The first quarter of 2023 hasn’t started much better for the blockchain and cryptocurrency industry than the fourth quarter of 2022 ended. Last week, in Friel v. Dapper Labs, Inc et al., a federal judge declined to dismiss a class action complaint alleging securities law violations, finding that the Plaintiffs plausibly alleged that the non-fungible tokens (NFTs) sold on the NBA’s Top Shot platform could be securities. The ruling was the first of its kind, and while the court expressly stated that it is narrow in scope and other NFTs may not be securities, the holding could ultimately have far-reaching implications for other NFT projects and marketplaces as applied, particularly in today’s uncertain environment.
NBA Top Shot is an NFT platform, owned and operated by Dapper Labs, that allows consumers to buy, sell, and trade “Moments” NFTs (digital video clips of player highlights) on Dapper Lab’s Flow Blockchain. On February 22, 2023, the United States District Court for the Southern District of New York denied Dapper Labs’ motion to dismiss, holding that although “it is a close call and the Court’s decision is narrow,” Moments NFTs qualify as securities under the Howey test, the four-pronged test created by the Supreme Court in SEC v. Howey Co. to determine whether certain transactions qualify as investment transactions and are thus regulated securities. In its decision to deny the motion to dismiss, the court focused on prongs two and three of the Howey test.
Under prong two of the Howey test, the court reasoned 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 the Flow Blockchain. Dapper Labs’ sale of “packs” of Moments and the transaction fees on the marketplace generate revenue used to support and grow the Flow Blockchain. Furthermore, once Moments are purchased on the platform, they may be sold only in the marketplace, which runs on the Flow Blockchain and is controlled by Dapper Labs. The Court reasoned that if, hypothetically, Dapper Labs were to go out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero.
The court found the third prong, expectation of profits, was present as well. First, it held that social media statements made by Dapper Labs showed promotion of sales and statistics of Moments on the marketplace. Second, the court found that because the posts included emojis such as the “rocket ship,” the “stock chart,” and “money bags,” they objectively meant one thing: a financial return on investment. The court also found that Dapper Labs’ continued management and efforts to develop the Flow Blockchain ecosystem, both technologically and as a matter of promotion, are crucial to Moments retaining and increasing in value.
The Dapper Labs ruling is important because it is the first in which a court has held that an NFT could be considered a security. Perhaps conscious of the precedent being set, however, the court expressly limited the scope of its holding to its facts, concluding its order by stating 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.” Nonetheless, while the order attempts to underplay the significance of this ruling, the uncertainty triggered by the opinion, taken with the potential for increased aggressiveness from the plaintiffs’ class action bar, may have far-reaching implications for clients that are active in (or seeking to enter) the NFT space.