A recent legal decision may offer some much-needed – though not much-liked – clarity on the regulatory landscape ahead for non-fungible tokens (NFT) that may define how centralized companies proceed in entering Web3.
The federal judge in New York overseeing a class-action lawsuit against Dapper Labs ruled Wednesday to deny the company’s motion to dismiss the suit, writing that the plaintiffs’ claims that Dapper Labs’ NBA-branded Top Shot Moments NFTs are securities – and that selling them without first registering with the U.S. Securities and Exchange Commission (SEC) was a violation of federal securities laws – are “plausible.”
In his 64-page Wednesday ruling, U.S. District Court Judge Victor Marrero of the Southern District of New York considered Dapper Labs’ NFT collection under the four prongs of the Howey test, a 90-year-old method devised by the U.S. Supreme Court to determine whether certain transactions qualify as “investment contracts.”
Marrero stated that the plaintiffs adequately argued that the Top Shot NFTs met each of the four prongs of the Howey Test. The fourth prong – that the profits expected from an investment must be derived from the efforts of others – was particularly important to Marrero’s analysis.
Because Dapper Labs controls the Flow blockchain the NFT collection is built on as well as the marketplace where the NFTs are bought and sold, Marrero suggested that the financial viability of the project was dependent on Dapper Labs’ continued success.
“All that Moments purchasers own is, essentially, the line of code recorded on the Flow Blockchain,” Marrero wrote. “It follows that, if, hypothetically, Dapper Labs went out of business and shut down the Flow Blockchain, the value of all Moments would drop to zero.”
Though Dapper Labs attempted to argue in its motion to dismiss that the NFTs were the digital equivalent of any other cardboard-based collectible, like Pokemon cards or baseball cards, Marrero fundamentally disagreed.
“It is the particular scheme by which Dapper Labs offers Moments that creates the sufficient legal relationship between investor and promoter to establish an investment contract, and thus a security, under Howey,” Marrero concluded.
An influential ruling
Though Marrero’s ruling is, by his own admission, “narrow” (meaning it does not necessarily mean that other NFTs are securities), and is neither final nor sets precedent, legal experts agree that it is significant – both for Dapper Labs and the broader NFT space.
Anthony Sabino, a professor of law at St. John’s University, told CoinDesk that Marrero’s opinion that Dapper Labs’ NFTs meet the definition of securities “may not necessarily be precedential, but it shall be quite influential because it emanates from the Southern District [of New York], because it's from an eminent jurist and because it just makes a lot of sense.”
“The judges in the Southern District of New York are particularly adept at securities cases, for the reason that they are within walking distance of Wall Street itself,” Sabino said. “They have their finger on the pulse of Wall Street. They see these cases all the time.”
Sabino added that the Southern District of New York reports to the federal Second Circuit Court of Appeals, which he said has been acknowledged by the U.S. Supreme Court since the 1970s as the “mother court” of federal securities laws.
Other lawyers, however, such as Jesse Hynes, a New Jersey-based attorney whose practice includes cryptocurrency law, see less reason to believe Marrero’s analysis spells disaster for either Dapper Labs or the wider NFT space.
Motions to dismiss, Hynes explained, are common – and usually unsuccessful – attempts to stop lawsuits before they get to trial.
“Attorneys will throw up a ‘Hail Mary’ of sorts [to end the litigation],” Hynes told CoinDesk. “Or, in keeping with the basketball analogy – a full court shot with their eyes closed.”
Hynes told CoinDesk that as long as the plaintiffs’ claim was deemed to be “reasonably feasible,” the complaint was determined to proceed to the next stage of litigation.
An issue of centralization
Whether or not Marrero’s ruling sets precedent or not, legal experts agree other judges will hardly be the only people to take note of his analysis – particularly his insinuation that it was Dapper Labs’ creation and control of the Flow blockchain and the marketplace that brought the Top Shots NFTs under the Howey Test’s prongs.
“This case is all about centralization and external dependencies,” said Mike Selig, a New York-based cryptocurrency attorney at Willkie Farr & Gallagher. “The plaintiffs argue that the NFTs are distinguishable from physical basketball trading cards because Dapper [Labs] maintains the blockchain on which the NFTs operate, runs the secondary marketplace where the NFTs trade and engages in the ongoing marketing of the NFTs to consumers.”
Moish Peltz, a New York-based partner at Falcon Rappaport & Berkman whose practice focuses on cryptocurrencies and intellectual property, told CoinDesk that it was “ironic” that Dapper Labs’ decision to build on top of the Flow blockchain “in a specific attempt to create a better consumer experience was seized on by the Court.”
“Since Moments live exclusively on the Flow blockchain, the [National Basketball Association] was trying to solve for many of the financial, intellectual property and regulatory issues that have plagued brand owners on public blockchains,” Peltz said. “This decision directly challenges the rationale that a centralized NFT marketplace experience is automatically safer for brands.”
Though Marrero construed his own decision as “narrow” and argued that “not all NFTs offered or sold by any company will constitute a security,” Peltz said his decision should push 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.”
Jeremy Goldman, an intellectual property (IP) lawyer and partner at law firm Frankfurt Kurnit Klein & Selz, told CoinDesk the ruling might be good news for NFT projects building on public blockchains.
“Folks minting NFTs on public blockchains and using open marketplaces can breathe a little easier,” Goldman said. “The vast majority of NFT projects don’t share those key facts that troubled the court.”
He noted that Dapper’s strategy in creating a “walled garden” within its platform is what contributed to the ruling, providing future guidance on how to create NFT platforms and products.
“As with most blockchain ventures, the more centralized the NFT offering, the greater the risk that the offering will be deemed a security,” said Goldman. “My hope is that the Dapper Labs decision helps educate courts, lawmakers and regulators on the fundamental distinction between private and public blockchains; between centralized platforms and decentralized protocols.”
Is decentralization the solution?
“This case demonstrates that decentralization is just as important in the case of NFTs as with fungible tokens,” Selig told CoinDesk.
Sabino, the law professor, agreed. He argued that if Dapper Labs was more decentralized, it could have possibly avoided triggering Howey.
Because Dapper Labs’ controlled the marketplace where its NFTs were sold, Sabino argued, the role of investors was diminished.
“That way, the purchasers become true investors, passive in nature, and therefore makes it a security subject to federal securities laws,” Sabino said. “To the extent that there is decentralization and the purchasers are far more active and they’re far less reliant on the ‘efforts of others,’ then it becomes less likely that the NFT falls within Howey.”
However, not all legal experts are hopeful that decentralization would offer any protection for NFT projects.
“I just don’t think that the argument of something being centralized or not being centralized would be sufficient to beat this case,” said Max Dilendorf, a New York-based cryptocurrency attorney, told CoinDesk, pointing to a 2018 case the SEC brought against decentralized trading platform EtherDelta.
In the EtherDelta case, Dilendorf said, ”the [SEC] said, ‘Hey, you know, we don’t really care if you’re decentralized or not, it’s irrelevant. You launched something that was illegal, the exchange was operated as an unregistered securities exchange, so you, as the founder, are liable.”
“I think it’s just so incredibly difficult to make an argument that any blockchain project is decentralized. It’s impossible, right?” Dilendorf said. “I don’t think anyone would be able to rely on that.”
Some NFT companies appear unbothered
While lawyers might be nervous about the implications of Marrero’s ruling, major players in the NFT space are thus far unfazed by the implications the case may have on their future operations. In other words, they are confident in the belief that NFTs are not securities.
“Courts have repeatedly found that consumer goods – including art and collectibles like basketball cards – are not securities under federal law,” a representative from Dapper Labs told CoinDesk. “We are confident the same holds true for Moments and other collectibles, digital or otherwise, and look forward to vigorously defending our position in court as the case continues.”
Josh Rosenblatt, chief operating officer and general counsel of Co:Create, a company that helps NFT projects launch their own cryptocurrencies, told CoinDesk that in regards to regulation the Dapper Labs case is “not an important ruling,” and that the case will set no precedent for the future of NFTs being classified as securities.
“Ultimately, if a token, whether fungible or non-fungible, were deemed a security, then the issuer would either need to register with the SEC or take advantage of an exemption from registration,” said Rosenblatt. “I think the crypto community will eagerly watch from the sidelines, and I personally would be shocked if the ruling ultimately went against Top Shot.”
Rosenblatt specified that while the risk of regulators deeming NFTs as securities is low, fractionalized NFTs – or NFTs that represent shared ownership of one token – are more likely to fall into this category.
Sanjay Raghavan, head of Web3 initiatives at blockchain real-estate company Roofstock onChain, told CoinDesk that the specificity of Dapper Labs’ scheme to create a private blockchain and marketplace may render its NFTs as securities, but applying the same ruling to all NFTs would be a “broad overreach” of the Howey Test.
“There are many NFT projects running on public blockchains with high consumptive value and associated IP rights that don’t necessarily meet the prongs of the Howey Test,” said Raghavan. “Whether it’s staking-as-a-service, stablecoin yield programs or NFTs on private blockchains, it is possible to look at the hundreds of appellate cases to determine what constitutes an investment contract and what likely does not.”
While the NFT regulatory landscape is still relatively new territory for both creators and collectors, the Dapper Labs ruling may not be promising for the future of a tokenized economy.
It’s especially difficult for Web3 companies that rely on centralized entities to help connect consumers and brands, which serves as the ethos behind many of these projects. As mainstream brands such as Nike and Starbucks take their first steps into NFTs, the Dapper Labs ruling may serve as a warning sign for centralized companies tapping into Web3.
A representative from secondary NFT marketplace OpenSea told CoinDesk that classifying all NFTs as securities isn’t plausible due to tokens’ varied utility. While the underlying technology may be adjacent, their use cases such as gaming, art, ticketing and digital identity all merit different levels of regulatory scrutiny.
While regulators may continue to use the Howey Test prongs on projects that pose the risk of being classified as securities, Goldman believes the ruling is a significant step in providing regulatory clarity for all NFT projects spanning the space, whether public or private.
“Right or wrong, the decision provides some of the best legal guidance I’ve seen – basically a road map – on how to structure NFT projects in a way that minimizes securities risks,” said Goldman.
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