Dapper Labs Ruling Dunks on Private Networks

A landmark ruling is bringing the NBA Top Shots creator back to court, and potentially opening up securities concerns for other NFTs.

AccessTimeIconFeb 28, 2023 at 9:41 p.m. UTC
Updated Mar 2, 2023 at 12:54 p.m. UTC
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On Feb. 22 came the publication of what will surely become an instant classic application of the Howey Test, part of a 64-page opinion written by Judge Victor Marrero of the U.S. District Court, Southern District of New York. In denying the motion by Dapper Labs and its CEO to dismiss an unregistered securities offering case brought against them, the court provided one overarching lesson: If you market NFTs [non-fungible tokens] using your own private blockchain and marketplace, then you should probably hire a good compliance lawyer beforehand.

Acknowledged by the court as the first case to decide whether an NFT constitutes an investment contract under the famous Howey Test, Judge Marrero allowed the putative class-action lawsuit Friel v. Dapper Labs, Inc. to proceed past a motion to dismiss. He focuses on several attributes common to several other NFT projects, namely the use of a private blockchain network and a native token backed by the founder of the network.

Paul Paray is one of the founders of ArtSwap, LLC based in Glen Rock, New Jersey.

Dapper Labs’ NBA Top Shots Moments were said by the court to represent investment contracts offered to the public with an expectation of profit. That, together with the finding that the NFTs’ financial success is tied to the success of Dapper's bespoke platforms, satisfies two prongs of the Howey Test – the four-prong test, resulting from a U.S. Supreme Court case, used to determine whether certain assets fall under the Securities and Exchange Commission’s purview.

Judge Marrero begins his legal analysis by referencing the definition of an “investment contract” as “a contract, transaction or scheme whereby a person invests [their] money in a common enterprise” where “profits solely from the efforts of the promoter party.” The court defines NFTs as “digital assets whose authenticity and ownership can be recorded on a blockchain.” On Page 9 he writes, “Moments are a digital video clip of highlights from NBA games, such as a spectacular dunk or game-winning shot.”

Distilled to its essence, on Page 23, the judge finds it was Dapper Labs’s control over its private blockchain that showcases how the scheme operates to promote Moments: “[T]he economic realities and technological interplay between FLOW [token], the Flow Blockchain, and Moments, as alleged by Plaintiffs, are what supports the Court’s conclusions.”

On Page 56, the court writes that “a company’s efforts to develop and maintain an ecosystem for trading sufficiently establishes the third Howey prong.” On the next page, he recognizes “Dapper Labs’ implicit promise to maintain the Flow Blockchain and facilitate trades on the Marketplace drive Moments’ value.” Further, on Page 62, “The allegations that Dapper Labs created and maintains a private blockchain is fundamental to the Court’s conclusion.” (emphasis added).

In particular, Judge Marrero is concerned that Dapper Labs restricts the trading of Moments to the Flow blockchain, a network built by Dapper as a faster and cheaper alternative to Ethereum. While this raises questions about profits and transaction fees, the judge also argues that, on a technical level, “by privatizing the blockchain” Moments “purchasers must rely on Dapper Labs’s expertise and managerial efforts as well as its continued success and existence.” Writing in agreement with the plaintiffs, the judge found this situation altogether different from “public blockchains, such as that underlying Bitcoin.”

Compelling authority

While Judge Marrero made the correct ruling as to Dapper Labs, there is always the possibility a future court might misconstrue what was done to the disadvantage of those selling NFTs using, for example, a layer 2 platform built on a public blockchain or a platform not reliant on a native token ecosystem. Such a potential future ruling would be an obvious bridge too far.

For example, unique items such as artwork more typically sold on an individual basis would not easily square with this ruling. It also raises potential concerns about NFT creators who partner with firms like Dapper to market and host their work. Judge Marrero actually addresses this issue when responding to Dapper’s motion to dismiss on Page 35, saying the case law the company cites, Dahl v. English, was not equivalent because the “unique pieces of artwork” being sold in that case did not have a “causal connection” to “the promoter making the offering.”

Fine art NFTs also retain another point of distinction from Moments, given that fine art NFTs will always have an intrinsic value. In its motion to dismiss, Dapper had argued Moments should not be seen as an investment contract because the works have intrinsic value. The judge did not buy that argument and noted Dapper’s terms of use states multiple times that Moments have “no inherent or intrinsic value.”

As a point of comparison, the company originally behind the messaging platform Kik – which raised a multimillion-dollar initial coin offering that was later found to be a securities offering, similarly promoted something with no intrinsic value. “Unlike real estate, [the kin token has] no inherent value and will generate no profit absent an ecosystem that drives demand,” the court there found.

There are certainly valid reasons why platforms built on private blockchains should be treated differently from those built on public blockchains, and likely why Voice recently made the move to a public blockchain. Platforms using native tokens such as Rarible with its RARI token may also have to strategize a bit after this decision. Finally, private blockchains focused on NFTs such as WAX may have to reevaluate how its promoters are compensated.

Going forward, however, the safest approach for NFT creators is to partner with a company that has built a platform from the ground up using a public blockchain and without the use of a platform native token or any other direct means of controlling the value of the digital assets. And further, those NFTs sold using such a platform that are least likely to be considered investment contracts are the fine art ones underlying the nascent Digital Art Movement now well underway.


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Paul Paray

Paul Paray is one of the founders of ArtSwap, LLC based in Glen Rock, New Jersey.

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