Are NFTs Securities? Analysis of the NBA Top Shot Litigation and Other NFT-Related Actions
NFTs, or “non-fungible tokens,” are in the headlines. Artists, politicians, and celebrities, along with everyday internet users, have been selling and trading various forms of the digital asset, sometimes earning millions of dollars from the sales. But how do NFTs fit into the current securities regulation framework? And what are the legal implications of participating in this new and volatile market? This blog post explores these issues and analyzes ongoing NFT-related litigation.
Are NFTs Securities?
NFTs permit users to tokenize and secure ownership over some form of digital content (images, videos, memes, music, etc.). The digital item is linked to the blockchain, the digital database supporting cryptocurrencies, like Bitcoin. However, unlike cryptocurrencies, NFTs are unique because of their content. That is, although owning one Bitcoin is much like owning any other Bitcoin, owning a particular NFT is unlike owning other NFTs because each NFT tokenizes a particular image, meme, video, or other form of content. Many analogize it to fine art collecting; each piece of art is an asset that can be tied to some amount of monetary value. But no two pieces of art are the same.
The Securities and Exchange Commission (“SEC”) has not yet issued any formal guidance on whether NFTs are securities, although some sources report that the SEC is beginning an investigation into the issue. Based on the definition of “security,” most NFTs, as the public currently uses them, are unlikely to be considered securities. But a security market involving NFTs could develop.
A widely accepted definition of “securities” stems from a 1946 Supreme Court decision, S.E.C. v. W.J. Howey Co. There, the Court explained that, while the Securities Act of 1933 does not offer a singular definition of security, the definition includes terms like “investment contract” or “certificate of interest or participation in any profit-sharing agreement.” The term “investment contract,” in turn, was not defined by the Securities Act, but the Court relied on its historical use to deduce the following meaning: “[A]n investment contract . . . means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the effects of the promoter or a third party.” The Court specified that it was “immaterial whether the shares . . . are evidenced by formal certificates or by nominal interests” in the enterprise.
The SEC has issued a Framework for implementing the Howey investment contract analysis on to digital assets. The Framework explains that digital assets may be investment contracts where users (1) exchange some form of currency or consideration for the digital asset; (2) engage in a “common enterprise” through the digital asset; and (3) have reasonable expectations of profit derived from others’ efforts. As to the last factor, the Framework lists several different characteristics of digital assets that could make them more likely to be investment contracts. No individual factor is determinative, but generally, the more these factors are present with regard to a digital asset, the more likely it is that the asset would be an investment contract. For example, one listed characteristic is that a digital asset is “not fully functional at the time of the offer or sale,” and purchasers would reasonably expect a sponsor, promoter, or other third party (often referred to as an “Active Participant”) to “further develop the functionality” of the asset. Another listed characteristic is that the digital asset is “transferable or traded on or through a secondary market or platform, or is expected to be in the future.” As discussed in a previous Securities Litigation Insider blog post, based on Howey and the Framework, the SEC has taken the position that cryptocurrencies may constitute investment contracts.
Using the Howey definition and the SEC’s Framework, many NFT transactions may not be securities. For example, when someone purchases a minted image of a meme (i.e., one entire NFT), they exchange some amount of currency for ownership of the digital asset. That type of digital asset is generally complete at the time of the purchase; that is, the buyer would not reasonably expect an Active Participant to further develop its functionality over time. Although the buyer may be interested in the value of the asset they own and hope to re-sell it at a later date for a profit, they did not invest in an ongoing, “common enterprise” that would pay the individual some share of profits. Additionally, without an active or imminent secondary trading market for the asset, it is less likely to be considered an investment contract.
However, some variations of NFT transactions may qualify as securities. For example, some NFT marketplaces could fractionalize NFTs. That is, multiple investors could buy portions of an NFT. In fractionalized transactions, no singular owner owns the digital asset. Fractionalization could also apply to a bucket of NFTs. Such platforms begin to resemble more traditional securities, as an Active Participant may play a “managerial” or “lead or central role” in validating transactions regarding the digital asset. SEC Commissioner Hester Pierce has hinted that some of these transactions could fall within the SEC’s jurisdiction and has suggested that the agency should be offering guidance to investors and innovators within the space. Moreover, as discussed, digital assets that trade on a secondary market or are expected to in the near future are more likely to provide users with a reasonable expectation of profits, and therefore, more likely to be an investment contract.
The NBA Top Shot Litigation
Many eyes are currently on an ongoing case that began in New York state court and is now proceeding in federal court in the Southern District of New York. Plaintiff Jeeun Friel, a Virginia resident, on behalf of a purported class of similarly situated individuals, sued Defendants Dapper Labs, Inc., and its founder and CEO, Roham Gharegozlou, alleging that Defendants sold NFTs called “NBA Top Shot Moments” to consumers in violation of federal securities laws.
The Complaint states that Ethereum is the second-most popular form of cryptocurrency, behind Bitcoin. Unlike Bitcoin, Ethereum has smart contract capabilities. Smart contracts are codes that verify and enforce financial agreements between two users. As smart contracts can be coded to self-execute, they often have lower transactional costs than traditional contracts. Although Dapper Labs initially used Ethereum smart contract technology in some of its early crypto endeavors, the Complaint alleges that Dapper Labs realized it needed to create its own blockchain to be able to host new types of digital assets. In September 2019, Dapper Labs announced that it was developing its own blockchain with its own native cryptocurrency, called “Flow.” The same year, Dapper Labs announced that it had partnered with the National Basketball Association (“NBA”) to sell NFTs on a digital platform for digital assets known as NBA Top Shot. NBA Top Shot offers digital assets, called “Moments” to investors. “Moments” are video clips of highlights from NBA basketball games. Moments are categorized into different tiers of rarity and significance and therefore hold different values.
In addition to purchasing Moments when they are “dropped,” investors can acquire them in the NBA Top Shot Marketplace, which is entirely created and controlled by Dapper Labs. The Complaint highlights how Dapper Labs’s singular control over the enterprise distinguishes it from Bitcoin, which is a decentralized cryptocurrency. NBA Top Shot allegedly receives a 5% transaction fee on all transactions in the Marketplace, and Dapper Labs allegedly receives fees when users transfer a Dapper wallet balance to their bank accounts. The Complaint alleges that “Moments are securities because they constitute an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others,” invoking language from Howey.
The Complaint alleges that investors experience significant delays and difficulties when attempting to withdraw money from their Dapper wallets. The NBA Top Shot website allegedly posted that most withdrawals are processed within 21 days but that some withdrawals could take 40 days or longer to process. Friel and the purported class claim “significant damages” and bring suit under Sections 5 and 12(a)(1) of the Securities Act.
After Friel filed the complaint in May 2021, Dapper Labs filed a notice of removal in July 2021, seeking to remove the action to federal court, namely, the Southern District of New York. According to Defendants, the purported class action meets the Class Action Fairness Act’s removal requirements. In federal court, the case has been assigned to District Judge Victor Marrero. Plaintiff filed an amended complaint in December 2021.
In January 2022, consist with the Southern District’s practices, Defendants filed a letter to the court previewing its arguments for an upcoming motion to dismiss the Complaint. Plaintiffs responded, and Defendants filed a reply in February. Defendants argue that the Complaint fails to meet the Howey test for what constitutes an investment contract, and, in turn, a security regulated by the Securities Act. First, Defendants point to the fact that investors share neither horizonal nor vertical commonality. Caselaw interpreting Howey refers to two possible ways of proving the “common enterprise” element of investment contracts. Horizontal commonality means that investors’ fortunes are tied to the fortunes of other investors by the pooling of assets, along with pro-rata distribution of profits. Strict vertical commonality means that the fortunes of individual investors are tied to the fortune of a promoter or third party. Defendants posit that neither form of commonality is present for Moments collectors, arguing that Moments collectors do not pool assets, the value of each separate Moment is independent of each other, and Moments collectors’ fortunes are not tied to the success or failure of Dapper Labs itself.
Second, Defendants argue that Moments do not come with a reasonable expectation of profits. According to Defendants, it should have been clear to plaintiffs that Moments are collectibles, as NBA Top Shot requires collectors to use Moments as “objects of play and not for investment or speculative purposes.” In so doing, Defendants invoke United Housing Foundation, Inc. v. Forman, where the Supreme Court explained: “What distinguishes a security transaction—and what is absent here—is an investment where one parts with his money in the hope of receiving profits from the efforts of others, and not where he purchases a commodity for personal consumption or living quarters for personal use.”
In a responsive letter, Plaintiffs argue that they can demonstrate both horizontal and vertical commonality because Dapper Labs allegedly takes a percentage of all transactions that occur in the secondary marketplace for Moments and because the value of Plaintiffs’ investments in Moments is tied to the overall success of Dapper Labs and its blockchain, as well as the popularity and success of Moments as an asset. Plaintiffs also argue that Dapper Labs’s disclaimer recommending that users use Moments for “play” is buried in fine print. However, according to Plaintiffs, the bulk of the online discourse about Moments refers to them as investments from which investors seek to gain profits.
After briefing on the motion to dismiss is complete, the NBA Top Shot litigation may be a key case in determining whether NFTs constitute securities, at least while the SEC continues to investigate the issue. If the District Court dismisses the Complaint on the grounds that the Defendants articulate in their letter, other similar NFT marketplaces may feel somewhat free from the weight of securities regulations. If the District Court denies the motion to dismiss, it could suggest that the securitization of NFTs is a fact-based inquiry that is inappropriate to determine at a motion to dismiss stage of a lawsuit. Discovery may be necessary to fully understand what investors expect when they choose to participate in particular NFT marketplaces.
Other NFT-Related Actions
Recently, a number of additional NFT lawsuits have begun to take shape around the country. These cases tend to center more around intellectual property issues than securitization issues. In November 2021, Miramax, LLC sued Quentin Tarantino for auctioning off NFTs of seven scenes from the 1994 motion picture Pulp Fiction. Miramax claims that Tarantino did not consult the company before putting up a variety of NFTs related to the film on a website, including handwritten film scripts and exclusive commentary from Tarantino on the film. The Complaint alleges that an agreement provided Miramax with “all rights of any kind and nature whatsoever in all media” related to Pulp Fiction, including the trademarked name of the film. Miramax brought claims for breach of contract, copyright and trademark infringement, and unfair and deceptive business practices.
Similarly, in January 2022, the French luxury fashion brand, Hermés, sued an NFT creator named Mason Rothschilds for marketing digital assets called “METABIRKINS.” Named after the popular luxury Hermés handbag, the BIRKIN, METABIRKINS appear to be tokenized images of BIRKINS made with multi-colored faux fur. Prior to creating METABIRKINS, Rothschild had already auctioned off an NFT called a “Baby Birkin,” a tokenized image of a BIRKIN bag with the image of a fetus super-imposed onto it, for $23,500. Hermés brought federal and state claims for trademark infringement and dilution, false descriptions of origin, and unfair competition.
Another notable recent case involves a hip-hop record label founded by a popular musician and entrepreneur and two music executives. The Complaint alleges that one of the founders was attempting to sell an NFT of one of the record label’s most famous albums. The record label claims that it is the sole owner of rights in the album and that, while the co-founder has a one-third equity interest in the record label, he has no copyright interests in the actual album. Interestingly, the court issued a temporary restraining order against the co-founder, preventing him from conducting the sale of the NFT and scheduling a July 2021 hearing on the matter. Following the hearing, the court issued a preliminary injunction against the co-founder as well, suggesting that the court found the record company’s arguments likely to succeed.
These cases suggest that NFTs are not the free-for-all, money-making asset that many users initially believed they could be. Corporations and individuals with intellectual property rights on the assets underlying NFTs that make references to art, film, and tangible products will not hesitate to enforce those rights, especially if the owners of those rights want to participate in the lucrative NFT market themselves. Based on the initial success of the record company’s action, it seems likely that courts will extrapolate intellectual property rights to protect owners from unauthorized NFT sales.
The most popular use of NFTs at the moment—exchanging digital currency for a digital asset—is unlikely to constitute a securities-related exchange. However, more complex transactions, such as ones that seek to invest in incomplete assets that require further development, that fractionalize the value of an NFT among many owners with a central arbiter monitoring all transactions around the asset, or that are connected to secondary markets of trade begin to more closely resemble a “security,” as defined in Howey, related caselaw, and the SEC’s Framework for digital assets.
NFT traders should remember, however, that agencies beyond the SEC might also have regulatory power over these transactions. For example, the Commodity Futures Trading Commission (“CFTC”) has defined “commodity” to include cryptocurrencies. Since NFTs are digital assets traded using blockchain technology, the CFTC could include them within the definition as well. Additionally, beyond regulatory concerns, NFT creators should be cognizant of intellectual property rights associated with the “real-life” counterparts of their tokenized content. Lastly, due to a general lack of regulatory guidance on NFTs at the moment, cybercriminals may use NFTs to create fraudulent schemes for financial gain. Users should be cautious while engaging with this volatile and unregulated asset.
 Decrypt, SEC Targets NFT Creators, Marketplaces Over ICO-Like Sales: Report (Mar. 2, 2022), available at https://decrypt.co/94268/sec-targets-nft-creators-marketplaces-ico-sales-report.
 328 U.S. 296 (1946).
 Id. at 297 (quotation marks omitted).
 Id. at 298-99.
 Id. at 299.
 U.S. Sec. & Exch. Comm’n, Framework for “Investment Contract” Analysis of Digital Assets (last modified Apr. 3, 2019), available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn1.
 Securities Litigation Insider, A Brief Overview of the SEC’s Guidance on Cryptocurrencies in the Context of the Commission’s Enforcement Action Against Ripple Labs (Feb. 3, 2022), available at https://www.pbwt.com/securities-litigation-insider/a-brief-overview-of-the-secs-guidance-on-cryptocurrencies-in-the-context-of-the-commissions-enforcement-action-against-ripple-labs/.
 Howey, 328 U.S. at 298-99; see also U.S. Sec. & Exch. Comm’n, Framework for “Investment Contract” Analysis of Digital Assets.
 U.S. Sec. & Exch. Comm’n, Framework for “Investment Contract” Analysis of Digital Assets.
 See CoinDesk, SEC Commissioner Hester Peirce Says Washington Doesn’t Need a New Crypto Regulator (Dec. 30, 2021), available at https://www.coindesk.com/policy/2021/12/30/sec-commissioner-hester-peirce-says-washington-doesnt-need-a-new-crypto-regulator/.
 U.S. Sec. & Exch. Comm’n, Framework for “Investment Contract” Analysis of Digital Assets.
 See Compl., No. 653134/2021 (N.Y. Sup. Ct. May 12, 2021).
 Id. ¶ 48.
 Id. ¶¶ 82, 89-100.
 See Dkt. No. 1:21-cv-5837 (S.D.N.Y.)
 Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994).
 Id. at 87-88. In Revak, the Second Circuit left unanswered whether strict vertical commonality alone is sufficient to establish the existence of a common enterprise. Id. at 88.
 See ECF No. 30 at 2, Dkt. No. 1:21-cv 05837 (S.D.N.Y. Jan. 27, 2022).
 421 U.S. 837, 858 (1975).
 See id. ¶¶ 38-41.
 Id. ¶¶ 31-34.
 Id. ¶¶ 51-72.
 See Compl. Dkt. No. 1:22-cv-384 (S.D.N.Y. Jan. 14, 2022).
 Id. ¶¶ 53-54.
 See id.