The court denies Dapper Labs’ motion to dismiss, finding that NFTs can be securities | Goodwin

On February 22, 2023, US District Judge Victor Marrero of the Southern District of New York denied a motion to dismiss a putative class action brought by purchasers of a non-fungible token (NFT) against Dapper Labs, Inc. (Dapper Labs), and its CEO . In the complaint, the plaintiffs alleged that Dapper Lab’s failure to register the NBA Top Shot Moments NFT with the US Securities and Exchange Commission (SEC) violated Sections 5 and 12(a)(1) of the Securities Act of 1933 (Securities Act) ), and that the executive director was responsible as a “control person.” In denying the motion to dismiss, the court rejected the defendants’ argument that the NFTs were not securities, and thus never needed to be registered in the first instance.

The court specifically applied the well-known test set out in SEC v. Howey Co ., 328 US 293 (1946), to determine whether the NFTs were “investment contracts”, and therefore securities (as the plaintiffs alleged), or were more akin to cardboard basketball cards not regulated under the securities laws (as urged by the defendants). The court held that the plaintiffs pleaded facts sufficient to establish the extent of Howey test: “an investment of money . . . in a joint enterprise. . . with the expectation of profit from the essential entrepreneurial or managerial efforts of others.” The defendant conceded that the first point was satisfied, and on the second point failed to convince the court that the plaintiffs had failed to allege a “joint enterprise”. The court credited the plaintiffs’ claims that the performance of their NFTs was tied to Dapper Labs as a result of its significant control over the primary and secondary markets for the NFTs and the Flow blockchain (a private blockchain created by Dapper Labs as a platform to sell the NFTs), and investors would have no way to sell or transfer their NFTs without the Flow blockchain—claims that the court concluded supported a claim that the NFTs would have no value without Dapper Labs’ efforts. Finally, the court found that Dapper Labs created an expectation of profit by promoting NFT sales on social media with emojis that the court interpreted as an alleged promise of future profits to buyers.

In particular, the court warned that its decision that the NFTs were securities was a “close call” and “narrow”, explaining that “[n]ot all NFTs offered or sold by a company will constitute collateral, as this must be decided “on a case-by-case basis.” Despite this caveat, this and other decisions categorizing NFTs as securities naturally increase exposure to those selling NFTs and serve as a reminder of the risks faced by similar businesses that exercise heavy or complete control over token sales on private platforms.

The Delaware Chancery Court rejects Caremark Claims against McDonald’s directors

On March 1, 2023, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery dismissed derivative claims against directors of McDonald’s Corporation based on their alleged failure to address sexual harassment within the company. The derivative suit alleged that the defendants ignored red flags of inappropriate behavior by the company’s former CEO and Global Chief People Officer.

In dismissing the case, the court determined that the plaintiffs had not met the demanding burden of alleging that the board members breached their duties pursuant to Caremark, which requires an allegation that the board either (1) completely failed to implement any reporting or information system or controls, or (2) knowingly failed to monitor the company’s operations despite the existence of internal controls. Although the court recognized and accepted the allegations of sexual harassment as red flags, this allegation was not sufficient to overcome the strong business judgment rule that the defendants acted in good faith in responding to them.

The court emphasized the difficulty of prosecuting Caremark claim, which is a favorable standard for those facing such claims and a reminder of the strong protection offered by the business judgment rule. As a practical matter, boards should remain aware of the risks facing the company, have a compliance system in place to address risks that require the board’s attention, and immediately remediate red flags.

For a more thorough discussion of McDonald’s decision, please see “McDonald’s Part Two: Delaware Court of Chancery Dismisses Caremark Claims Against Directors Arising from Sexual Harassment Issues.”

Delaware Chancery Court Dismisses Shareholder Monopoly Lawsuit Against Facebook\

On March 1, 2023, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery dismissed an antitrust lawsuit filed by shareholders of Facebook’s parent, Meta Platforms, Inc., against the issuer and several directors and officers. The plaintiffs also alleged that the directors and officers breached their fiduciary duty to prevent a “monopolistic buy-or-bury” business strategy that in turn pushed potential social media competitors out of business. These claims largely cut and pasted those asserted by the Federal Trade Commission in ongoing litigation in the US District Court for the District of Columbia.

Vice-Chancellor Laster ruled from the bench after oral argument, and rejected the shareholder complaint with the caveat that he did not make a claim. He sharply criticized the plaintiffs for bringing such general and untargeted claims—which the court deemed to be no more than broad accusations that Facebook was a bad actor unsupported by any allegation of specific tortious wrongdoing.

Vice-Chancellor Laster focused particularly on Caremark aspect of the plaintiffs’ action, in which the plaintiffs sought to use In re Caremark International Inc. Derivative Litigation, which imposes on corporate directors a duty of care and a duty of care to recognize and act on “red flags” in a company, to argue that Facebook’s directors and management breached their fiduciary duties by implementing a monopolistic business strategy despite knowing that it would likely lead to federal enforcement of antitrust measures. Vice-Chancellor Laster did not allow himself to be persuaded, and noted that Caremark was not intended as an open license to sue directors under any federal or state law.

Vice Chancellor Laster also criticized Caremark argues that they are premature, as the FTC antitrust action is still pending in federal court. Here, Facebook had not yet suffered a loss on which the burden needed to be shifted, and Vice Chancellor Laster noted that the plaintiffs could not rely on the pending federal antitrust lawsuit as evidence of a loss to the company that could trigger Caremark duties.

First ever criminal insider trading case based solely on 10b5-1 plans

On February 24, 2023, federal prosecutors filed criminal insider trading charges against Terren Peizer, the founder and executive chairman of healthcare company Ontrak Inc. (Ontrak). According to the indictment, Peizer illegally sold nearly $20 million of his stock through two Rule 10b5-1 plans that he adopted after learned that Ontrak’s largest customer planned early termination of the $90 million contract.

Rule 10b5-1 plans generally serve as a defense to claims of improper insider trading, but only if they are adopted when the owner is not in possession of material nonpublic information about the company. In addition, the SEC recently adopted rules requiring a mandatory cooling-off period of 120 days after a 10b5-1 plan is adopted before trades may be made pursuant to it. Although these requirements were not in effect when Peizer made his trades, the Department of Justice (DOJ) claimed not only that Peizer opened his 10b5-1 plans while in possession of the material non-public early termination information, but also that when a brokerage firm refused to let Peizer open a 10b5-1 plan with it without a cooling-off period, and switched to another brokerage that would allow him to start trading immediately.

After dropping its indictment against Peizer on March 1, the DOJ issued a press release calling the case “groundbreaking” as the first criminal prosecution based solely on an executive’s use of 10b5-1 trading plans, and stated its commitment to identifying executives who attempt to use 10b5-1 trading plans to avoid insider trading costs. The DOJ’s criminal charges are proceeding in parallel with a separate SEC enforcement case against Peizer and Acuitas Group Holdings, his wholly-owned investment company, in the Central District of California. The SEC has similarly alleged that Peizer, individually and through his investment company, violated federal securities laws by acting on material non-public information about the client’s intention to terminate its relationship with Ontrak.

SDNY allows Bitcoin Tips case to proceed against stock promoter

On March 7, 2023, U.S. District Judge Andrew L. Carter of the Southern District of New York denied defendant Gannon Giguiere’s motion to dismiss an insider trading case brought by the SEC. Giguiere is a stock promoter whose website, TheMoneyStreet.com (TMS), promoted penny stocks. In 2017, Giguiere agreed to use TMS to market the stock of Long Island Iced Tea Corp. (LTEA). In its complaint, the SEC alleged that Giguiere learned via confidential draft announcements provided by a contact associated with LTEA that LTEA planned to shift its business plan from soda production to focus on blockchain, and that Giguiere asked and was informed of the announcement date in advance of public release of this information. After allegedly receiving this confidential information, but before announcing the pivot to blockchain, Giguiere placed two market orders to buy a total of 35,000 LTEA shares, which he sold less than two hours after the announcement for a profit of $162,500. The SEC subsequently filed an enforcement action against Giguiere, as well as two other individuals involved in the tipping scheme.

In his motion to dismiss, Giguiere argued that he was not subject to tipping liability, since he had not received this information directly from an LTEA employee, but instead through a third-party intermediary who had connected him to LTEA, while the SEC argued that intermediary had informed Giguiere about his insider source. The court agreed with the SEC, holding that the complaint sufficiently alleged that Giguiere both knew that the source of the information was an insider and knew that there was no business reason for him to learn this inside information.

[View source.]