US District Court signals that NFTs may qualify as securities in certain circumstances | Baker Hostetler

Important takeaways

• The United States District Court for the Southern District of New York recently confirmed for the first time that, under certain circumstances, non-fungible tokens (NFTs) may qualify as securities under the Securities Act of 1933 (Securities Act), and that crypto-assets (non- fungible or otherwise) may also qualify as securities regardless of whether they were offered during an “initial coin offering” (ICO).
• In the decision, the district court denied the defendants’ motion to dismiss a class action alleging the offering and sale of basketball-themed NFTs (referred to as “Moments”), which resided on a decentralized “private” blockchain and were accessible only through a centralized platform, qualified as “investment contracts” under the standard set forth by the United States Supreme Court in SEC v. WJ Howey Co . (Howey).
• In issuing its holding, the district court found “fundamental” plaintiff’s contention that defendant’s maintenance of a private blockchain was necessary to support the sale and ongoing trading of Moments.

Background

Dapper Labs was founded in 2018 shortly after the debut of its first NFT collection, “CryptoKitties,” [1] which was so successful that it created a bottleneck of transactions on the decentralized Ethereum network. Seeking faster transaction throughput, Dapper Labs later launched its own decentralized “Flow Blockchain” and native FLOW token. In 2019, Dapper Labs launched the NBA Top Shots (Top Shots) platform on the Flow Blockchain as a joint venture between itself, the National Basketball Association (NBA) and the National Basketball Players Association. Dapper Labs then announced the creation of Moments – NFTs individually tagged with unique identifiers referencing video clip highlights from basketball games. Moments can be acquired through “packs” sold directly by Dapper Labs on the Top Shots platform, or individually through secondary sales on the Marketplace.

In May 2021, class plaintiffs sued Dapper Labs and its CEO in New York State Court. The complaint alleged that Dapper Labs used its control over the Top Shots platform and Flow Blockchain to prop up Moments’ value, citing among other things the inability of certain plaintiffs to withdraw money from the platform for up to months at a time. Relying on these and other facts, the plaintiffs’ complaint alleged that Dapper Labs violated Sections 5 and 12(a)(1) of the Securities Act through its unregistered offering and sale of Moments. Section 12(a)(1) provides a private right of action against issuers of securities for failure to comply with the registration and prospectus requirements of Section 5. In July 2021, Dapper Labs removed the lawsuit to the US District Court for the Southern District of New York and moved then to dismiss the complaint.

22 February 2023, depending on the “investment contract” analysis i Howeythe court denied the defendants’ motion to dismiss, holding that the plaintiffs plausibly argued that Moments could qualify as securities because the complaint pleaded (1) an investment of money (2) in a joint venture (3) with the expectation of profits from the founder. or the managerial efforts of others.[2]

FLOW, Flow Blockchain and Moments

The court rejected the defendant’s argument that the plaintiff’s allegations about the FLOW token and blockchain were irrelevant, finding instead that the analysis would necessarily include “the entirety of the scheme at issue,” including allegations of Dapper Labs’ control of FLOW, the Flow Blockchain, and moment.[3] The court also considered the plaintiffs’ description of the Flow Blockchain as “private” and reasoned that because FLOW’s utility created value for Moments through “the Flow network’s consensus on ownership and the price of each transaction,”[4] such facts adduced by the plaintiffs were relevant and critical to support their claims that the Moments were offered as investment contracts pursuant to Howey.[5]

The Howey Test

Find the first point of Howey not in dispute, the Court spent the bulk of its opinion explaining its determination that plaintiffs adequately pleaded the test’s other two prongs.

Joint enterprise

Rejecting the defendant’s position that the Second Circuit relies solely on the application of the “horizontal community” test to determine whether a joint enterprise existed, the court affirmed its practice of applying both the “horizontal community” and the “strict vertical community” test .

The Court first addressed horizontal commonality, stating that to plead it, plaintiffs must show (i) “a division or pooling of the investors’ funds” and (ii) “that the assets of each investor in a group of investors are related to each other and to the success of the overall venture.”[6] Regarding the pooling of funds, the court rejected the defendant’s contention that “the offering and the capital raised therefrom” must “precede the construction of the ecosystem that supports, and enhances, the value of the token.” The Court explained that a temporal requirement “is not supported by case law and does not follow from a practical perspective” because it would “improperly limit the scope of investment contracts to pre-development initial offers.”[7] Instead, the court found that the plaintiffs successfully argued that Dapper Labs raised investor funds by alleging that Dapper Labs received revenue through the sale of Moments and charged fees on secondary sales on the platform, which were used to support the growth of the Flow Blockchain; buyer’s funds were held in Dapper Labs-controlled wallets; and Dapper Labs limited customers’ ability to withdraw money during certain time periods. The court concluded that amalgamation “occurs when the funds received by the promoter through an offer are substantially reinvested by the promoter in the business.”

The court also found unavailing the defendants’ argument that the plaintiffs failed to show that their wealth was tied to other Moments owners and the success of the overall venture. Instead, the court held that the plaintiffs “sufficiently allege that the value of Moments is causally related to the profitability of [Dapper Labs] as a whole because their value depends on the success of Flow Blockchain.”[8] In support of its contention, the court pointed to the plaintiffs’ contention that Moments can only be traded on the defendants’ proprietary Top Shot platform and referred to an article presented by the plaintiffs that reported the sharp decline in Moments’ value during a period when trading of Moments was halted . The court also found persuasive the terms of use of Top Shot, which states: “Moments have no intrinsic value or intrinsic value outside of the Flow Blockchain”[9] and the fact that plaintiffs own nothing other than “the line of code recorded on the Flow Blockchain, as no other rights to use or display the image are transferred.”[10] Accordingly, the court reasoned that if Dapper Labs went out of business, Moments would have no value, unlike rare collectibles.

Regarding the strict vertical commonality test, the Court agreed with the defendants that the plaintiffs’ sole claim that Dapper Labs’ charging a 5% fee on each transaction in the marketplace was insufficient to satisfy the test, which requires that “plaintiff’s and defendant’s linked together so that they rise and fall together.” The court held that while the transaction fees were “potentially probative” in deciding the issue, the fees are not dispositive, as the fees were collected regardless of the success of Moments on the Marketplace. The court also rejected the plaintiffs’ argument that the value of Moments and FLOW tokens is inextricably linked, reasoning that the launch of new Dapper Labs projects may increase the price of FLOW tokens but decrease the value of Moments, further demonstrating the plaintiff’s inability to show their assets were tied to the defendant’s so they would rise and fall together.

Expectation of profit based on the managerial efforts of others

As for the final Howey and whether the buyers had an expectation of profit, the court stated that the defendants’ argument that the plaintiffs were required to show a “continuing” promise of profit had “no support in the Second Circuit.” The court instead found that Dapper Labs’ public statements and marketing materials, such as tweets promoting high-value Moments — replete with “rocket ship” and “money bag” emojis, as well as evidence of investors describing Moments as investments — sufficient to suggest the likelihood and expectation of profit. The Court also relied on the Terms of Service restrictions on Buyers’ use of Moments to support its conclusion that Plaintiffs adequately pleaded an expectation of profit because the restrictions, which limited sharing of the Moments on social media under certain conditions and restricted Buyers from changing Moments, limited their use as collectibles.

As to whether the purchasers’ expectation of profit was based on the managerial or entrepreneurial efforts of others, the court held that regardless of market forces that might affect Moments’ value, the purchasers relied on the defendants’ efforts to maintain Moments’ value because their viability as a digital asset is substantially dependent on the Flow Blockchain, the FLOW token and the Top Shots platform. Unpersuaded by Defendants’ contention that Dapper Labs’ role in the creation and promotion of Moments was not managerial, the Court held that Plaintiffs plausibly alleged that “[w]without Dapper Labs’ continued maintenance of the Flow Blockchain and “the token that powers it all,” FLOW . . . Moments would have no value”[11] and that “[d]efendant’s failure to acknowledge the blockchain technology underlying Moments is fatal to their movement in this regard.”[12]

Conclusion

The Court concluded by stating that its decision was a narrow and “[n]ot all NFTs offered or sold by a company will constitute collateral and each arrangement must be assessed on a case-by-case basis.”[13] The privatization of Flow Blockchain under Dapper Labs’ control was a fundamental factor in reaching its decision. The court specifically stated that “[t]The privatization and restrictions implemented by Dapper Labs are what separate Moments from cardboard basketball cards, which can be freely alienated to whoever and over whatever platform the owner prefers.[14] The court’s denial of the motion to dismiss is not a final decision on the merits; rather, the court determined whether the allegations, if accepted as true, are sufficient to warrant the case proceeding to discovery. Unless the case is resolved, the court will have the opportunity to determine whether Moments are securities and whether their offering and sale violates federal securities laws.

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