On February 22, 2023, a federal judge in the Southern District of New York issued a first-of-its-kind order allowing a securities class action lawsuit to proceed against the issuer of non-fungible tokens (“NFTs”) on the grounds that the NFTs are securities for purposes of federal securities laws.[1] NFTs are digital tokens, frequently associated with digital content, for which ownership of the tokens is recorded on a blockchain. The order was issued in the context of a lawsuit against Dapper Labs, the creator and issuer of NBA Top Shot “Moments.” Moments are digital video clips of NBA game highlights and their associated NFTs minted by Dapper Labs. Moments are offered and sold on Dapper Labs’ proprietary digital platform, validated on Dapper Labs’ private blockchain (the “Flow Blockchain”) and trade on a secondary marketplace controlled by Dapper Labs. The lawsuit claims that Moments are securities and Dapper Labs offered and sold those securities in violation of the registration requirements of the federal securities laws. Dapper Labs filed a motion to dismiss the lawsuit, and the court rejected the motion, concluding that Moments are securities.

Importantly, the order does not definitively settle whether all NFTs, or even Moments, are securities. The order concludes that the plaintiffs have adequately shown that Moments meet the definition of a security, which allows the lawsuit to proceed. The order is not a final ruling on the merits of the securities class action lawsuit, which has been pending since 2021 and may eventually proceed to trial. However, the order outlines a rationale for the court to hold in the future that Moments are securities and may encourage additional plaintiffs to bring securities law actions against issuers of NFTs. The order may also provide a roadmap for the U.S. Securities and Exchange Commission (“SEC”) and other regulators to bring securities enforcement actions against NFT issuers.[2]

Below we discuss the plaintiffs’ securities law claims, key factors highlighted by the court and potential implications for NFTs more broadly.

This securities class action lawsuit against Dapper Labs and its CEO was brought by purchasers of Moments who allege that Moments are securities and Dapper Labs, which issues Moments in partnership with the NBA and the NBA Players Association, violated federal securities laws by not registering the offer and sale of Moments with the SEC. Section 5 of the Securities Act of 1933, as amended (the “Securities Act”), prohibits persons from offering or selling securities unless a registration statement is filed with and declared effective by the SEC. Section 12 of the Securities Act creates a private right of action for persons who purchased securities sold in violation of Section 5 and allows such persons to recover the consideration paid for the securities plus interest. In this case, the question of Dapper Labs’ liability under Sections 5 and 12 of the Securities Act rests on whether Dapper Labs’ offer and sale of Moments amounts to an offer or sale of a security.

In rejecting Dapper Labs’ motion to dismiss the lawsuit, the court concluded that Moments are securities and the plaintiffs’ securities lawsuit can proceed. The court stated that the securities analysis was “a close call” and that Moments “toe the line” separating offerings that are securities from those that are not.

The court concluded that Moments are securities because they satisfy all elements of the “Howey Test”, which has been used by courts and the SEC for over 75 years to determine whether an asset is an investment contract, a type of security. Under the Howey Test, which was outlined in the 1946 Supreme Court case SEC v. W.J. Howey Co., an investment contract exists when there is: an investment of money, in a common enterprise, with a reasonable expectation of profit derived from the efforts of others. The court found that Moments satisfy each of these elements.

Below are key factors that the court highlighted to support its conclusion that Moments are securities:

• Use of a Private Blockchain Underlying the NFTs. The court found that Dapper Labs’ creation and maintenance of a private blockchain underlying Moments was “fundamental” to the conclusion that Moments are securities. Dapper Labs created and controls the Flow Blockchain, which is used to record ownership, pricing and transactional information for Moments. The court found that the Flow Blockchain “significantly dictates” Moments’ use and Moments’ value are tied and depend upon the continued success of the Flow Blockchain. The court further found that Dapper Labs’ decision to utilize its own private blockchain and restrict the trading of Moments to that blockchain, means that purchasers of Moments must rely on Dapper Labs’ expertise, managerial efforts and existence. These facts, and the fact that Dapper Labs uses capital raised through the sale of Moments to develop and maintain the Flow Blockchain, were cited by the court when it determined that the “common enterprise” and “efforts of others” elements of the Howey Test had been met.
• Promotional Materials and Media Discussion of Profits. The court found that Dapper Labs’ “public statements and marketing materials objectively led purchasers to expect profits” when they acquired Moments. The court found that Dapper Labs touted Moments as a means for purchasers to realize substantial profits through discounted sales of packs of Moments and through resales of Moments on Dapper Labs’ proprietary secondary marketplace. The court also cited third party media articles and the views of third party commentators to suggest that purchasers had an expectation of profits. The court cited these along with other facts when it determined that the “expectation of profits” element of the Howey Test had been met.
• Moments are Not Collectibles. The court found that the restrictions that Dapper Labs imposes on Moments, including the requirements that they remain on the Flow Blockchain and resell and trade only on Dapper Labs’ secondary marketplace, distinguish Moments from basketball cards and other collectibles, which can be freely sold and traded. The court stated that, because Dapper Labs controls the Flow Blockchain and Moments cannot be sold or traded outside of the secondary marketplace, Moments are unlike collectibles that retain their value irrespective of whether their creators continue to operate a business or enterprise. The court stated that “hypothetically, [if] Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero.” The court further stated that “Moments are unique and (definitionally) non-fungible,” however, they are distinct from collectibles in that “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.” The court cited these facts when it determined that the “common enterprise” and “efforts of others” elements of the Howey Test had been met.
  • The court acknowledged that purchasers buy Moments for personal and consumptive use, which raises questions about whether that use outweighs Moments’ alleged use as an investment. The court stated that these are “difficult questions” which are factual in nature and should be considered in a future stage of the litigation.

The court stated 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.” By the court’s own admission, its conclusion that Moments are securities is “narrow.” These statements caution against a sweeping interpretation of this order and suggest that, to the extent future courts consider whether other NFTs are securities, those analyses will be individually-tailored and fact specific. The court’s order also does not address questions regarding the scope of liability. For example, left unaddressed by the court is the degree to which the owners of the content connected to NFTs have any liability under securities laws.

More broadly, this order may encourage purchasers of other NFTs to bring suit against the issuers of those digital assets. The order also indicates to the SEC and other regulators that courts may be willing to entertain enforcement actions based on the premise that an NFT is a security.

The securities class action lawsuit will continue to proceed and a final ruling on the merits of the lawsuit, and the status of Moments as securities, remains pending.

If you have any questions concerning the material discussed in this client alert, please contact members of our Fintech, Entertainment and Media, Securities and Capital Markets, and Sports groups.