On February 22, 2023, a judge in the Southern District of New York ruled that a class action lawsuit may proceed alleging that Dapper Labs, Inc. violated federal securities laws when it issued of a series of non-fungible tokens (“NFTs”) of digital video clips of highlights from NBA games in 2019. [i] Dapper Labs, a blockchain technology company, is alleged to have issued securities without filing a required registration statement with the Securities and Exchange Commission (“SEC”), as required by Section 5 of the Securities Act of 1933. [ii]
As the Court noted, despite a growing body of court rulings on initial coin offerings, “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.” [iii]
The S.E.C. has made clear that the agency considers existing securities laws to be adequate to guide participants in the crypto-asset marketplace, stating:
“A digital asset should be analyzed to determine whether it has the characteristics of any product that meets the definition of “security” under the federal securities laws. … Both the Commission and the federal courts frequently use the “investment contract” analysis to determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws.” [iv]
The long-established test for whether an asset qualifies as a security was set forth by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey“), describing a security as including any investment contract where there is (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) to be derived from the efforts of others. [v]
The S.E.C reminds digital asset issuers and promoters that:
“The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales).” [vi]
While many NFT issuers rely on established, independent blockchains such as the Ethereum blockchain to record and validate transactions, Dapper Labs used a different model. Dapper Labs developed and launched its own independent blockchain, the Flow Blockchain, which created a wholly self-contained environment in which the NFTs were issued and traded, all controlled by Dapper Labs.
The Court pointed out that, while Dapper Labs sought to differentiate the NFTs from the tokens and Flow Blockchain, this view was “too narrow,” and would “ignore that FLOW is part of the economic realities of the investment scheme in dispute.” [vii]
The Court applied the 4-factor Howey test to the Dapper Labs NFTs, calling attention to the difference between traditional collectibles (and by extension, NFTs that reside on independent blockchains) and those of Dapper Labs, stating:
“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. That is not true here, where Plaintiffs allege that the pooling of capital generated from the sale of [NFTs] propped up the Flow Blockchain and where the value of Moments is intertwined with the success of that blockchain and Dapper Labs.” [viii]
The Court reasoned that because the value of the NFTs was inextricably linked to the Flow Blockchain, and therefore to Dapper Labs, the Court could not rule out the possibility that the plaintiff class could demonstrate that they qualify as securities for purposes of registration.
This is among the latest court decisions to offer additional guidance to investors and issuers on where blockchain-based assets fit into federal and state regulatory schemes.
In the past months, the S.E.C. reached settlements with media personality Kim Kardashian [ix] and former basketball player Paul Pierce [x] for each allegedly making false and misleading statements promoting the “EMAX” or “Emax Tokens,” a cryptocurrency issued by EthereumMax in 2021 that relies on the Ethereum blockchain to record transactions. EMAX tokens have lost almost all value since trading at an all-time high of $5.80 per token. [xi]
In September of 2021, the operator of a cryptocurrency trading platform with more than 100 million users worldwide, sought to launch a lending function that would have allowed account holders to earn interest on certain assets held with the platform. The company took the position that the proposed interest-bearing product did not qualify as a security, and therefore was outside the S.E.C. regulatory purview. The S.E.C. disagreed and after a months-long investigation, which included a dispute over the names of wait-listed account holders, the S.E.C. notified the platform that the agency would seek to block the launch of the interest-bearing product in court. [xii] The platform ultimately cancelled the launch.
More recently, in January 2023, the digital asset trading platform reached a settlement with the New York State Department of Financial Services (“DFS”). [xiii] To resolve DFS’ findings of deficiencies in the company’s Bank Secrecy Act/Anti-Money Laundering compliance, the platform agreed to pay a fine of $50 million, committed to spend $50 million to improve these Know-Your-Customer systems, and consent to the installation of a monitor. [xiv]
Although the Dapper Labs court ruled in favor of the putative investor class at this early stage, plaintiffs will now have to demonstrate all the elements of their claim, including meeting the requirements to certify their putative class.
We expect the S.E.C., other regulators, and the courts to continue to develop the body of guidance on how federal and state regulations apply to digital assets. As the Dapper Labs court reminded issuers:
“[E]mbrac[ing] a new technology – NFTs – does not change the underlying legal analysis.” [xv]
For prospective investors, NFTs and other digital assets will likely remain a class that requires significant due diligence.
[i] Friel v. Dapper Labs, Inc., Dkt. No. 1:21-cv-05837-VM (S.D.N.Y.) (the “Action”).
[ii] 15 U.S.C. ? 77e. The Action also names Roham Gharegozlou, Dapper Labs’ Chief Executive Officer, as a defendant, asserting control person liability pursuant to Section 12(a)(1). 15 U.S.C. ? 77l.
[iii] Friel, Dkt. No. 1:21-cv-05837-VM, slip op. at 20.
[iv] Framework for “Investment Contract” Analysis of Digital Assets, Secs. & Exch’g Comm’n, Apr. 3, 2019, available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
[v] 328 U.S. 293 at 298-99.
[vi] See n.4 supra.
[vii] Friel, slip op. at 21-22.
[viii] Id. at 36-37.
[ix] In the Matter of Kimberly Kardashian, Admin. Proc. File No. 3-21197 (S.E.C. Oct. 3, 2022), available at https://www.sec.gov/litigation/admin/2022/33-11116.pdf.
[x] In the Matter of Paul Anthony Pierce, Admin. Proc. File No. 3-21305 (S.E.C. Feb. 17, 2023), available at https://www.sec.gov/litigation/admin/2023/33-11157.pdf.
[xii] See Paul Grewal, The SEC Has Told Us It Wants to Sue Us Over Lend. We Don’t Know Why., Coinbase, Sept. 7, 2021, available at https://www.coinbase.com/blog/the-sec-has-told-us-it-wants-to-sue-us-over-lend-we-have-no-idea-why.
[xiii] See In the Matter of Coinbase, Inc., N.Y.S. Dept. of Fin. Svcs., Consent Order, available at https://www.dfs.ny.gov/system/files/documents/2023/01/ea20230104_coinbase.pdf.
[xv] Friel, slip op. at 22 (alteration in original) (quoting Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230, 237 (2d Cir. 1985)).