On February 22, 2023, Judge Victor Marrero of the United States District Court for the Southern District of New York declined to dismiss a putative class action asserting claims under the Securities Act of 1933 against a blockchain technology company and its CEO. Friel v. Dapper Labs, Inc., —F. Supp. 3d—, 2023 WL 2162747, at *1 (S.D.N.Y. 2023). Plaintiffs alleged that the company’s offer and sale of non-fungible tokens (“NFTs”) constituted a sale of unregistered securities. The Court held that plaintiffs adequately alleged that the NFTs in question were securities subject to SEC registration requirements.
The crux of the allegations concerned NFTs the company developed in connection with a joint venture with a major sports league. Although the NFTs depicted video clips of game highlights, the purchaser of an NFT owned only the NFT itself and not any rights to the underlying images. Id. at *4-5. The company earned revenue from (i) selling “packs” of the NFTs, (ii) charging transaction fees for secondary market sales, and (iii) charging fees when secondary market participants transferred money out of their company account. Id. at *5.
The Court’s analysis focused on whether the NFTs amounted to securities within the meaning of the Securities Act, which defines a security to include an “investment contract.” Id. at *7. The Court observed that the Supreme Court has defined “investment contract” as “a contract, transaction or scheme whereby a person invests [their] money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” Id. (citing SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)). The Court noted that, because the parties did not dispute that the NFTs involved an investment of money, application of Howey turned on whether plaintiffs had adequately alleged a common enterprise and an expectation of profits derived from the efforts of others. Friel, 2023 WL 2162747, at *9.
The Court explained that there are two theories of common enterprise: (i) horizontal commonality, involving the sharing or pooling of investor funds and that investors’ fortunes are tied to each another and to the success of the overall venture; and (ii) vertical commonality, which in the Second Circuit requires a “one-to-one relationship between the investor and investment manager” such that “the fortunes of plaintiff and defendants are linked so that they rise and fall together.” Id. at *10.
The Court concluded that plaintiffs adequately alleged a horizontal theory of common enterprise. The Court explained that pooling occurs when the funds received by the promoter through an offering are reinvested into the business, which increases the value of the instrument that is offered. Id. at *11. The Court found pooling was adequately alleged because the company’s sales and transaction fees were allegedly used to generate revenue and grow the company’s blockchain and because the company allegedly delayed customers’ requests to transfer money from their digital wallets to their bank accounts, using those funds in the interim to support its blockchain and the NFTs’ value. Id. In addition, the Court determined that plaintiffs adequately alleged that the NFT purchasers’ fortunes were tied to the overall success of the company. Id. at *13. The Court explained that plaintiff effectively alleged that the company controlled the entire enterprise involving the NFTs, the NFTs could only be resold through tools owned by the company, and purchasers needed the company to be successful for the NFTs to have value. Id. The Court also observed that an article incorporated by reference in plaintiffs’ complaint indicated that, when the company halted trading of the NFTs, the value of the NFTs declined, further suggesting that the value of the NFTs was tied to the company’s success. Id. Moreover, the Court noted that it could be reasonably inferred that, if the company went out of business, the NFTs would be worthless since they had no intrinsic value outside of the systems maintained by the company. Id. The Court contrasted this scenario to sports trading cards and other traditional collectibles, which have intrinsic value even if the card manufacturer ceased to exist. Id. at *14.
Although the Court was not required to do so, it also assessed the alternative plaintiffs’ allegations under the “strict” vertical commonality theory and held that plaintiffs’ allegations were insufficient under this theory. While plaintiffs argued that the company’s collection of a five percent fee on NFT secondary market transactions constituted a sufficient link between the fortunes of the investor and the investment manager, the Court emphasized that this fee was collected regardless of the performance of the NFTs, whereas the “strict” vertical commonality theory requires that both sides’ fortunes rise and fall together. Id. at *15.
With respect to the remaining prong of the “investment contract” analysis, the Court held that plaintiffs adequately alleged that the company’s offer of the NFTs came with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The Court observed that the company’s statements allegedly led NFT purchasers to expect profits by highlighting statistics of recent sales of the NFTs, and the use of the “rocket ship” emoji, “stock chart” emoji, and “money bags” emoji to refer to a financial return on investment. Id. at *17. The Court also noted that the company marketed the NFTs based on scarcity, offering common, rare, legendary, and other premium packs of NFTs for purchase. Id. The Court concluded that these allegations plausibly suggested that the company led purchasers to expect they would realize the same gains touted by the company. Id. While the company argued that purchasers were motivated by a desire to consume the videos underlying the NFTs and to collect items associated with their favorite sports teams and players, the Court found these were factual points that could support an argument that not every purchaser of the NFTs intended to pursue profits from them, but that this argument was not sufficient at the pleadings stage to compel dismissal. Id. at *18.
In addition, the Court determined that this expectation of profits was plausibly derived from the entrepreneurial or managerial efforts of others, because the value of the NFTs appeared to be dependent on the continued operation of the company and its blockchain technology. Id. at *19. In this regard, the Court explained that the company allegedly created and maintained a private blockchain, and that, because the blockchain was privatized and access restricted, purchasers had to rely on the company’s expertise and managerial efforts, as well as its continued success and existence. Id. at *22. The Court emphasized that the private nature of the company’s blockchain was “fundamental to the Court’s conclusion,” and that “[n]ot all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.” Id.