Court Refuses to Dismiss Securities Class Action Claiming DraftKings NFTs Are “Securities” | Skadden, Arps, Slate, Meagher & Flom LLP

Securities litigation arising from the purchase or sale of digital products such as cryptocurrencies, non-fungible tokens (NFTs), and security tokens has proliferated in recent years. A sticking point 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 had adequately alleged that DraftKings’ NFT transactions were investment contracts and therefore “securities” under the U.S. Supreme Court’s seminal test set forth in Howey.

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

• A ““joint enterprise” through horizontal commonality because (i) DraftKings allegedly pooled assets by reinvesting revenue generated from the sale of the NFTs into its NFT business, and (ii) NFT purchasers 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 statements by DraftKings about the investment prospects presented by NFTs and because the value of NFTs allegedly depended on the success of DraftKings’ “marketplace.”

Dufoe marks only the second case in which a court has addressed whether sales of NFTs can constitute securities under the Howey rubric. In 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 National Basketball Association’s (NBA) sale of Top Shot Moments NFTs constituted investment contracts. The Friel court acknowledged that this conclusion was a “tough call.”

While Dufoe and Friel provide a framework for analyzing NFT transactions under Howey, neither decision predetermines an outcome in future cases — or even in cases before the courts based on a complete factual record.1 On the contrary, both courts made clear that their respective decisions were limited, fact-dependent, and motivated by specific allegations that could be challenged on summary judgment or at trial.

Bottom

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 so-called “gamified NFTs.” Owners of gamified NFTs could use their NFTs in “Reignmakers” contests to win cash prizes. DraftKings NFTs were minted, or created, on the Polygon blockchain that exists independently of DraftKings.

DraftKings NFT owners could resell their NFTs on the DraftKings Marketplace. Owners could also potentially sell their NFTs outside of the Marketplace. But to make a sale outside of the Marketplace, the owner must first transfer the NFT from the Marketplace to the owner’s personal digital wallet, and DraftKings reportedly retained the “exclusive right” to allow or prohibit such a transfer.

DraftKings allegedly promoted the NFTs, including through an online chat room and on social media.

Plaintiff, an alleged purchaser of DraftKings NFTs, asserted a putative class action lawsuit against DraftKings and several of its executives alleging that (i) DraftKings NFTs constituted unregistered securities and (ii) defendants operated an unregistered securities exchange. Plaintiff 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

Defendants moved to dismiss the complaint in its entirety on the grounds that the DraftKings NFTs are not “securities” subject to federal or Massachusetts securities laws. The court denied the motion, holding that plaintiff adequately alleged that the DraftKings NFTs were “securities” under Howey based on the facts alleged in the complaint, accepted as true for purposes of the motion.

The court applied the standard established in Howey more than 75 years ago to assess whether a transaction constitutes an investment contract and thus a “security” subject to federal securities laws and requirements. Under Howey, an investment contract exists when a person (i) “invests his money” (ii) “in a common enterprise” and (iii) “is led to expect profits solely from the efforts of the promoter or a third party.”

Defendants did not contest the first point—investment of money—at the pleading stage. The court found that plaintiff had adequately alleged facts to support the remaining two points:

Joint venture. A plaintiff may allege a common enterprise through “horizontal commonality,” 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 respect to NFTs—in contrast to other forms of digital goods—“it is less obvious that the risks and profits are shared among all investors because each NFT is defined as unique or nonfungible.” The court, however, found that plaintiff adequately alleged that all DraftKings NFT purchasers shared in the risks and profits of the “enterprise.” The court relied on allegations that DraftKings reinvested revenue generated from the sale of DraftKings NFTs into its business, including for purposes of promoting the DraftKings-controlled Marketplace on which the NFTs were traded. Furthermore, the value of the NFTs was allegedly dependent on the Marketplace. The court noted, “if DraftKings were to close the Marketplace or interest in the Marketplace evaporated, the value of the NFTs would plausibly fall to zero.”

Reasonable expectation of profits only from the efforts of others. To claim a reasonable expectation of profits solely from the efforts of others, a plaintiff must allege facts that support two independent requirements.

First, a plaintiff must allege a reasonable expectation of profits. 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 about the transaction histories of DraftKings NFTs, news reports about the “biggest rises and falls” within the Marketplace, and proclamations that buyers would “keep the open market profit of their cards.” The court also relied on allegations that the public viewed DraftKings NFTs as an investment, such as through chat room correspondence 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 is dependent on the efforts of others. The court accepted the plaintiff’s claims that the NFTs were dependent on the success of the Marketplace and therefore 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 arguably could not, withdraw their NFTs from DraftKings’ system and place them in their own wallets.” Furthermore, DraftKings allegedly undertook a substantial effort to promote the Marketplace and the NFTs.

Practical implications

Dufoe broadly traces Friel’s reasoning, but with a twist: In Friel, the defendant, Dapper Labs, was accused of controlling the “Flow Blockchain” on which NBA Top Shot Moments NFTs were traded. That claim was at the heart of the court’s determination that the plaintiff had adequately alleged horizontal commonality and a reasonable expectation of profits from the efforts of others.

In Dufoe, on the other hand, DraftKings’ NFTs were traded on the Polygon blockchain, which “exists independently of DraftKings” and is not controlled by DraftKings. The Dufoe court ruled that this was a distinction without a difference for purposes of Howey because the plaintiff plausibly claimed that all trading occurred 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 securities laws. Both are district court decisions that are subject to appeal. Moreover, the decisions are based on specific factual allegations in the case that can be rebutted on summary judgment or at trial.

Indeed, the court in Dufoe began its analysis by noting that it “need not decide whether each and every NFT transaction should be considered an investment contract.” Instead, the court “assesses[d] only whether Dufoe plausibly alleged that DraftKings’ NFTs in the Marketplace context are securities.” The court in Friel also tied its decision to the alleged facts and noted that each NFT project “must be evaluated on a case-by-case basis.”

Dufoe also catalogued factual disputes that he failed to resolve at the pleadings stage that could alter Howey’s analysis on a full factual record, such as defendants’ allegations that:

• DraftKings commingled NFT funds with its “vast collection of other revenue,” undermining the plaintiff’s claim that there was sufficient pooling of assets to establish horizontal pooling.
• The prices of DraftKings NFTs did not move in tandem and instead depended on other factors specific to a given NFT, refuting the plaintiff’s claim that all users shared the risks and profits of the venture sufficiently to establish horizontal commonality. The court noted that “[a]At a later stage of the litigation, DraftKings will have the opportunity to present evidence that investors “could realize profits or suffer losses independently of the fortunes of other purchasers” and thus negate horizontal commonality.
• Defendants did not, in fact, control the primary and secondary markets for their NFTs because users could trade outside of the Marketplace.
• Plaintiff’s expectations of profit were unreasonable or were motivated by consumer intent (e.g., participation in Reignmakers contests). The court acknowledged that DraftKings reduced the price of NFTs over time, contradicting an expectation of profit, and that the complaint alleged “at least a mixed motive of consumption and speculation on the part of NFT purchasers.” But the court concluded that “these issues are not suitable for resolution in a motion to dismiss, where all plausible inferences are drawn in favor of [the plaintiff].”

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1 The parties in Friel entered into a settlement agreement prior to the completion of discovery and summary judgment briefing. The settlement is subject to final approval by the court.

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