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DraftKings Should Prevail in NFT-Securities Litigation
In February 2022, we wrote about the extent to which NFTs could raise novel securities laws questions, invoking the case of Friel v. Dapper Labs and utility-based NFT offerings conjoined to ownership-based privileges associated with securities. A year later, in February 2023, a judge from the U.S. District Court for the Southern District of New York denied Dapper Labs’s motion to dismiss, holding that the plaintiff’s allegations that Dapper Labs’s NBA TopShot Moments constituted an unregistered securities offering are “facially plausible.”
Now, in a similar case, DraftKings has filed a motion to dismiss a class action lawsuit. The class action alleges that DK sports collectibles sold through its digital marketplace are unregistered securities. Indeed, DraftKings has stated in its memo that the suit is an attempt to “mimic the allegations at issue in the only decision by any court that ever has found that an NFT could be a security, the out-of-circuit district court decision in Friel v. Dapper Labs, Inc.” With DraftKings’ filing, the company also requested oral arguments to assist the Court’s consideration of their motion to dismiss. If permitted, both parties would address Judge Casper on December 19th, when the next hearing is scheduled.
As DraftKing correctly points out in its motion to dismiss, the differences between the two NFT offerings are critical.
The Howey Test and Friel v. Dapper Labs, Inc.
While the court’s holding was ultimately a narrow one—resulting in the denial of Dapper Labs’ motion to dismiss—rather than a determination that all NFTs offered or sold by a company will constitute a security, the court’s ruling in Friel v. Dapper Labs, Inc. marked the first time a judge has explicitly addressed the issue of whether and how the securities laws can apply to NFTs.
In August 2022, Dapper Labs filed a motion to dismiss, primarily arguing that NBA Top Shot Moments are not securities, but instead digital versions of card-board collectibles the sorts of which are found in Pokémon and Topps Baseball Cards, for example.
On February 22, 2023, Judge Victor Marrero of the U.S. District Court for the Southern District of New York denied the motion to dismiss. The court determined that the complaint contained sufficient factual matter that (accepted as true) would allow the court to draw the reasonable inference that the defendant is liable for the misconduct alleged. In its analysis, the court closely examined the three prongs of the Howey test to determine whether the defendant’s NFT offering could plausibly constitute an investment contract (and, accordingly, security) “whereby (1) a person invests their money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.” Because the first prong is easily satisfied when the digital asset is purchased or otherwise acquired in exchange for value—whether in the form of currency or other type of consideration—the court focused on the latter two prongs.
Either of two accepted theories of commonality demonstrates a “common enterprise,” the second prong of the Howey test in the Second Circuit—strict vertical commonality or horizontal commonality. Strict vertical commonality requires that the fortunes of investors be tied to the fortunes of promoters, which means that, as cited in the ruling, “strict vertical commonality exists where there is a ‘one-to-one relationship between the investor and investment manager’ such that there is ‘an interdependence of both profits and losses of the investment.’” Horizontal commonality exists where there is (1) a sharing or pooling of the funds of investors and when (2) “the fortunes of each investor in a pool of investors” are tied to one another and to the “success of the overall venture.”
As to NBA Top Shot, the court found that pooling was adequately alleged, in the first place, because the plaintiffs alleged that the defendant’s sale of NFT Moments packs and other transaction fees such as royalties generate revenue used to grow Dapper Labs’ native Flow Blockchain, on which the Moments are housed and the maintenance and success of which is fundamental to Moments’ continued value. This point directly coincides with the second consideration of horizontal commonality, namely, that the fortunes of each investor in a pool of investors are tied to one another and to the venture’s success. As the court explained,
Having concluded that NBA Top Shot Moments exhibit horizontal commonality, the court noted that they likely do not exhibit strict vertical commonality. Among other reasons, the Court determined that the plaintiffs could not establish that the value of Moments and FLOW would rise and fall together.
The final Howey prong consists of two parts: (1) a promise or expectation of profits (2) to be derived from the entrepreneurial or managerial efforts of others.
As to the first part, the court determined that “Defendants’ public statements and marketing materials objectively led purchasers to expect profits,” in addition to the sales structure of Moments packs, which thrive on artificial scarcity. Further buttressing the allegation was the conclusion (and evidence supporting the notion) that purchasers were likely to purchase Moments as a speculative investment rather than for its purported consumptive use as a collectible. As the court wrote, “Other than the ability to view particular Moments one owns, and to seek out certain players, plays, or teams in the Marketplace, Moments have no other utility,” especially since Dapper Labs places strict limitations on how purchasers can consume Moments.
The second aspect of the third prong—the reliance on the efforts of others for an expected profit—is perhaps the most complicated element of the Howey test because of the presence of external market forces that may drive prices one way or another regardless of the efforts of others. Indeed, this is a common preliminary defense in cases involving federal securities laws and cryptocurrencies. Yet, Dapper Labs’ role is essential in the value of Moments whether market forces are part of the picture or not. As the court reasoned, Dapper Labs itself maintains the only market by which Moments can be bought, sold, or otherwise exchanged, in conjunction with the fact that the Moments are housed solely on Dapper Labs’ Flow Blockchain, and thus are an essential component to the value of Moments themselves. The court notes further, “the allegations that Dapper Labs created and maintains a private blockchain is fundamental to the Court’s conclusion. By privatizing the blockchain on which Moments’ value depends and restricting the trade of Moments to only the Flow Blockchain, purchasers must rely on Dapper Labs’s expertise and managerial efforts, as well as its continued success and existence.” According to the court, such features and underlying circumstances surrounding Moments are what distinguish them from card-board collectible cards as Dapper had argued in its motion.
DraftKings’ NFTs, however, present an altogether different set of circumstances than Moments.
Justin Dufoe v. DraftKings, Inc.
A few critical facts differentiate the DraftKings’ and DapperLabs’ NFT offerings, and each fact touches upon the various prongs of the Howey test analysis in important ways, likely leading to a decision in favor of DraftKings.
First, DraftKings offers two sorts of NFTS, the latter of which is the primary focus of the complaint: (1) static or animated collectible images, most of which are of professional athletes, and (2) Reignmakers NFTs that are used in Reignmakers fantasy sports-style contests, primarily relating to professional football.
Reignmakers contestants assemble a roster of player-athletes by acquiring the associated Reignmakers NFTs for use in the fantasy-style contests, the winners of which are based on the actual collective statistical performance of each selected real-world athlete in the designated event relative to other competitors who create a competing lineup from among the Reignmakers NFTs that they own.
The focus of the complaint is Reignmakers NFTs, which possess a well-established consumptive use case described above. Because a transaction does not fall within the scope of the securities laws when a reasonable purchaser is motivated to purchase by a consumptive intent, Reignmakers NFTs are a wholly inappropriate target for a securities offering allegation. Further, while DraftKings also offers collectible NFTs, like Dapper Labs, such collectibles were marketed by DraftKings solely as collectibles without mind for any potential price appreciation and explicitly qualified sales as “not for any investment or speculative purposes” in Marketplace agreements. This latter fact explains the complaint’s relative disregard for the first sort of NFT and the attempt to home in on the second as there is potential for financial gain. This leads to the second critical fact.
Second, the value of Reignmakers NFTs is based on their utility in games and the contestant’s ability to build competitive player lineups.
The structure of the Reignmakers contests touch squarely upon the “expectation of profit to be derived solely through the effort of others” prong of the Howey test insofar as winning contests was the principal alleged means by which purchasers of NFTS were to expect profits. However, the prize-earning potential of competing in a Reignmakers contest depends on the skill of contestants assembling a lineup and the real-world performance of athletes rather than the managerial efforts of DraftKings. Indeed, the price of the primary “drops” of Reignmakers NFT decreases as the sports season progresses and DraftKings stops selling the packs altogether as the regular season ends.
Even further on the topic of the expectation of profit, the complaint fails to adequately allege, as in the case of Dapper Labs, that the issuing company (in this case, DraftKings) made public statements indicating that the NFTs could be purchased for a return on investment. DraftKings’ only mentions of any form of financial gain were in marketing the potential prospect of winning contests against other NFT owners in Reignmakers contests by means of skillfully selecting lineups.
Notably, the feature of competition between NFT owners also evinces a lack of commonality between “investors,” or vertical commonality, as competitors’ “success varies from contest to contest and is highly individualistic, determined solely by their ability to select the players who perform the best on the field.” This leads to the third critical fact.
Third, DraftKings’ NFTs are minted on a public blockchain developed by Polygon Labs, which is a wholly distinct company unaffiliated with DraftKings, whereas Dapper Labs’ NFTs are housed in customers’ “Dapper Wallets” on the FLOW Blockchain, the private blockchain of Dapper Labs.
In the Dapper Labs case, horizontal commonality was adequately alleged based on Dapper Labs’ reliance on the success of its proprietary FLOW Blockchain and the capital raised from Moments’ sales. But with DraftKings and Reignmakers, there’s no proprietary blockchain, and the value of Reignmakers NFTs is not tied to DraftKings’ overall success: “Even if DraftKings were to dissolve today, the NFTs and Polygon blockchain would continue to exist.” Additionally, DraftKings’ NFT business comprises only 3% of its revenues, making any correlation with its overall success unlikely.
While the complaint attempts to capitalize on the Dapper Labs decision, DraftKings’ NFT offerings present a much different case, much to DraftKings’ advantage.
To no one’s surprise, the preliminary judgement in Friel v. Dapper Labs, Inc. was employed in an effort to retrieve losses from drastic NFT price depreciations. In this case, however, use of Friel v. Dapper Labs is entirely misguided. Previously we’ve discussed the extent to which NFTs were potentially being used as investment contracts to, among other things, bestow ownership privileges commonly associated with securities offerings or promise a return on investment by merely holding the NFT, all in an attempt to attract purchasers. But in the case of DraftKings, this is far from what is happening. No reasonable understanding of the DraftKings NFT offering scheme as well as Howey case law yields a judgement against DraftKings. The company made no efforts to market or promise financial gain to NFT purchasers, and indeed, was careful not to do so. Among other facts, the above discussion highlights the critical ways in which Dapper Labs’ and Draft Kings’ NFT offerings differ as a matter of securities laws. So, while Friel v. Dapper Labs, Inc. was the first case of its kind in which the legal separation between securities and NFTs were eradicated, the potential conjoining of the two has long been a concern. DraftKings, no doubt, was well aware of securities law considerations.
 Justin Dufoe v. DraftKings, Inc. Defendants’ Memorandum of Law In Support of Their Motion to Dismiss the Amended Complaint. Accessed: https://www.bonus.com/wp-content/uploads/2023/10/dkmemodufoe.pdf
 Friel v. Dapper Labs.
 Ibid. See also: Revak.
 Justin Dufoe v. DraftKings, Inc. Defendants’ Memorandum of Law In Support of Their Motion to Dismiss the Amended Complaint.