On February 22, 2023, The Honorable Victor Marrero of the United States District Court of the Southern District of New York released a 64-page opinion providing an instant classic exposition of the Howey Test applied in a Web 3.0 context. In denying Dapper Labs’s and its CEO’s Motion to Dismiss the unregistered securities offering case brought against them, the Court relies on logic and attention to detail while using an unobstructed view of the applicable law. The decision can be easily unpacked and likely distilled to one overarching lesson: market digital assets using your own private blockchain and marketplace and you should probably hire an SEC compliance lawyer beforehand.
In Friel vs. Dapper Labs, Inc., it is the marketing and sale of NFT “Moments” that give rise to Plaintiffs’ putative class action and not Defendant’s FLOW tokens – which were sold in an initial coin offering (“ICO”) outside the United States. The Court defines NFTs as “digital assets whose authenticity and ownership can be recorded on a blockchain” and the underlying “Moments are a digital video clip of highlights from NBA games, such as a spectacular dunk or game-winning shot.” Opinion at 9 (“NBA Top Shot is a platform or application, owned and operated by Dapper Labs and built on top of the Flow Blockchain. The purpose of the NBA Top Shot application is primarily to provide a platform to sell “Moments,” the alleged security at issue in this action.”). The Court could have also labeled Moments “programmable digital assets or PDAs” given these digital assets are both programmable for purposes of writing on a blockchain as well as “programmable” for purposes of automating transactions, e.g., the use of royalty payments.
As with most PDAs/NFTs, “[o]wnership of a Moment is limited to only the NFT itself. When a person purchases a Moment, the owner does not acquire any rights to the basketball highlight depicted by the NFT or the underlying artwork or other intellectual property, and thus does not acquire any rights to exploit the highlight without the express permission of the NBA, NBAPA, and Dapper Labs.” Opinion at 10.
The Court’s ruling ultimately addressed “whether Moments are more like cardboard basketball cards, i.e., commodities, or more like crypto tokens.” Opinion at 20. And, in so doing, it was standing on new ground given that “no other courts have addressed either the exact substance or posture of the dispute here: whether allegations that an unregistered offer for purchase or sale of, specifically, an NFT constitutes an investment contract under Howey and thus survive a motion to dismiss under Rule 12(b)(6).” Id.
The Court had little problem denying the Motion to Dismiss and finding Moments could potentially constitute “investment contracts” based on “the plausible allegations that Dapper Labs maintains private control over the Flow Blockchain, which significantly, if not entirely, dictates Moments’ use and value; that Dapper Labs touted Moments as a means for purchasers to realize substantial profits through the low sale prices for packs and marketing of the substantial profits others had made through sale on Dapper Labs’s proprietary Marketplace; and that without Dapper Labs’s essential efforts in maintaining the Flow Blockchain and Marketplace, Moments would be valueless.” Opinion at 63.
The fact that Dapper Labs controls the marketplace where Moments are sold as well as the private blockchain where they are minted and associated transactions are recorded were the primary reasons why the Court ruled as it did. Opinion at 11 (“[P]eople may acquire Moments through a secondary marketplace, hosted on the NBA Top Shot application and created and controlled by Dapper Labs (the “Marketplace”). In the Marketplace, Moments owners can re-sell individual Moments they acquired in packs or that they bought from other Moments owners. They may also gift Moments. Ownership of the Moments, the price paid for the Moments, and the transfer and sale of the Moments in the Marketplace are all recorded on only the Flow Blockchain.”).
Judge Marrero begins his legal analysis by referencing the definition of an “investment contract” found in the seminal case SEC v. W.J. Howey Co. where the Supreme Court of the United States defined an “investment contract” as “a contract, transaction or scheme whereby a person invests [their] money in a common enterprise and is led profits solely from the efforts of the promoter party.” Opinion at 17 – 18 (citing SEC v. W.J. Howey Co., 328 U.S. 293, 298-99 (1946)).
As pointed out by the Court, some of the instruments that “at first blush” would not appear as securities include whiskey casks, chinchillas, and rare coins. Opinion at 19. Similarly, PDAs/NFTs may not at first blush appear like an “investment contract”. The Court reasoned that the Dapper Labs token “FLOW is part of the economic realities of the investment scheme in dispute. And, moreover, the Court finds that Defendants are wrong that Dapper Labs’s “embrac[ing] a new technology – NFTs – does not change the underlying legal analysis.” (Id.) In stark contrast to Defendants’ contention, “the involvement of blockchain technology does  alter” the conclusion, as the Plaintiffs’ allegations make plausible that but for Dapper Labs’s creation, development, and maintenance of the private Flow Blockchain, Moments would have no value.” Opinion at 22.
Buttressing its view that the private nature of the Flow Blockchain is what sets this case apart, the Court cites a law review article for the following proposition: “Private blockchains use the same technology as public blockchains, however, a single entity administers them. This results in more control for the entity to restrict permission or allow access to only approved, or invited users.” Opinion at 4, n. 4. See also Opinion at 23 (“In each case, the promoters privatized their ledger, making the purchasers reliant upon the promoter for the asset’s value. That similarity is true whether the instrument is a crypto token or an NFT. And it is the critical similarity here.”).
Again, it is ultimately control over the private blockchain that drives the ruling:
The interplay among FLOW, the Flow Blockchain, and Moments is necessary to the totality of the scheme at issue. Plaintiffs have alleged that, without FLOW tokens, no transactions on the Flow Blockchain can be validated. Indeed, the “Proof-of-Stake” mechanism employed by the Flow Blockchain requires FLOW to power it and incentivize miners to validate transactions. In that respect, FLOW’s utility creates value for Moments through the network’s consensus as to ownership and the price of each transaction.
Indeed, the Court affirmatively states as much: “[T]he economic realities and technological interplay between FLOW, the Flow Blockchain, and Moments, as alleged by Plaintiffs, are what supports the Court’s conclusions.” Opinion at 23. See also Opinion at 62 (“The allegations that Dapper Labs created and maintains a private blockchain is fundamental to the Court’s conclusion. By privatizing the blockchain on which Moments’ value depends and restricting the trade of Moments to only the Flow Blockchain, purchasers must rely on Dapper Labs’s expertise and managerial efforts, as well as its continued success and existence. As Plaintiffs allege, this is unlike public blockchains, such as that underlying Bitcoin.”) (emphasis added).
Plaintiffs were found to allege a scheme providing directly correlated value between FLOW and Moments, “[i]nsofar as FLOW is necessary to creating the value of Moments via blockchain validation with “[t]he economic impact [being] that as more value is created on top of the Flow [B]lockchain, more demand is generated for FLOW tokens.” Opinion at 23.
As for the respective component prongs of the Howey Test, such as the “common enterprise” requirement, the Court largely relied on what it called “the ICO Cases” and found this pooling of interests prong satisfied given “allegations plausibly tied the funds received by the promoter through the offering to an improvement of the ecosystem (i.e., the private blockchain) that consequently increases the value of the token offered during the ICO.” Opinion at 28. See also Opinion at 32 (“Plaintiffs allege that Dapper Labs has pooled Moments purchasers’ funds to raise additional capital, outside of and along with revenue, to ensure the Flow Blockchain does not collapse. The reasonable inference to draw from these allegations is that the capital Dapper Labs raises through the offer of Moments is used to develop and maintain the Flow Blockchain.”); Opinion at 34 (“Plaintiffs have alleged that purchasers of Moments are “hitching their wagons to the continued success of NBA Top Shot, [and] to Dapper Labs and the Flow Blockchain that underlies the platform. . . . If the fortunes of Moments purchasers were entirely divorced from the success of Dapper Labs’s Flow Blockchain, then such price reactions based on Dapper Labs’s management of the Flow Blockchain would be unlikely.”); Opinion at 56 (“[I]f Dapper Labs became insolvent and purchasers were unable to trade their Moments on the Marketplace, purchasers would lose the value of their Moments.”).
Of note, the Court rejected any temporal bar that would provide a safe harbor for promoters who waited until their project was far along before introducing the purported investment contract element. Opinion at 30 (“Implementing the temporal bar that Defendants urge is impractical and would inappropriately limit the scope of investment contracts to pre-development initial offerings.”).
Shared success was found in the fact that Moments’ continued value is contingent on the success of Dapper Labs. Moreover, this was reasonably inferred given “Dapper Labs controls the Flow Blockchain” and “all that Moments purchasers own is, essentially, the line of code recorded on the Flow Blockchain, as no other rights to use or display the image are transferred.” Opinion at 36.
The Court also found that “Defendants’ public statements and marketing materials objectively led purchasers to expect profits.” Opinion at 45. Moreover, under the applicable test, the promise of profits must also be “derived from the entrepreneurial or managerial efforts of others.” Opinion at 52. More specifically, “[t]he law requires  that . . . the efforts of the promoters . . . must be necessary to the success of the venture, such that without them, the ‘investments would be virtually worthless.’” Opinion at 53 (citation omitted). Plaintiffs easily satisfied this requirement for purposes of the Motion to Dismiss.
And finally, the Court broadly concluded that “Defendants’ failure to acknowledge the blockchain technology that underlies Moments is fatal to their Motion in this respect. Without Dapper Labs’s continued maintenance of the Flow Blockchain and the “token that powers it all,” FLOW, Plaintiffs’ [complaint] plausibly alleges that Moments would have no value.” Opinion at 54. See also Opinion at 56 (“a company’s efforts to develop and maintain an ecosystem for trading sufficiently establishes the third Howey prong.”); Opinion at 57 (“Dapper Labs’s implicit promise to maintain the Flow Blockchain and facilitate trades on the Marketplace drive Moments’ value.”).
While the Court made the correct ruling as to Dapper Labs, there is always the possibility a future court might misconstrue what was done to the disadvantage of others selling PDAs/NFTs using, for example, a layer 2 platform build on a public blockchain or on a platform not reliant on a native token ecosystem. Such potential future ruling would be an obvious bridge too far.
The Court recognizes the potential for such mistakes being made prior to signing off by providing a disclaimer 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.” Opinion at 62.
It is highly unlikely that the Court’s ruling could be used against a fine art PDA/NFT platform using public blockchain networks. The Court even acknowledges that truly individual and unique items such as artwork would not easily square with its ruling. See Opinion at 35 (“In each of the cases cited by Defendants, horizontal commonality did not exist because there was no causal connection between “unique pieces of artwork” being sold and the promoter making the offering.”) (citing Dahl v. English, 578 F. Supp. 17, 20 (N.D. Ill. 1983)); Opinion at 36 (“[I]f, hypothetically, Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero. That is the critical causal connection that other collectibles cases lack, and which is alleged here.”); Id. (“Assessing those allegations in connection with the analogy Defendants favor – cardboard basketball cards – reveals the flaw in their analysis. Hypothetically, if Upper Deck or Topps, two longtime producers of physical sports trading cards, were to go out of business, the value of the cards they sold would be wholly unaffected, and may even increase, much like posthumously discovered art.”).
On the chance a PDA/NFT sale couples with the physical twin underlying it, there would stand yet another reason to distinguish this decision. See Opinion at 52 (“Other than Dapper Labs’s self-serving definition of Moments as “Art,” Defendants concede that the definition connects only to “the videos and pictures underlying each Moment,” which purchasers do not own, thus ignoring that the “totality of the evidence” supports a finding that Moments were purchased with “investment intent.”); Opinion at 58 (“[W]hile Moments purchasers may “own” the NFT (or line of code that indicates ownership on the blockchain) they have no rights to the underlying intellectual property the NFT depicts.”).
Almost as an aside, it is also hoped that future courts citing this decision do not value too highly the Court’s comment regarding the hyping of sales – something every promoter or seller does in some form or another. See Opinion at 55 (“Plaintiffs also plausibly allege that the value of Moments in the secondary market depends upon Dapper Labs’s ability to maintain hype and keep purchasers interested in buying and trading Moments.”). Fine art gallery owners certainly routinely “hype” their artists in the secondary market and such conduct standing alone should never point the needle in any one direction.
And finally, to the extent the Court extols in general terms the virtues of blockchain technology as a way of demonstrating why the entire Flow ecosystem – including Moments, necessarily relied on Dapper Labs’s success, the failure to parse between private and public blockchains might cause a future court into mistakenly equivocating privately-run blockchain network with a true public one. See Opinion at 57 – 58 (“Plaintiffs plausibly allege that Moments would be worth far less without the price transparency and trust that the Flow Blockchain enables as well as Dapper Labs’s facilitation of trading on the Flow Blockchain via the Marketplace.”). Overall, this language comes off as slanted in a single direction without proper distinctions being made but this criticism remains a minor quibble in an otherwise extremely well-written decision.
There are certainly valid reasons why platforms built on private blockchains should be treated differently from public blockchains and likely why Voice wisely recently made the move to a public blockchain. Platforms that use native tokens such as Rarible with its RARI token may also have to strategize a bit after this decision. And finally, private blockchains focused on NFTs such as WAX may have to decide how the efforts of its promoters are compensated. At some point in the future, the fact that the Cayman Islands company “Exposition Park Holdings SEZC” owns the intellectual property filings referenced below may create a problem for the WAX ecosystem:
Going forward, the safest approach to take for those looking to build out a PDA marketplace is to partner with a company that has built a platform from the ground up using a public blockchain and without the use of a platform native token or any other direct means of controlling the value of the digital assets marketed using the platform. And, the PDAs/NFTs sold using such a platform least likely to be considered investment contracts are the fine art ones underlying the nascent Digital Art Movement now well underway.