NFT Marketers Could Face Liability under U.S. Securities Laws

A recent court ruling on a pre-trial motion to dismiss exposed an NFT marketer to potential liability under federal securities law. A federal class action lawsuit styled Friel v. Dapper Labs, Inc. (decided on February 22, 2023 in the Southern District of New York) considered the issue of whether NFTs featuring basketball stars should be treated more like simple sports collectibles or as investment contracts that are subject to strict SEC regulation, including registration of their sale. While Judge Victor Marrero did not definitively answer the question, he denied the NFT marketer’s motion to dismiss, which means the plaintiffs will be able to move forward with their claims that federal securities laws were violated. About three weeks after the ruling was issued, the defendant challenged some of the key factual underpinnings in a new court filing.

In moving to dismiss the case, the attorneys for Dapper Labs likened the NFTs to sports trading cards: “Basketball cards are not securities. Pokemon cards are not securities. Baseball cards are not securities. Common sense says so. The law says so. And courts say so.” But the court did not agree.

Judge Marrero ruled that the NFTs “might” be securities, and a trial was needed to make that determination. “In the most general terms, the court is asked to assess whether Moments [the series of NFTs featuring NBA highlights] are more like cardboard basketball cards, i.e., commodities, or more like crypto tokens,” he wrote. “Here, it is a close call and the court’s decision [to deny the motion to dismiss] is narrow.”

Judge Marrero relied on what is known as the Howey Test, which refers to a 1946 U.S. Supreme Court case for determining whether a transaction qualifies as an “investment contract.” If a transaction is found to be an investment contract, it’s considered a security and is then subject to disclosure and registration under the Securities Act of 1933 and the Securities Exchange Act of 1934.

The decision that the NFTs “might” be securities was very fact specific. Among the key allegations that persuaded Judge Marrero to deny the motion to dismiss were:

The NFTs can only be resold or traded through an app that was created and controlled by the seller of the NFTs. The plaintiffs alleged the app used a private blockchain, so that NFT owners allegedly had no way of “liberating” the NFTs from the defendants’ private blockchain and selling them elsewhere. Upon "cashing out" by selling the NFTs, consumers were required to pay fees to Dapper Labs. Those fees were then used to develop and maintain the private blockchain. According to the plaintiffs, these features are characteristics of investments in the blockchain technology, not sports collectibles. 

Judge Marrero found this argument to be credible. In the judge’s view, purchasers were therefore investing in the technology as much as they were in the NFTs themselves. He reasoned that the only thing the NFT purchasers acquired was a line of code recorded on the blockchain, because no other rights to use or display the image were transferred. If the defendant were to go out of business and shut down the app, the value of the NFTs would drop to zero because they would essentially cease to exist. That is very different from other collectibles like basketball or baseball cards. Hypothetically, wrote Judge Marrero, if Upper Deck or Topps, two longtime producers of sports trading cards, were to go out of business, the value of the cards they sold would be wholly unaffected, and might even increase.

However, on March 15, 2023, Dapper Labs filed an answer that disputed the key allegations upon which Judge Marrero based his ruling. According to the answer, the blockchain that stores the NFT is not private, but rather “a permissionless, open-source, public digital ledger.” Dapper Labs also asserted that the NFTs can be traded or sold “outside of the marketplace, including on third-party marketplaces.” Resolution of these factual disputes, which will take months if not years, could well determine the outcome of this lawsuit.

Takeaway: This lawsuit requires close monitoring because, as it progresses, it will create important precedent for NFT marketers. While the ruling carefully stated that each “scheme” must be assessed on a case-by-case basis, NFT marketers wishing to avoid federal securities requirements should consider a feature that enables purchasers to untether the NFTs from proprietary blockchains or apps.

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