By: Tanner Sandor
On Wednesday, February 22, 2023, a potentially major development occurred in the Decentralized Finance (“DeFi”) space. The U.S. District Court Judge for the Southern District of New York, the Honorable Victor Marrero, denied the defendant’s motion to dismiss the amended complaint in the case of Friel v. Dapper Labs, Inc. The case is a putative class action, brought against Dapper Labs by customers of Dapper Labs’ NFT project, NBA Top Shot, alleging that Dapper Labs failed to register as a securities exchange with the SEC. The denial of the motion is potentially important because the industry is currently awaiting the results of a reported SEC investigation into whether NFTs and cryptocurrency are securities, which will have important implications for registrations and disclosures that businesspeople in the industry will have to undertake.
NBA Top Shot is a joint venture between Dapper Labs, the National Basketball Association (“NBA”) and the NBA Players Association. Through NBA Top Shot, Dapper Labs sought to create, sell, and exchange NFTs known as “Moments,” which are digitized NBA game highlight video clips. In ruling on the motion, the Judge determined whether, when taken as true, the facts could lead a reasonable factfinder to find for the plaintiff on each element of the claim. Because the claims are for alleged violations of the Securities Act of 1933 (“Securities Act”), the Judge had to determine whether, on the facts alleged, the NFTs qualified as securities. Thus, the ruling on this motion will potentially have implications for how courts view NFT projects in the future.
The Securities Act contains an expansive definition of a security that includes “investment contracts,” under which NFTs might qualify. The Supreme Court created a tripartite test for defining an investment contract in SEC v. W.J. Howey Co. The Honorable Victor Marrero ruled that the plaintiffs in Dapper Labs, Inc. adequately plead facts that facially satisfy 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. The first prong was adequately plead because customers invested money by purchasing NFTs. The remaining prongs require further analysis as they each have one or several conditions.
To satisfy the second prong of the Howey Test there must be a common enterprise, a legal term of art. A financial instrument satisfies the common enterprise test if there is horizontal commonality, broad vertical commonality, or strict vertical commonality in the enterprise. . The Judge ruled that the pleading satisfied the second prong of the Howey Test on either horizontal or strict vertical commonality grounds because investors purchased NFTs from a single source that used those funds for business operations, and investors’ fortunes essentially depended on each other and Dapper Labs.
To satisfy the third prong of the Howey Test, the investors must invest with “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” The first consideration, under the third prong, is an objective test that determines whether a reasonable purchaser would expect profits based on the project promoters’ assertions. It is a case-by-case, totality of circumstances analysis, paying particular attention to the efforts of the promoter, and the structure of the NFT project in question. In this case, the privatization of the blockchain (including the reliance on Dapper Labs’ Flow token to facilitate transactions) and the control that Dapper Labs exerted over the trading of Moments NFTs (by restricting their trade to the NBA Top Shots exchange) were the dispositive factors. Thus, the Moments NFTs met both considerations of the Howey Test’s third prong because of the structure of the NBA Top Shots project.
The denial of the motion to dismiss sets up a case-by-case analysis for whether NFTs are securities. However, one can apply the logic of the Judge’s order to all NFTs that are listed on a private blockchain. Under the order’s logic: all NFT projects will satisfy the first prong of the Howey Test; nearly all private blockchain NFT projects, and some public blockchain projects will satisfy the second prong; any private blockchain project that the promotors advertise as profit-generating will satisfy the third prong. Because many NFT and other DeFi projects are being built on private blockchains that use their own tokens to validate transactions, and the promoters attract investors with the promise of profits, the logic of the order can be applied to many projects. We will have to wait to see how this ruling affects the SEC’s investigation, whether the plaintiffs meet their burden of proof, and whether other circuits find the ruling persuasive.
 See Friel v. Dapper Labs, Inc., 21-civ-5837 (S.D.N.Y. Feb. 22, 2023) (order denying the motion to dismiss the amended complaint) (BL).
 See id. at 1-2, 13-15.
 Gargi Chaudhury & James Masella, Are NFTs Securities? Analysis of the NBA Top Shot Litigation and Other NFT-Related Actions, JDSUPRA (Mar. 30, 2022), https://www.jdsupra.com/legalnews/are-nfts-securities-analysis-of-the-nba-2972108/.
 See Dapper Labs, Inc., 21-civ-5837 at 8-9.
 See id. at 8-13.
 See Ashcroft v. Iqbal, 556 U.S. 662, 678 (2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)); see also Twombly, 550 U.S. at 555 (stating that the facts alleged must “raise a right to relief above the speculative level. . .”).
 See Dapper Labs, Inc., 21-civ-5837 at 8-9; see also 15 U.S.C. §§ 77e, 77l.
 15 U.S.C. § 77b (a)(1).
 328 U.S. 293, 298-99 (1946).
 Dapper Labs, Inc., 21-civ-5837 at 18-20; See also 328 U.S. at 298-99.
 Dapper Labs, Inc., 21-civ-5837 at 23-24.
 See id. at 24; see also Chaudhury & Masella, supra note 3 (discussing SEC guidance on the application of the Howey Test).
 See id. at 24-25 (discussing the tests for a common enterprise accepted by the Second Circuit).
 Horizontal commonality “exists where there is (1) a sharing or pooling of the funds of investors and (2) “the fortunes of each investor in a pool of investors” are tied to one another and to the “success of the overall venture.”” Dapper Labs, Inc., 21-civ-5837 at 24 (citing Revak v. SEC Realty Corp., 18 F.3d 81, 87 (2d Cir. 1994) and In re J.P. Jeanneret Assocs., Inc., 769 F. Supp. 2d 340, 359 (S.D.N.Y. 2011)).
 Id. at 24-26. Broad vertical commonality is when investors’ fortunes are bound to the promotors’ efforts, while in strict vertical commonality investors’ fortunes are bound to the promotors’ fortunes. Id. at 25-26 (quoting Revak, 18 F.3d at 88).
 Id. at 24.
 United Hous. Found., Inc. v. Forman, 421 U.S. 837, 849 (1975) (noting that Second Circuit precedent dictates a non-literal interpretation of the word “solely” in the Howey opinion).
 See Dapper Labs, Inc., 21-civ-5837 at 43-44.
 See id. at 45-52.
 See id. at 52-62 (discussing the reasonable expectation of a profit derived from the efforts of Dapper Labs).
 See id. at 63 (“[I]t 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. . .”).
 Id. at 62.
 See id. at 62 (“The allegations that Dapper Labs created and maintains a private blockchain is fundamental to the Court’s conclusion.”).
 See Dapper Labs, Inc., 21-civ-5837 at 22, 47, 51 (noting that the primary investment purpose plausibly alleged would be sufficient to satisfy the third prong of the Howey test).
 See SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352, 367-68 (S.D.N.Y. 2020) (providing an example of a crypto project built on a private blockchain); see also SEC v. Kik Interactive, Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020) (providing another example of a crypto project built on a private blockchain).