There have been several investment fads and mass enthusiasms this year that have been agitating the financial markets, but amidst the froth the fizziest speculative investments on the scene are non-fungible tokens (NFTs). This new asset class uses blockchain technology to track tokens that are attached to verify the authenticity of everything from artwork to sports highlights. The boosters of these assets have mined the enthusiasm for collectibles to drive sky-rocketing asset values for NFTs. With this new type of asset attracting so much attention and activity, it arguably should come as no surprise that the backers promoting NFTs have attracted litigation as well.
In a new lawsuit filed in New York state court against the promotors of NBA Top Shot Moments – basketball highlight videos to which NFTs are attached – alleging that the NFTs are unregistered securities that the defendants sold in violation of the federal securities laws As the author of a June 9, 2021 memo from the Frost Brown Todd law firm put it in the memo’s title, “We Knew It Was Coming: The First NFT Lawsuit is Here.”
As described in a March 2021 Wall Street Journal article detailing this latest speculative investment craze (here), NFTs are similar to cryptocurrencies, but with one essential difference: for most cryptocurrencies, one token is very much like another. In other words, the tokens are fungible. By contrast, NFTs are meant to be unique – that is, non-fungible. As the Journal put it, the tokens are meant to “act as virtual deeds, conveying ownership of a digital asset.” Each one is uploaded to a digital ledger conveying essential information such as the date it was created, when it was sold, for how much, and to whom. This information creates a unique identifier, which allows would-be buyers to ensure that an asset has not been tampered with.
The NFTs allow people to buy provably original versions of everything from digital art to pop albums. One NFT application is the NBA Top Shot Moment, which is a digital video basketball highlight to which an NFT has been attached. NBA Top Shot Moments were developed by a technology company called Dapper Labs, a Canadian-based company that has partnered with the NBA to develop and promote the assets. Dapper Labs also launched a digital platform called NBA Top Shot, where the Top Shot Moments can be sold, stored, and traded. NBA Top Shot Moments have been available to the public through the NBA Top Shot platform since October 1, 2020.
NBA Top Shot generates revenue from selling Moments, and also receives a 5% transaction fee on all transactions that occur on the secondary Marketplace. NBA Top Shot also takes a cash-out fee when users transfer the balance from their digital wallet account to their bank account.
According to the subsequently filed securities complaint, NBA Top Shot sells digital packs of Moments, with prices varying based on scarcity. There are three tiers of packs available: Common, consisting of nine common Moments, which have production of over 1,000 with no maximum; Rare, consisting of seven common Moments and one rare Moment, with a maximum production of 999; and Legendary, consisting of six common Moments, one rare moment, and one legendary moment, with a maximum production of 99.
The NBA Top Shot platform has proven to be extraordinarily successful. The securities lawsuit complaint quotes media sources as saying that NBA Top Shots had sold over $500 million worth of the NBA Top Shot Moments, and that the combined market capitalization of NBA Top Shot Moments had by February 2021 reached $1.9 billion, which, according to the complaint, is “greater than the median value of an NBA franchise.”
On May 13, 2021, an individual who had purchased NBA Top Shot Moments filed a securities class action lawsuit in the New York (New York County) Supreme Court against Dapper Labs and its founder and CEO, Roham Gharegozlou. A copy of the plaintiff’s complaint can be found here. The complaint purports to be filed on behalf of all persons who purchased or otherwise acquired NBA Top Shot Moments between June 15, 2020 and the present.
The gist of the plaintiff’s complaint is that the NBA Hot Shot Moments are securities under federal law, and, as such, the issuers are required to register the assets as securities with the U.S. Securities Exchange Commission. By selling these “unregistered securities” to investors, the defendants, the complaint alleges, “reaped hundreds of millions of dollars in profits.” The members of the class “many of whom lack the technical and financial sophistication necessary to have evaluated the risks associated with their investment” were “denied information that would have been contained in the materials required for registration of the Moments” and “have suffered significant damages.”
A significant portion of the complaint consists of a history of the development of cryptocurrencies and of blockchain technology. The largest part of the complaint is given over to the plaintiff’s contentions that under the standards of the so-called Howey test the NBA Hot Shot Moments are “investment contracts” and therefore would be considered a security and subject to the registration requirements of the Securities Act of 1933 and the disclosure requirements of the Securities Exchange Act of 1934.
For example, the complaints asserts, in order to show that the assets are securities under the Howey test, that investors purchase NBA Hot Shot Moments in the hope that their value will increase in the future as the project grows in popularity, based on the managerial efforts of the issuer of the asset and those working to develop the project.
The complaint alleges that the defendants violated Sections 5 and 12(a)(1) of the Securities Act of 1933 for their sale of unregistered securities. The complaint seeks to recover damages on behalf the class.
As recent years have shown, technological changes and the evolution of the financial marketplace have produced a host of novel legal questions, especially as laws developed at an earlier time are tested against unanticipated new circumstances. Digital assets generally have raised a host of questions about the potential applicability of the federal securities laws to the assets.
With respect to NFTs in particular, an interesting June 3, 2021 memo from the BakerHostetler law firm (here) analyzes the question of whether NFTs can be considered securities subject to the ’33 Act’s registration requirements. The memo concludes by saying that “ultimately, the conclusion of whether a digital asset is a security depends on the economic reality of the transaction and the manner in which the digital asset is offered and sold, including marketing efforts.”
While the plaintiff in this case differentiates NFTs from cryptocurrencies on a number of levels, the legal violations alleged in this complaint are quite similar to the violations alleged in the various securities class action lawsuits that have been filed against promoters of cryptocurrencies and other digital assets. In this case and as in those other cases, the plaintiffs allege that the defendants violated Sections 5 and 12(a)(a) of the Securities Act of 1933. In both this case and in those other cases, the plaintiffs allege that the digital assets at issue represent securities within the meaning of the federal securities laws, and that the defendants violated the securities laws by failing to register the assets as securities with the U.S. Securities Exchange Commission.
It is interesting that the plaintiff, represented by one of the more active plaintiffs’ securities law firms, chose to file his complaint in New York state court, rather than in federal court. He has the right to do so, of course, in light of the U.S. Supreme Court’s March 2018 decision in the Cyan case, which confirmed that state courts retain concurrent jurisdiction with federal courts over cases alleging violations of the ’33 Act. Indeed, the plaintiff’s complaint, in its statement of the court’s jurisdiction, specifically references the Cyan decision. But even if there is no question whether the plaintiff is in fact able to file his complaint in state court, there is still the question of why the plaintiff has chosen to file in state rather than federal court. Some day I would like to understand the thinking behind this particular choice of forum, in this and in other cases where plaintiffs’ counsel has chosen a state court venue.
One final note. While it may or may not be true, as has been asserted, that “everything everywhere is securities fraud,” it does seem that every twist and turn in the ever-changing investment arena eventually finds its way into a securities lawsuit. That is what I meant at the outset when I said that it hardly comes as a surprise that the NFT craze has led to an NFT-related lawsuit.
Plaintiffs’ lawyers are nothing if not opportunistic, and in the current securities class action litigation arena, plaintiffs’ lawyers inevitably will seek to transform the flavor-of-the-day into a securities suit. While others may have varying opinions about this phenomenon, I have to say as a blogger that I think it is just great, as the continuing supply of new developments generates endless blog fodder, for which I am grateful.
SEC Files COVID-19-Related Enforcement Action: In other news, and with respect to another securities litigation trend, the SEC on Friday filed its latest COVID-19-related securities enforcement action. On June “11, 2021, the SEC filed an enforcement action complaint in the Central District of California against Wellness Matrix Group, Inc. and George Todt. A copy of the complaint can be found here. Todt allegedly is a business consultant whom the complaint alleges controlled Wellness Matrix’s day-to-day activities.
The complaint alleges that in February and March 2020 the defendants made misleading statements regarding COVID-19 at-home test kits and disinfectants. Specifically, the complaint alleged that Wellness Matrix and Todt marketed the test kits and disinfectants to consumer on Wellness Matrix’s website. Wellness Matrix and Todt also made materially false statements to the effect that the products were approved by the FDA and the EPA. Wellness Matrix did not have the products to deliver to consumers and the products were neither approved by or registered with the FDA and the EPA. The complaint alleges that the defendants’ statements violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. The complaint seeks a permanent injunction and civil penalties against Wellness Matrix and Todt, and an officer bar and conduct bar against Todt.
By my count, the new Wellness Matrix action is the eighth COVID-19 related enforcement action filed by the SEC. The interesting thing about the action is that it is being filed now, more than a year after the events described in the complaint. The fact that this action is only coming in now suggests that there could be yet other COVID-19 related actions to come.