SDNY holds NBA Top Shots NFTs might be unregistered securities under Howey

Federal district court Judge Victor Marrero of the Southern District of New York has denied a motion to dismiss by defendant Dapper Labs, makers of the wildly popular NBA Top Shots NFT platform, in Friel v. Dapper Labs, Inc. (S.D.N.Y., Feb. 22, 2023, No. 21 CIV. 5837 (VM)) 2023 WL 2162747. The court found the plaintiffs had plausibly alleged that Top Shots NFTs (called Moments) are unregistered securities within the meaning of SEC v. W.J. Howey Co., 328 U.S. 293, 298 99 (1946).

After addressing each step of the Howey test, on February 22, 2023 Judge Marrero reached a conclusion he deemed “a close call” in a “narrow decision.”

The court prefaced its analysis by addressing a series of high-profile cases dealing with initial coin offerings (ICOs), by which entities offer fungible digital tokens for sale to raise capital (together, the ICO cases). In the court’s view, these cases “do not involve identical schemes” compared to the Top Shots platform and therefore “do not dictate an outcome” in this case.

Despite this pronouncement, the court’s decision relied on these cases extensively. In particular, the court paid special attention to the relationship between Moments NFTs and Dapper Labs’ allegedly proprietary blockchain Flow. While acknowledging that NFTs are “separate instruments” from the blockchain they are built on, the court nevertheless concluded that the Flow blockchain “creates value for Moments through the network’s consensus as to ownership and the price of each transaction.” To the court, this feature offered a “throughline” connecting the ICO cases to Moments NFTs. That “throughline” threaded each prong of the court’s Howey analysis.

The analysis

First, the court found, as the parties essentially agreed, that Moments purchases are an investment of money.

Second, the court found the plaintiffs had adequately alleged that Moments are a common enterprise. In the Second Circuit, a common enterprise forms where there is “horizontal commonality,” meaning (1) a sharing or pooling of the funds of investors and (2) that “the fortunes of each investor in a pool of investors” are tied to one another and to the “success of the overall venture.”

Again relying on the ICO cases, the court found “pooling of funds” in the allegations that funds from sales and secondary market transaction fees of Moments were used to “support and grow the blockchain.” It was especially relevant to the court that Dapper allegedly retained those funds “in Dapper-controlled wallets” to “prop up the value of the FLOW token.”

Next, the court found the plaintiff had plausibly alleged that the fortunes of Moments purchasers are tied to the success of NBA Top Shots overall. The plaintiffs’ key allegations were that “Moments’ continued value is dependent upon the success of Dapper Labs,” and “Dapper Labs controls the Flow Blockchain.” The court viewed this as the “critical causal connection” that distinguishes Moments from traditional “carboard basketball cards.” If “Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero.” Based on these allegations, the court found the plaintiffs had alleged a common enterprise.

Though it wasn’t necessary for the analysis, the court also addressed strict vertical commonality, which is an alternative test for common enterprise in the Second Circuit. Vertical commonality requires that “the fortunes of plaintiff and defendants are linked so that they rise and fall together.” Here, the court found the plaintiffs did not adequately allege vertical commonality because they could not show that the value of the Flow Blockchain would rise and fall with the value of Moments NFTs. In the court’s understanding, Moments could become worthless independent of the FLOW token or the Flow blockchain if, for example, a different successful collection existed on Flow.

Finally, the court found the plaintiffs had adequately alleged an expectation of profits derived from the entrepreneurial or managerial efforts of Dapper Labs. Under this prong, courts “examine the offering from an objective perspective,” to decide if “purchasers were led to expect” profits by the promoter. Those expectations must come from “efforts made by those other than the investor” that are “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”

Here, the court found the plaintiffs had adequately alleged that Dapper’s “public statements and marketing materials objectively led purchasers to expect profits.” To illustrate this, the court included screenshots of tweets from the NBA Top Shots Twitter account touting a record sale and especially high sales volumes. The court observed that “although the literal word ‘profit’ is not included in any of the tweets, the ‘rocket ship’ emoji, ‘stock chart’ emoji, and ‘money bags’ emoji objectively mean one thing: a financial return on investment.”

The court further “buttressed” the objective perspective with “subjective observations of purchasers” to show that individuals perceived an expectation of profit. Though the court acknowledged Dapper’s argument that purchasers buy Moments for “consumptive use,” it declined to find that consumption was a “primary” purpose for collecting Moments. The court regarded that question as “mostly, factual in nature” and one that therefore “should not be answered” on a motion to dismiss.

Tying this expectation of profit to Dapper’s efforts, the court found it “plausible that Moments’ value is derived almost entirely from the continued operation by Dapper Labs of the Flow Blockchain” which “critically, appears to provide purchasers with the ability to trade at all.” Thus, the expectation of profit was derived from Dapper’s essential efforts in running the Flow Blockchain and Moments marketplace.

In concluding, the court again reiterated that “[t]he allegations that Dapper Labs created and maintains a private blockchain [are] fundamental” to its findings. Thus, the court left open the possibility that fact discovery on several issues could alter its analysis.

Going forward

Questions about the public’s ability to run a node or deploy smart contracts on the Flow blockchain will likely be important. So too will facts about third-party secondary marketplaces, real-world utilities for Moments NFTs, and the prevalence of purchasers who collect them for consumptive uses.

No matter what discovery reveals, this case is already an important precedent for NFT projects and organizations looking to launch their own digital asset collections.

Learn more about the implications of this case for your business by contacting any of the authors or your usual DLA Piper relationship attorney.