S. District Court for the Southern District of New York held that "Moments"—Dapper Labs' NBA Top Shot non-fungible tokens—are plausibly securities under the U.S. Supreme Court's Howey test. This is the first U.S. court decision indicating that NFTs might constitute securities.
Although the court was careful to describe its decision as a "narrow" one at the motion-to-dismiss stage, it took a broad approach in applying the Howey test. The decision is likely to have far-reaching impact, including an uptick in securities-related NFT litigation.
Dapper Labs, Moments & the Marketplace
"Moments" are non-fungible tokens ("NFTs") linked to digital video clips of highlights from NBA basketball games. Dapper Labs "mints" or creates Moments. While Dapper Labs might create 1,000 copies of a memorable Lebron James dunk, each Moment is non-fungible because it gets assigned a unique serial number as part of the minting process.
Dapper Labs sells "packs" of Moments on its "NBA Top Shot" application. The application includes a secondary "Marketplace" on which people can trade Moments with each other. The Top Shot application and Moments exist on the Flow Blockchain, a private blockchain that Dapper Labs developed and maintains—a fact that plays a prominent role in the court's decision.
Howey Meets NFTs
Plaintiffs allege in this putative class action that Dapper Labs and its CEO (the "Defendants") violated federal securities law by selling Moments without registering them as securities. Defendants moved to dismiss the Amended Complaint. In its February 22, 2023 decision, the District Court held that Plaintiffs sufficiently allege that Moments constitute "investment contracts"—a type of security.
In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court defined an "investment contract" as a "contract, transaction or scheme," whereby there is (1) an investment of money, (2) in a common enterprise (3) with the expectation of profit from the "essential entrepreneurial or managerial efforts of others." Decision and Order, Friel v. Dapper Labs, Inc., No. 21-cv-5837 (VM), ECF No. 43, at 17-18 (S.D.N.Y. Feb. 22, 2023). As is common under the Howey test, the court focused its analysis on the second and third prongs.
Relying heavily on prior Initial Coin Offering ("ICO") cases, the court held that Plaintiffs sufficiently pled a type of commonality—"horizontal commonality"—which requires a "sharing or pooling of the funds of investors," such that, the fortunes of each investor are "tied to one another" and "to the success of the overall venture." Id. at 24.
Pooling. The court observed that allegations plausibly tying "the funds received by the promoter through the offering to an improvement of the ecosystem (i.e., the private blockchain) that consequently increases the value of the token offered," satisfy the pooling requirement. Id. at 28. Here, the court found plausible Plaintiffs' allegations that Dapper Labs used proceeds from the sale of Moments and transaction fees from the Marketplace "to support and grow [the Flow] blockchain," which, in turn, was "necessary to the value of the Moments." Id. at 32-33. The court also held that pooling need not occur prior to the construction of the ecosystem, but can also occur post-launch to "support the [platform's] continued development." Id. at 29-30.
Tying of Investors' and Venture's Fortunes. The court found Plaintiffs' allegations—that (i) Dapper Labs "controls the enterprise;" (ii) Moments can only be traded on Dapper Labs' Marketplace; and (iii) purchasers of Moments are "hitching their wagons to the continued success" of NBA Top Shot, Dapper Labs and the Flow Blockchain—are sufficient to support the conclusion that Moments' value is "tied" to "the continued success of the blockchain." Id. at 33-34. The court reasoned: it follows that, if "Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero." Id. at 33-36.
Expectation of Profits and Consumptive Use
The court found sufficient Plaintiffs' allegations that Dapper Labs led purchasers to expect profits from buying Moments. Like courts in the prior ICO cases, this court focused on Defendants' marketing and public statements: it highlighted Plaintiffs' allegations that Dapper Labs marketed Moments based on scarcity; tweeted about record Moment sales; and its CEO promoted Moments as "valuable" holdings. Id. at 46-48.
More consequentially for future NFT-cases, the court found Defendants' utility argument—that purchasers bought Moments for a consumptive motive, as they would a physical sports card, rather than a profit or investment motive—raised "factual" questions that must be resolved at a later stage in the case.
Efforts of Others
At the heart of the court's efforts-of-others analysis—and in a sense the entire decision—is a strong focus on the "private blockchain." The court explained: "By privatizing the blockchain on which Moments' value depends and restricting the trade of Moments to only the Flow Blockchain, purchasers must rely on Dapper Labs's expertise and managerial efforts, as well as its continued success and existence." Id. at 62. The court concluded that, "if Dapper Labs became insolvent... purchasers would lose the value of their Moments," underscoring the "essential efforts" of Dapper Labs to the value of Moments. Id. at 56, 63.
The Dapper Labs court emphasized that its decision does not mean every NFT is a security. Id. at 62. Moreover, with the court's decision, Plaintiffs only survived a motion to dismiss; they must still prove that Moments are "investment contracts." Nonetheless, the Dapper Labs decision offers key takeaways for how courts might address future securities claims involving NFTs and other digital assets.
- Private Blockchains. One of the most far-reaching aspects of the Dapper Labs decision is the court's emphasis on blockchain technology, which it finds "alter[s]" the Howey analysis. Id. at 22. The court effectively equates, at least for motion-to-dismiss purposes, Dapper Labs' "private blockchain" on which Moments exist and trade, with satisfaction of the efforts-of-others requirement. The big differentiator for the court is the private (versus public) nature of the Flow Blockchain. While creators of NFTs on private blockchains should take special note of this decision, it does not preclude plaintiffs from arguing that NFTs on public blockchains are also securities based on other factors.
- Commonality without Fractionalization. The predominant view in the crypto industry has been: given that each NFT is unique, NFTs might constitute Howey securities only if they are fractionalized—i.e., more than one owner shares an interest in one unique NFT. The Dapper Labs decision says otherwise. The court acknowledges NFTs' "definitional" uniqueness, but finds commonality among Moment purchasers by analyzing the NFT within the larger "ecosystem" of the underlying blockchain and applications on the blockchain that support Moments. This broader approach could push many NFTs closer to crossing the line into a Howey investment contract. Whether other courts take a similar broad view is still to be seen.
- Consumption versus Investment. This dichotomy is likely to arise frequently in securities cases involving NFTs since NFTs are often compared to, and marketed as, collectibles. Here, the court deferred resolution of that debate to summary judgment. However, its decision indicates that being able to "view" the linked contents of an NFT—here the NBA highlights—might not suffice, and that courts will look carefully at what consumable rights the NFT-owners effectively hold.
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