Court refuses to dismiss class action lawsuit alleging DraftKings NFTs are ‘securities’ | Skadden, Arps, Slate, Meagher & Flom LLP

Securities litigation involving the purchase or sale of digital products such as cryptocurrencies, non-fungible tokens (NFTs), and security tokens has proliferated in recent years. A key question in these cases is whether the digital product purchased is a “security” subject to federal or state securities laws.

On July 2, 2024, Judge Denise Casper of the U.S. District Court for the District of Massachusetts ruled in Dufoe v. DraftKings, Inc. that the plaintiff has sufficiently demonstrated that transactions in DraftKings NFTs are investment contracts and thus “securities” within the meaning of the fundamental test of the US Supreme Court, which in Howey.

The district court based this decision on allegations, accepted as true in the complaint, that DraftKings’ NFT sales reflected:

• “joint venture” through horizontal commonality because (i) DraftKings allegedly pooled assets by reinvesting the proceeds generated from the sale of the NFTs into its NFT business, and (ii) the NFT buyers allegedly shared profits and risks because DraftKings controlled the online “marketplace” through which the NFTs were traded.
• A “reasonable expectation of profits solely from the efforts of others” based on alleged promotional claims by DraftKings about the investment prospects offered by the NFTs and because the value of the NFTs allegedly depended on the success of DraftKings’ “marketplace.”

Dufoe is only the second case in which a court has dealt with the question of whether the sale of NFTs constitutes securities within the meaning of HoweyIn 2023, Judge Victor Marrero of the U.S. District Court for the Southern District of New York ruled in Friel v. Dapper Labs, Inc. that a complaint adequately alleged that the sale of National Basketball Association (NBA) Top Shot Moments NFTs constituted investment contracts. Friel The court acknowledged that this conclusion was “narrow”.

Although Dufoe And Friel provide a framework for analyzing NFT transactions under Howeyneither decision determines the outcome for future cases – or even for those cases that will be tried on all the facts.¹ On the contrary, both courts made clear that their respective rulings were narrowly drafted and factually based, and supported by specific allegations that could be challenged in summary proceedings or in court.

background

DraftKings is a digital sports entertainment and gaming company. In August 2021, DraftKings began selling NFTs through the DraftKings Marketplace (the Marketplace), an online platform owned and operated by DraftKings. In February 2022, DraftKings launched what it called “gamified NFTs.” Owners of gamified NFTs could stake their NFTs in “Reignmakers” contests to win cash prizes. The DraftKings NFTs were minted, or created, on the Polygon blockchain, which exists independently of DraftKings.

Owners of DraftKings NFTs could resell their NFTs on the DraftKings Marketplace. Owners could potentially sell their NFTs outside of the Marketplace as well. However, to make a sale outside of the Marketplace, the owner must first transfer the NFT from the Marketplace to their personal digital wallet, and DraftKings reportedly reserved the “sole discretion” to allow or prohibit such a transfer.

DraftKings is said to have promoted the NFTs via an online chat room and on social media, among other things.

The plaintiff, a purported purchaser of DraftKings NFTs, brought a putative class action lawsuit against DraftKings and several of its officers, alleging that (i) the DraftKings NFTs constituted unregistered securities and (ii) the defendants operated an unregistered securities exchange. The plaintiff asserted claims for alleged violations of Sections 5, 12(a)(1), and 15 of the Securities Act of 1933; Sections 5, 15(a)(1), 20, and 29(b) of the Securities Exchange Act of 1934; and Chapter 110A, Sections 201(a), and 301 of the Massachusetts General Laws.

The court’s decision

The defendants moved to dismiss the lawsuit in its entirety on the grounds that the DraftKings NFTs were not “securities” subject to the federal or Massachusetts securities laws. The court denied the motion, finding that the plaintiff had sufficiently argued that the DraftKings NFTs were “securities.” Howey based on the facts alleged in the complaint, which are accepted as true for the purposes of the application.

The court applied the Howey more than 75 years ago to determine whether a transaction constitutes an investment contract and thus a “security” subject to federal securities laws and requirements. HoweyAn investment contract exists when a person (i) ‘invests his money’ (ii) ‘in a joint venture’ and (iii) ‘can expect to receive profits solely as a result of the efforts of the organiser or a third party’.

The defendants did not dispute the first point – investment – in the complaint. The court ruled that the plaintiff had presented sufficient facts to support the other two points:

Joint venture. A plaintiff can assert a joint enterprise through “horizontal jointness,” or a pooling of assets from multiple investors in such a way that all share in the profits and risks of the enterprise. The court acknowledged that with NFTs—unlike other forms of digital products—it is “less obvious that risks and profits are distributed among all investors because each NFT is by definition unique or non-fungible.” The court nonetheless ruled that the plaintiff sufficiently asserted that all purchasers of DraftKings NFTs shared in the risks and profits of the “enterprise.” The court relied on claims that DraftKings reinvested the proceeds generated from the sale of DraftKings NFTs in its business, including to promote the DraftKings-controlled marketplace on which the NFTs were traded. In addition, the value of the NFTs was allegedly dependent on the marketplace. The court found: “If DraftKings were to close the marketplace or interest in the marketplace were to dwindle, the value of the NFTs would plausibly drop to zero.”

Reasonable expectation of profits solely from the efforts of others. To establish a legitimate expectation of profits based solely on the efforts of others, a plaintiff must allege facts supporting two independent premises.

First, a plaintiff must assert a reasonable expectation of profit. The court found that the plaintiff met this standard based on statements made by DraftKings and the individual defendants about the NFTs. These statements included, for example, details of transaction histories for DraftKings NFTs, news about the “biggest movers and losers” within the marketplace, and statements that buyers would “keep the profit from the open market of your cards.” The court also relied on claims that the public viewed DraftKings NFTs as an investment, such as through correspondence in chat rooms comparing the marketplace to the stock market and discussing ways to make money trading DraftKings NFTs.

Second, a plaintiff must allege that a buyer’s expectation of profit depends on the efforts of others. The court accepted the plaintiff’s claims that the NFTs were dependent on the success of the marketplace and thus DraftKings, even though the NFTs were not minted on a proprietary DraftKings blockchain. The court reasoned that “it is plausible that users did not, and may not have been able to, withdraw their NFTs from DraftKings’ system and place them in their own wallets.” In addition, DraftKings allegedly made significant efforts to promote the marketplace and the NFTs.

Practical implications

Dufoe largely follows the argument of Friel but with a twist: In Frielthe defendant, Dapper Labs, was accused of controlling the “Flow Blockchain” on which the NBA Top Shot Moments NFTs were traded. This allegation was central to the court’s finding that the plaintiff had asserted sufficient horizontal commonality and a reasonable expectation of profits from the efforts of others.

In DufoeIn contrast, DraftKings NFTs are traded on the Polygon blockchain, which “exists independently of DraftKings” and is not controlled by DraftKings. Dufoe The court ruled that this was a distinction without difference within the meaning of Howey because the plaintiff plausibly alleged that all trading took place through the marketplace and that DraftKings could prohibit transactions outside the marketplace at its sole discretion.

Dufoe And Friel are not the final word on whether NFT sales constitute securities subject to the securities laws. Both are appealable district court decisions. Moreover, the decisions are based on case-specific factual allegations that could be rebutted on summary judgment or in court.

In fact, the court in Dufoe began its analysis by noting that it “does not have to decide whether all NFT transactions should be considered an investment contract.” Rather, “the court only assessed whether Dufoe plausibly alleged that DraftKings NFTs are securities in the context of the marketplace.” The court in Friel also based its decision on the alleged facts, noting that each NFT project “must be assessed on a case-by-case basis.”

Dufoe In addition, actual disputes were listed that could not be resolved within the scope of the complaint and that Howey Analysis based on all the facts, such as the defendants’ allegations that:

• DraftKings commingled NFT funds with its “vast trove of other revenues,” thereby refuting the plaintiff’s claim that there was sufficient pooling of assets to create horizontal commonality.
• The prices of DraftKings’ NFTs did not move in lockstep but depended on other factors specific to a particular NFT. This undermines the plaintiff’s claim that all users shared the company’s risks and rewards sufficiently to create horizontal commonality. The court noted that “DraftKings will have the opportunity at a later stage of litigation to present evidence that investors ‘could earn profits or suffer losses regardless of the wealth of other purchasers,’ thereby negating horizontal commonality.”
• In fact, the defendants did not control the primary and secondary markets for their NFTs, as users could also trade outside of the marketplace.
• The plaintiff’s profit expectations were unreasonable or they were motivated by the intention to consume (e.g.The court acknowledged that DraftKings had lowered the price of NFTs over time, contrary to an expectation of profit, and that the lawsuit alleged “at least a mixed consumption and speculation motive on the part of NFT buyers.” However, the court concluded that “these issues are not appropriate for deciding a motion to dismiss in which all plausible inferences are drawn in favor of (the plaintiff).”

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1 The parties in Friel A settlement agreement was reached before the conclusion of the evidence and the summary of the judgment. The settlement is subject to final court approval.

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