Dapper Labs’ decision could spell trouble for other centralized NFT projects, experts say

A recent legal decision could provide some much-needed – but not much-liked – clarity on the regulatory landscape going forward for non-fungible tokens (NFTs) that could define how centralized companies enter the Web3.

In his 64-page ruling Wednesday, U.S. District Judge Victor Marrero of the Southern District of New York considered Dapper Labs’ NFT collection under the four prongs of the Howey test, a 90-year-old method developed by the U.S. Supreme Court to determine whether certain transactions qualify as “investment contracts.”

Marrero stated that the plaintiffs sufficiently argued that the Top Shot NFTs met each of the four prongs of the Howey test. The fourth point – that the profit expected from an investment must come from the efforts of others – was particularly important to Marrero’s analysis.

Because Dapper Labs controls the Flow blockchain the NFT collection is built on, as well as the marketplace where the NFTs are bought and sold, Marrero suggested that the financial viability of the project depended on Dapper Labs’ continued success.

“Essentially, everything Moments buyers own is the code registered on the Flow Blockchain,” Marrero wrote. “It follows that if, hypothetically, Dapper Labs went out of business and shut down the Flow Blockchain, the value of all moments would drop to zero.”

Although Dapper Labs tried to argue in its motion to dismiss that the NFTs were the digital equivalent of any other cardboard-based collectibles, like Pokemon cards or baseball cards, Marrero fundamentally disagreed.

“It is the particular arrangement that Dapper Labs offers Moments that creates the sufficient legal relationship between investor and promoter to establish an investment contract, and thus a security, under Howey,” Marrero concluded.

Although Marrero’s ruling is, by his own admission, “narrow” (meaning it does not necessarily mean that other NFTs are securities), and is neither final nor precedent-setting, legal experts agree that it is significant – both for Dapper Labs and beyond. NFT place.

Anthony Sabino, a law professor at St. John’s University, told CoinDesk that Marrero’s opinion that Dapper Labs’ NFTs meet the definition of securities “may not necessarily be precedent, but it should be quite influential because it comes from the Southern District [of New York]because it is from an eminent jurist and because it just makes a lot of sense.”

“The judges in the Southern District of New York are particularly skilled in securities cases, for the reason that they are within walking distance of Wall Street itself,” Sabino said. “They have their finger on the pulse of Wall Street. They see these cases all the time.”

Sabino added that the Southern District of New York reports to the federal Second Circuit Court of Appeals, which he said has been recognized by the U.S. Supreme Court since the 1970s as the “mother court” of federal securities laws.

However, other lawyers, such as Jesse Hynes, a New Jersey-based attorney whose practice includes cryptocurrency law, see less reason to believe that Marrero’s analysis spells disaster for either Dapper Labs or the broader NFT space.

Motions to dismiss, Hynes explained, are common — and usually unsuccessful — attempts to stop lawsuits before they get to trial.

“Lawyers will throw up some kind of ‘Hail Mary’ [to end the litigation]”, Hynes told CoinDesk. “Or, in keeping with the basketball analogy — a full court shot with eyes closed.”

Hynes told CoinDesk that as long as the plaintiffs’ claims were deemed to be “reasonably feasible,” the complaint was determined to proceed to the next stage of the litigation.

Whether or not Marrero’s ruling sets a precedent, legal experts agree that other judges are unlikely to be the only ones to notice his analysis — particularly his insinuation that it was Dapper Labs’ creation and control of the Flow blockchain and marketplace that brought Top Shots NFTs under the Howey test’s withdrawal.

“This case is about centralization and external dependencies,” said Mike Selig, a New York-based cryptocurrency attorney at Willkie Farr & Gallagher. “Plaintiffs argue that the NFTs are distinguishable from physical basketball trading cards because Dapper [Labs] maintains the blockchain on which the NFTs operate, operates the secondary marketplace where the NFTs trade and engages in the ongoing marketing of the NFTs to consumers.”

Moish Peltz, a New York-based partner at Falcon Rappaport & Berkman whose practice focuses on cryptocurrencies and intellectual property, told CoinDesk that it was “ironic” that Dapper Lab’s decision to build on top of the Flow blockchain “in a specific attempt to to create a better consumer experience was seized by the court.”

“Since Moments lives exclusively on the Flow blockchain, has [National Basketball Association] tried to solve many of the financial, intellectual property and regulatory issues that have plagued brand owners on public blockchains,” said Peltz. “This decision directly challenges the rationale that a centralized NFT marketplace experience is automatically safer for brands.”

Although Marrero interpreted his own decision as “narrow” and argued that “not all NFTs offered or sold by any company will constitute a security,” Peltz said his decision should push brands to “more deeply consider the relative merits of build custom experiences under their exclusive control on centralized blockchains, versus deploying on public blockchains.”

Jeremy Goldman, an intellectual property (IP) lawyer and partner at Frankfurt law firm Kurnit Klein & Selz, told CoinDesk that the ruling could be good news for NFT projects that build on public blockchains.

“People minting NFTs on public blockchains and using open marketplaces can breathe a little easier,” Goldman said. “The vast majority of NFT projects do not share the key facts that troubled the court.”

He noted that Dapper’s strategy of creating a “walled garden” within the platform is what contributed to the ruling, and provided future guidance on how to create NFT platforms and products.

“As with most blockchain ventures, the more centralized the NFT offering, the greater the risk that the offering will be considered a security,” Goldman said. “My hope is that the Dapper Labs decision helps educate courts, lawmakers and regulators about the fundamental distinction between private and public blockchains; between centralized platforms and decentralized protocols.”

“This case shows that decentralization is just as important in the case of NFTs as it is with fungible tokens,” Selig told CoinDesk.

Sabino, the law professor, agreed. He argued that if Dapper Labs was more decentralized, it could possibly have avoided triggering Howey.

Because Dapper Labs controlled the marketplace where the NFTs were sold, Sabino argued, the role of investors was diminished.

“That way, the buyers become true investors, passive in nature, and therefore make it a security subject to federal securities laws,” Sabino said. “To the extent that there is decentralization and the buyers are far more active and they are far less dependent on ‘other people’s efforts’, it becomes less likely that NFT will fall within Howey.”

However, not all legal experts are hopeful that decentralization will provide any protection for NFT projects.

“I just don’t think the argument that something is centralized or isn’t being centralized will be sufficient to beat this case,” Max Dilendorf, a New York-based cryptocurrency attorney, told CoinDesk, pointing to a 2018 case brought by the SEC . against decentralized trading platform EtherDelta.

In the EtherDelta case, Dilendorf said, “the [SEC] said, ‘Hey, you know, we don’t really care if you’re decentralized or not, it’s irrelevant. You launched something that was illegal, the exchange was run as an unregistered stock exchange, so you as the founder are responsible.”

“I think it’s so incredibly hard to argue that any blockchain project is decentralized. It’s impossible, right?” Dillendorf said. “I don’t think anyone would be able to trust that.”

While lawyers may be nervous about the implications of Marrero’s ruling, major players in the NFT space are so far unfazed by the implications the case could have on their future operations. In other words, they are safe in the belief that NFTs are not securities.

“Courts have repeatedly found that consumer goods — including art and collectibles like basketball cards — are not securities under federal law,” a representative from Dapper Labs told CoinDesk. “We are confident that the same applies to Moments and other collectibles, digital or otherwise, and look forward to defending our position in court as the case continues.”

Josh Rosenblatt, CEO and general counsel of Co:Create, a company that helps NFT projects launch their own cryptocurrencies, told CoinDesk that in terms of regulation, the Dapper Labs case is “not an important ruling” and that the case will be set. no precedent for the future of NFTs being classified as securities.

“Ultimately, if a token, whether fungible or non-fungible, was considered a security, the issuer would either have to register with the SEC or take advantage of an exemption from registration,” Rosenblatt said. “I think the crypto community will be eagerly watching from the sidelines, and I personally would be shocked if the ruling ultimately went against Top Shot.”

Rosenblatt specified that while the risk of regulators considering NFTs as securities is low, fractional NFTs – or NFTs that represent shared ownership of one token – are more likely to fall into this category.

Sanjay Raghavan, head of Web3 initiatives at blockchain real estate firm Roofstock onChain, told CoinDesk that the specificity of Dapper Labs’ scheme to create a private blockchain and marketplace could render the NFTs as securities, but to apply the same ruling to all NFTs -s will be a “wide range” of the Howey test.

“There are many NFT projects running on public blockchains with high consumer value and associated IP rights that don’t necessarily meet the edges of the Howey test,” Raghavan said. “Whether it’s staking-as-a-service, stablecoin return programs, or NFTs on private blockchains, it’s possible to look at hundreds of lawsuits to determine what constitutes an investment contract and what probably doesn’t.”

While the NFT regulatory landscape is still relatively new territory for both creators and collectors, the Dapper Labs ruling may not bode well for the future of a tokenized economy.

It’s especially difficult for Web3 companies that rely on centralized entities to help bring consumers and brands together, which serves as the ethos behind many of these projects. As mainstream brands like Nike and Starbucks take their first steps into NFTs, the Dapper Labs ruling could serve as a warning sign for centralized companies tapping into Web3.

A representative from secondary NFT marketplace OpenSea told CoinDesk that classifying all NFTs as securities is not plausible due to the tokens’ varied utility. While the underlying technology may be adjacent, their use cases such as gaming, art, ticketing and digital identity all deserve different levels of regulatory scrutiny.

While regulators may continue to apply the Howey Test prongs to projects that pose a risk of being classified as securities, Goldman believes the ruling is an important step in providing regulatory clarity for all NFT projects spanning the space, whether public or private.

“Right or wrong, the decision provides some of the best legal guidance I’ve seen — basically a road map — on how to structure NFT projects in a way that minimizes securities risk,” Goldman said.

Read the full ruling below: