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.