By: Gai Sher, Esq. and Ariela Benchlouch*
Dapper Labs has been under fire since Jeeun Friel, a Virginian woman and NBA Top Shot user, filed a putative securities class action lawsuit against Dapper Labs, Inc., alleging that the tech company violated the Securities Act of 1933 by operating an application called “NBA Top Shot” that promoted, offered, and sold securities, known as NBA Top Shot Moments (“Moments”), throughout the United States. Friel claims that as a result of Dapper Labs’ issuance, promotion, and sale of unregistered securities, plaintiffs and the class have suffered significant damages in an amount to be later proven at trial.
On August 31, 2022, Dapper Labs filed a motion to dismiss the case, and nearly five months later on February 22, 2023, the court denied the motion, finding the claim to be plausible on its face. Dapper Labs had to have responded to the court’s decision by March 15, 2023.
Dapper Labs, currently valued at $7.6 billion, is a popular and innovative blockchain-focused technology company that was founded in 2018 and is based in Vancouver, Canada. On October 2020, Dapper Labs partnered with the NBA and NBPA to launch NBA Top Shot —an NFT marketplace of the NBA’s greatest plays and players—and have since sold over $1 billion worth of digital assets to collectors. NBA Top Shot sells digital basketball cards referred to as “Moments,” which are NFTs featuring a short video clip of a play from an NBA game and are accompanied by statistics about the player and the game. Moments are sold in packs and each card is assigned its own serial number, making each a unique digital asset sold in the form of a non-fungible token. NBA Top Shot is built on Dapper Labs’ Flow blockchain—a Proof-of-Stake blockchain developed and controlled by Dapper and powered by their native FLOW token. Dapper Labs initially used the public and decentralized Ethereum blockchain, and its smart contract technology, for its early projects, but after their popular NFT project Cryptokitties “broke” Ethereum with its popularity, Dapper Labs developed their own exclusive blockchain with capabilities to scale up and meet their consumers’ needs. This has now become a material factor in the court’s analysis of the “Howey Test,” as it made the blockchain privatized – giving Dapper significant control over the sale and success of Moments.
The crux of Friel v. Dapper Labs depends on whether the court determines that Dapper Labs’ NBA Top Shot “Moments” are considered securities under the “Howey Test.” Dapper Labs claims that their Moments are not securities, but simply digital basketball collectible cards utilizing innovative NFT and blockchain technology. Friel rejects that claim and argues that NBA Top Shot Moments are not standard cardboard basketball cards and are instead securities. If the court finds that these Moments do qualify as securities, Dapper would need to register with the S.E.C. or operate pursuant to a registration exemption.
The Supreme Court’s decision in S.E.C. v. W.J. Howey Co. established a three-part test (“Howey Test”) to determine whether a contract or transaction constitutes an investment contract. These three components include: (1) an investment of money, (2) in a common enterprise, (3) with the expectation that profits will be derived from the efforts of the promoter or third party. The parties focused only on the second and third elements of the “Howey Test, since it is undisputed that collectors pay an investment of money for their Moments.
Friel is arguing that all three of the “Howey test prongs are met, and that the Court should therefore find that Dapper Labs’ NBA Top Shot Moment NFT are securities under the Securities Act of 1933. Friel claims that the fact that Dapper Labs hosts its Moments on its Flow blockchain directly impacts the second and third prong of the “Howey Test” and further alleges that NBA Top Shot, Dapper’s Flow blockchain, and Dapper’s FLOW tokens are inextricably linked in a way that leads investors to expect profits from the efforts of Dapper Labs’ ability to maintain interest in its Flow blockchain—making Moments securities.
Dapper Labs rejects that claim and argues that neither the second nor third prongs of the “Howey Test” are met because Moments’ collectors do not allege that they have purchased any FLOW tokens, and since there is no legal support connecting FLOW tokens to the digital basketball cards, Friel’s references to the Flow Blockchain and FLOW tokens are merely an attempt at distraction without any relevant correlation.
The court will need to analyze the importance of Dapper Labs’ Moments residing on their privately owned and operated Flow blockchain powered by their FLOW token, and what impact this has on the “Howey Test” analysis. Friel alleges that Dapper Labs is using NBA Top Shot Moments as a scheme to stir up activity on the Flow blockchain and prop up the value of the FLOW token – at the expense of innocent investors. Dapper Labs states that Friel’s Flow allegations are immaterial because FLOW tokens are completely separate products requiring separate analyses, regardless of the involvement of blockchain technology, and neither Friel nor digital basketball cards have any necessary connection to FLOW tokens. The court stated that this question is fundamental to its conclusion and that the privatization and restrictions that Dapper Labs implements are what distinguish Moments from cardboard basketball cards.”
The court’s denial of Dapper Labs’ motion to dismiss puts NFT sellers on notice that they might be dealing with securities, hopefully leading sellers to instill more protective measures and guidelines for their consumers. It is important to note that there are other federal agencies beyond the S.E.C. that may have the requisite regulatory power over these transactions, such as the Commodity Futures Trading Commission (“CFTC”), which regulates commodities including cryptocurrencies.
*Not a lawyer.
