Judge Rules: NBA “Top Shot” Moment NFTs Might Be Securities
By: Moish E. Peltz, Esq. and Kyle M. Lawrence, Esq.
NBA Top Shot launched in 2020 as one of the first killer use-cases for NFTs – next generation cryptographically authenticated digital basketball cards. They were officially licensed by the NBA and the NBA Players Association and built by Dapper Labs on top of its Flow blockchain, which provided faster transactions with lower transaction costs. The result was one of the early success stories of the 2020s NFT market. NBA Top Shot was also a prominent success story that attracted other big consumer brands to consider creating their own NFTs.
However, the launch of the platform was not all a smooth ride, and in 2021, a putative class action lawsuit was brought by a group of Top Shot NFT purchasers against Dapper Labs and its CEO alleging that Dapper offered and sold unregistered securities (so called Top Shot “Moments”). Dapper moved to dismiss the Amended Complaint. On February 22, 2023, Judge Victor Marrero of the U.S. District Court for the Southern District of New York issued his decision.
In the decision, Judge Marrero denied Dapper Labs’ motion to dismiss the putative class action complaint alleging that Dapper violated the federal securities laws by offering for sale to the public NBA Top Shot Moments without filing a registration statement with the SEC. Because the decision was on Dapper’s motion to dismiss, the decision does not resolve the merits of the case, but instead allows the case to proceed to discovery, class certification, and (perhaps eventually) trial.
As discussed further below, our analysis shows that this decision directly challenges a prevailing theory that a centralized NFT marketplace (or “walled garden”) experience is automatically “safer” for brands. The decision also raises new questions that offerors of NFTs can ask to help mitigate the chance that their NFT will be considered part of an unregistered securities offering.
SDNY’s Legal Reasoning
The decision applied the Howey Test: (1) an investment of money, (2) in a common enterprise (3) with the expectation of profit derived from the essential entrepreneurial or managerial efforts of others (this last prong is often separated into two parts of the Howey Test). SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”)
The first prong was uncontested by the parties because the plaintiffs used a considerable amount of money to purchase their Moments. Therefore, the prongs two and three were at issue in the decision.
For the second prong, the “common enterprise,” the court examined whether there were proper allegations of “pooling” of investor funds. Primarily relying on SEC v. Kik Interactive, the court found that the pooling requirement is satisfied when the funds received by investors, in exchange for the offering, are contributed to the improvement of the blockchain ecosystem (i.e., a private blockchain).
Dapper stressed in its arguments that the Moments are an NFT representation of basketball cards, and basketball cards have historically been deemed to not be securities. Dapper’s motion papers only minimally discussed the Flow blockchain and FLOW tokens, however, the Plaintiffs’ allegations that Dapper Labs created and maintains the Flow blockchain was fundamental to the Court’s decision.
Judge Marrero rejected Dapper’s attempt to simplify the nature of the NFTs. Instead, the decision focused on the private nature of the Flow Blockchain, as well as the connection between the Flow Blockchain, and the Moments NFTs that Dapper (in partnership with the NBA and NBA Players Association) created on top of the Flow Blockchain. The Court focused on the economic differences between cardboard basketball cards, and Dapper’s NFT version of basketball cards, and determined that the “economic reality” of the NFTs should be analyzed differently (indeed, the Court noted that cardboard basketball cards can be freely sold without reliance on their manufacturer). The Court also found that the Plaintiffs have adequately alleged that “the value of Moments is ‘causally related to the profitability of [Dapper Labs] as a whole’ because their value depends on the success of the Flow Blockchain.”
Because Flow is private and its maintenance relies (in part) on transaction fees generated by the trading of Moments (among other digital assets), there is arguably an interdependent relationship between the investors buying Moments from Dapper, Dapper’s operation of the NFT marketplace, and Dapper’s operation of the Flow Blockchain. Thus, a common enterprise was found to exist on the motion to dismiss standard.
The third prong was examined in two parts. First, the court found that there was an expectation of profits based on the marketing materials and statements made by Dapper Labs. For example, the Court cited tweets by the official @NBATopShot Twitter Account that promoted the statistics of recent sales of Moments on the Top Shot marketplace.
The Court determined 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.” In addition, the court considered Dapper’s sales strategy of creating scarcity by offering common, rare, legendary, and other premium packs, as well as a series of news publications where NBA Top Shot collectors discussed their purchases of Moments as profitable investments, to show the public’s potential perception of expected profits.
Second, the court examined whether the expectation of profit derived from the managerial efforts of Dapper Labs. Here, the fact that the Flow Blockchain is allegedly privately owned was again given substantial weight. In contrast to cardboard basketball cards (or presumably even NFTs minted on public decentralized blockchains), the Court decided that purchasers of the NFTs “must rely on Dapper Labs’ expertise and managerial efforts, as well as its continued success and existence.” The court found that the purchasers have “practical dependence” on Dapper Labs because Dapper created the NFTs, maintains control over the exclusive marketplace where those NFTs can be traded, tightly controls the underlying intellectual property (e.g., officially licensed NBA highlights) represented in the Moments, and even the blockchain on which the Moments exist.
In other words, if Dapper Labs decided to no longer maintain the Flow Blockchain or the NFT marketplace, owners of the NFTs would have no rights to the underlying intellectual property referenced by each Moment, and the value of Moments would essentially become zero because they could no longer be traded, purchased, or sold. Therefore, the value of Moments at least plausibly relies on Dapper Labs’ implied promise to maintain the Flow Blockchain, NFT marketplace, and intellectual property license from the NBA and NBAPA.
The Court construed its decision as narrow and that “not all NFTs offered or sold by any company will constitute a security.” Further, the Court stressed that the test established by the Howey decision “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” In addition, the Court cautioned that these situations will be viewed through a substance-over-form lens, and that assets will be deemed to be securities if “in light of the economic reality and the totality of the circumstances, the investment was an investment contract.” (citing Glen-Arden Commodities, Inc. v. Constantino).
Accordingly, this decision should cause NFT issuers, including major consumer brands, to more deeply consider the relative merits of whether to build customized experiences under their exclusive control on centralized blockchains, versus deploying on public blockchains. This decision also reflects a growing application of the so-called “fifth prong” of the Howey Test, which isn’t part of the actual Howey ruling, but relates to the economic realities and totality of the circumstances in applying the test. In other words, given Judge Marrero’s willingness to apply the Howey Test in as flexible a manner as possible, it portends that courts may use judicial flexibility to classify certain types of digital assets as securities according to a perceived “economic reality.”
Flow vs. Public Blockchains (Ethereum)
The SDNY conclusion leaves the digital asset and NFT industry with a plethora of questions. Primarily, while this decision was rendered in context of the Flow Blockchain, what does this decision mean for projects running on more decentralized blockchains like Ethereum? This decision relies on the privity between the three components of (1) Dapper selling NFTs, (2) Dapper maintaining an exclusive NFT marketplace, and (3) Dapper maintaining the Flow Blockchain. However, most projects will likely not have all three components, and there are stark differences between projects operating on private versus public blockchains.
For example, Ethereum is a decentralized network where anyone can participate in the maintenance of the blockchain for example by running a node. In addition, Ethereum has various community-driven governance mechanisms to ensure that there is no centralized control over the network. If a company launches an NFT on Ethereum, and then goes out of business, the NFT would still exist on the Ethereum blockchain and could still be purchased or sold. However, even then, the Chairman of the SEC has recently commented that the SEC potentially has jurisdiction over: “Everything other than bitcoin,” Gensler told me, “you can find a website, you can find a group of entrepreneurs, they might set up their legal entities in a tax haven offshore, they might have a foundation, they might lawyer it up to try to arbitrage and make it hard jurisdictionally or so forth.”
It is ironic that the NBA and Dapper’s decision to build on top of a semi-centralized Flow Blockchain in a specific attempt to create a better consumer experience was seized upon by the Court. The NBA and Dapper presumably made that decision for several reasons, including Dapper’s reported prior experiences with Ethereum scaling issues (in their CryptoKitties prime), but also with the NBA likely enjoying the benefits of more control over the release and resale of Moments. Since Moments lived exclusively on the Flow Blockchain, the NBA was trying to solve many of the financial, intellectual property, and regulatory issues that have plagued brand owners on public blockchains.
Considering the nuances between Ethereum and Flow, it seems unlikely that NFTs running on Ethereum would be analyzed exactly as provided by the SDNY. However, there are many other blockchains that might look more like the Flow Blockchain, or when comparing the element of decentralization, might be somewhere in between the Flow Blockchain and the Ethereum Blockchain. However, as Judge Marrero explicitly recognized in his decision, "no other courts have addressed … 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 under Rule 12(b)(6).” Surely more Courts will now be called on to analyze similar questions, likely in both the civil and regulatory context, and this decision could become a roadmap for other judges to follow.
For the time being, this decision potentially raises direct questions about NFTs exclusively deployed on centralized blockchains. NFT sponsors should consider their offerings accordingly.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.