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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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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