The recent decision rendered by Judge Victor Marrero of the Southern District of New York is of critical  importance to the NFT industry.  For the first time, a court held that the issuer of an NFT offered an “investment contract” and, therefore, can potentially be held liable for selling unregistered securities.  The decision was made in the context of denying Dapper Lab’s motion to dismiss in Friel v Dapper Labs — meaning that, at the pleading stage, and accepting the allegations of the amended complaint as true, Plaintiffs set forth a valid cause of action as a matter of law.

An NFT (non-fungible token) can be thought of as a unique cryptographic key contained within a digital token on the blockchain that verifies the corresponding content file as genuine.  It is most often used with music or art. 

Defendant Dapper Labs is the company that was known originally for CryproKitties.  That ran on the Ethereum blockchain.  But Dapper Labs then developed its own blockchain, called Flow, to house NBA Top Shot, its co-venture with the NBA.  Top Shot is best known for selling “Moments,” which are often compared to sports trading cards.  Dapper Labs clips NBA highlights and turns them into NFTs, which can be bought and sold. 

The lawsuit alleged that the NFTs sold by Dapper Labs on its platform constituted unregistered securities that were sold in violation of federal securities laws.  According to the complaint,  Moments are “securities” because, among other things, they  “constitute an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”  That language, of course, comes from the well know Howey test that has been used by the SEC for decades to determine whether something is a security — including with respect to ICOs.  Not surprisingly, Howey was at the heart of the court’s decision, with the court holding that the allegations of the amended complaint “rendered each consideration under Howey facially plausible.”

The first Howey factor — an investment of money — was easy for the court because that was not contested.   The second factor — whether there is a “common enterprise” — was not as straightforward.  The court applied both the horizontal commonality and vertical commonality tests.

As the court explained, horizontal commonality exists when two considerations are established: (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.”  Dapper Labs’s sale of packs of Moments and the transaction fees on the Marketplace (which the court defined as  the secondary marketplace, hosted on the NBA Top Shot application and created and controlled by Dapper Labs) generate revenue used to support and grow the blockchain, which  was sufficient to support a reasonable finding of pooling.  That conclusion was further supported by the allegation that purchasers’ capital was then held by Dapper Labs in Dapper-controlled wallets.  And the court held that Plaintiffs adequately alleged that the purchasers’ fortunes were tied to the overall success of Dapper Labs because they alleged Dapper Labs controlled the enterprise, including the “Flow Blockchain” that Moments sit atop, and that Moments, once purchased in packs, can be sold only in the Marketplace, which again, is controlled by Dapper Labs.

With respect to vertical commonality, the Second Circuit recognizes only so-called “strict vertical commonality, under which a plaintiff must establish that the fortunes of plaintiff and defendants are linked so that they rise and fall together.” The court was not persuaded by Plaintiffs’ argument that Dapper Labs’ collection of a 5% fee on every transaction in the Marketplace was sufficient to establish strict vertical commonality.

Under the final Howey factor, Plaintiffs had to show that Dapper Labs’s offer of Moments on NBA Top Shot came with “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”  In the Second Circuit, that means “whether, under all the circumstances, the scheme was being promoted primarily as an investment.”  This expectation of profits test is an objective one.

The court found that Defendants’ public statements and marketing materials objectively led purchasers to expect profits.  Dapper Labs’s tweets promoted recent sales.  Although the word “profit” was not used therein, the court believed that stock chart and rocket ship emojis sent a similar message.  The court mentioned also that Dapper Labs markets Moments based on scarcity in that it offers so-called common, rare, legendary, and other premium packs.  And the court said that its conclusion was buttressed by the subjective observations of purchasers and those reporting on the NBA Top Shot offerings.

The court next addressed the requirement that the promise of profits must be “derived from the entrepreneurial or managerial efforts of others.”  It said:

It is plausible that Moments’ value is derived almost entirely from the continued operation by Dapper Labs of the Flow Blockchain, which enables price transparency (and thus influences value) but, perhaps more  critically, appears to provide purchasers with the ability to trade at all. 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’ [amended complaint] plausibly alleges that Moments would have no value. …

And because Moments can be purchased only from NBA Top Shot in packs, or traded on the Marketplace that Dapper Labs controls, Dapper Labs’s continued management and efforts to develop the ecosystem, both technologically and as a matter of promotion, are crucial to Moments retaining and increasing in value.

Finding that the allegations of the amended complaint satisfied the Howey factors, the court denied the Defendants’ motion to dismiss. 

The decision is clearly not one holding that all NFTs are securities.  The court specifically noted that its decision was “narrow,” saying also:  “Not all NFTs offered or sold by any company will constitute a security, and each scheme must be assessed on a case-by-case basis.”  The critical factor here was the “particular scheme” by which Dapper Labs offered Moments.  Of special importance to the court was that Dapper Labs maintained private control over the Flow Blockchain, which significantly, if not entirely, dictated Moments’ use and value.  And, “without Dapper Labs’s essential efforts in maintaining the Flow Blockchain and Marketplace, Moments would be valueless.” 

Thus, NFT creators will be in a better position to avoid the same fate as Moments if they use a public blockchain and do not create a specialized token.  Or, if they want to use a private blockchain, the Dapper Labs decision offers a good road map for steps to take to try to avoid meeting the Howey test.


David Zaslowsky has a degree in computer science and, before going to Yale Law School, was a computer programmer. His practice focuses on international litigation and arbitration. He has been involved in cases in trial and appellate courts across the United States and before arbitral institutions around the world. Many of David’s cases, including some patent cases, have related to technology. David has been included in Chambers for his expertise in international arbitration. He is the editor of the firm's blockchain blog.