(Article from Securities Law Alert, March 2023)
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On February 22, 2023, in a decision of first impression, the Southern District of New York denied dismissal of a putative class action alleging that a company violated the Securities Act by offering for sale to the public NFTs (non-fungible tokens) without filing a registration statement with the SEC, in violation of Sections 5 and 12(a)(1) of the Securities Act.[1] Friel v. Dapper Labs, 2023 WL 2162747 (S.D.N.Y. 2023) (Marrero, J.). Looking to SEC v. W.J. Howey Co., 328 U.S. 293 (1946), to analyze whether the NFTs constituted a security, the court held that plaintiffs adequately pleaded all three prongs of Howey.
Background
The NFTs at issue are digital video clips of professional sports highlights. The defendant company may produce multiple copies of a given highlight, but each copy has a unique serial number. The authenticity and ownership of the NFTs is recorded on a private blockchain—a decentralized digital ledger—that the company developed. The company also created an application to provide a platform to sell the NFTs and a digital token to validate transactions on its private blockchain. The NFTs at issue could be acquired only when the company sold “packs” of them on its application, or through a secondary marketplace hosted on the company’s application.
Whether the NFTs Are Securities Depends on Whether They Amount to an Investment Contract
The issue before the court was whether plaintiffs had sufficiently pled that the company’s offer and sale of the NFTs amounted to an offer or sale of a security. The Securities Act’s definition of a “security” includes an “investment contract.” The U.S. Supreme Court defined an “investment contract” in SEC v. W.J. Howey Co. as “a contract, transaction or scheme whereby a person invests their money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” The Southern District of New York explained that at the motion to dismiss stage, plaintiffs “must plead facts adequate to establish the three prongs of the Howey test: (1) an investment of money (2) in a common enterprise (3) with the expectation of profit from the essential entrepreneurial or managerial efforts of others.” Because the parties did not dispute the first prong, the court focused on the second and third prongs.
As to the second prong, the court noted that a common enterprise can be alleged under a theory known as “horizontal commonality,” which requires “(1) a sharing or pooling of the funds of investors and (2) that the fortunes of each investor in a pool of investors are tied to one another and to the success of the overall venture.” Revak v. SEC Realty, 18 F.3d 81 (2d Cir. 1994). The court explained that “[g]enerally, pooling occurs when the funds received by the promoter through an offering are, essentially, reinvested by the promoter into the business. In turn, such reinvestment increases the value of the instrument offered” (referencing Milnarik v. M-S Commodities, 457 F.2d 274 (7th Cir. 1972)). The Southern District of New York held that plaintiffs adequately alleged a pooling of assets because they alleged that the company’s NFT sales and the related transaction fees generated revenue that was used to support and grow the company’s blockchain. The court also determined that plaintiffs adequately pled that the fortunes of each investor were tied to the success of the overall venture because the company controlled the enterprise, including its private blockchain. Further, plaintiffs plausibly alleged that the continued value of the NFTs depended on the company’s success because the NFTs had no value outside of the private blockchain that the company controlled.
The court also determined that plaintiffs adequately pled the third
Howey prong by alleging that the company’s NFT offer came with “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The court found that the company’s public statements and marketing materials, including tweets promoting a recent sale or statistics of recent sales, objectively led purchasers to expect profits. Notably, while the court acknowledged that the word “profit” did not appear in any of the tweets, it concluded that the “rocket ship” emoji, “stock chart” emoji, and “money bags” emoji objectively suggested a financial return on investment. The court also determined that plaintiffs plausibly alleged that the “promise of profits must also be derived from the entrepreneurial or managerial efforts of others.” The court stated that the “allegations that [the company] created and maintains a private blockchain is fundamental” to its conclusion. The court explained that privatizing the blockchain on which the NFTs’ value depend and restricting their trade to only its blockchain, forces purchasers to rely on the company’s “expertise and managerial efforts, as well as its continued success and existence.”
[1] Section 5 prohibits persons from offering, selling, or delivering any security, unless a registration statement is filed with the SEC. 15 U.S.C. § 77e(a), (c). Section 12 creates a private right of action for any person who purchased a security in violation of Section 5 to recover from the seller the consideration paid for such security, with interest. 15 U.S.C. § 77l(a).