On May 12, 2021, a class action law suit was filed against Dapper Labs, Inc. in the U.S. District Court for the Southern District of New York (the “Court”) alleging that Dapper Labs violated U.S. securities laws by offering certain non-fungible tokens (“NFTs”) without a registration statement as required by U.S. securities laws. On February 22, 2023, the Court denied Dapper Labs’ request to dismiss the suit before trial and found that the purchasers of its NFTs had sufficiently demonstrated there was a triable issue surrounding whether such NFTs are securities. This decision suggests that, in certain circumstances, NFT and digital asset sales may be considered securities offerings to which U.S. securities laws apply.
NBA Top Shot Moments
Dapper Labs, a Canadian corporation based in Vancouver, British Columbia, develops applications that run on blockchain technology. At a high level, a blockchain is a decentralized and distributed digital ledger where all transactions are validated by a network of users. In September 2019, Dapper Labs created its own blockchain called the Flow Blockchain, which hosts all of its applications and, most importantly, all of Dapper Labs’ transactions are validated on its Flow Blockchain. Such transactions include the sale of Dapper Labs’ most prolific NFTs – NBA Top Shot Moments (“Moments”).
Moments launched in July 2019 as part of a joint venture between Dapper Labs, the National Basketball Association (“NBA”) and the National Basketball Players Association. Moments are tradeable NFTs that allow purchasers to buy, sell and collect officially licensed video highlights of the NBA. Moments are unique digital assets whose authenticity and ownership are recorded on the Flow Blockchain, but ownership is limited to the NFT itself; purchasers of a Moment acquire no rights to the NBA game highlight depicted in the video clip, the underlying artwork or any other intellectual property from the NBA.
Moments can be acquired in two ways. The first option is to purchase Moments directly through Dapper Labs in “packs”, similar to buying a pack of physical sports trading cards. The second option is to purchase Moments through a secondary marketplace, which is hosted and entirely controlled by Dapper Labs. Like any secondary marketplace, owners can sell Moments to other interested purchasers at an agreed price. All sales and transfers are recorded only on the Flow Blockchain.
The Class Action
The class action was filed in May of 2021 by certain purchasers of Moment NFTs (the “Plaintiffs”) against Dapper Labs and its Chief Executive Officer (the “Defendants”). The Plaintiffs alleged that the Defendants breached Sections 5 and 12(a)(1) of the U.S. Securities Act of 1933 (the “Securities Act”) by actively promoting, offering and selling Moments without filing a registration statement with the U.S. Securities and Exchange Commission (the “SEC”).
On January 27, 2022, the Defendants filed a pre-motion letter addressed to the Plaintiffs stating the action should be dismissed because “basketball cards are not securities.” The Plaintiffs filed their response on February 3, 2022, and while they did not disagree with the above statement, they insisted that Moments are “not basketball cards.” Instead, the Plaintiffs claimed that Moments are “crypto assets” that can be re-sold on a secondary market that is completely controlled by Dapper Labs and, as such, Moments are securities which should be subject to securities law registration requirements. On August 31, 2022, the Defendants filed a motion to dismiss the class action.
The Court’s Ruling
The Court held that the claims sufficiently alleged that Moments were an offer of an “investment contract” and therefore a security required to be registered with the SEC, and denied the Defendants’ motion to dismiss.
Under the Securities Act, the definition of a security includes an “investment contract”. To determine what constitutes an investment contract, the Court once again relied on the “Howey” test established by the U.S. Supreme Court in SEC v. Howey. The Howey test defines an investment contract as (i) an investment of money, (ii) in a common enterprise, (iii) with profits to be derived solely from the efforts of others.
The Court quickly concluded that the owners of Moments spent a considerable amount of money to purchase the NFTs, satisfying the first prong of the Howey test. Next, the Court found that a common enterprise was established since Dapper Labs pooled funds to raise additional capital to sustain the Flow Blockchain and noted that, should the Flow Blockchain collapse, the value of all Moments would go to zero. This factor satisfied the second prong of the Howey test since the NFT owners’ and Dapper Labs’ fortunes were tied together, and thus an investment in a common enterprise existed. Finally, the Court found that the Defendants made numerous public statements, including through marketing tools such as Twitter, which objectively led purchasers to expect profits. Interestingly, the Court noted that while the word “profit” was not used in its Tweets, Dapper Labs’ use of certain emojis – namely rocket ships, money bags and stock charts – objectively implied a financial return on investment. In addition, because Dapper Labs controlled the entire marketplace for Moments, its continued management and efforts to maintain an ecosystem for trading its NFTs sufficiently satisfied the third prong of the Howey test.
Dapper Labs publicly offered NFTs recorded on its privately controlled blockchain – a blockchain which dictated the value of such digital assets – and engaged in overt marketing efforts to promote sales while touting the potential to earn substantial returns. The Court’s decision indicates that, at least in similar instances, NFTs and digital asset sales may constitute securities offerings under U.S. securities laws. The Court was clear, however, that not all NFTs offered or sold by a company will be treated as securities, and “each scheme must be assessed on a case by case basis.”
Platforms like Dapper Labs promoting trading in digital assets that bear the hallmarks of a security should understand that, while NFTs and digital assets are unique and still evolving, the courts will continue to apply existing securities laws to businesses based on blockchain technology and will consider the economic realities of a transaction as a whole in determining whether digital assets are securities.
Notably, this decision is only the denial of a motion to dismiss and Dapper Labs was given 21 days to respond to the Court’s order. However, this important decision shines further light on how the courts continue to apply securities laws to businesses based on this evolving technology.
Goodmans Technology Group
Blockchain technology is quickly transforming the corporate landscape, disrupting many industries and creating novel legal challenges like those described above. Goodmans’ technology practice offers unparalleled expert advice to allow our clients to capitalize on the benefits of this exponential technology while remaining abreast of the complex laws and evolving regulations that govern it. Our lawyers deliver innovative and sophisticated solutions to meet the challenges of this new and evolving industry in the areas of corporate and securities laws (including advising on ICOs and other token offerings), venture financing, investment funds, tax law, brokers, consulting firms and exchangers.
As blockchain radically changes business as we know it, Goodmans remains ahead of the pack in this new technology space. For additional information on these issues and opportunities, please contact any member of our Technology Group.
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