Friel v. Dapper Labs, Inc.

657 F.Supp.3d 422

Jeeun FRIEL, Individually and on behalf of all others similarly situated, Plaintiff, v. DAPPER LABS, INC. and Roham Gharegozlou, Defendants.

21 Civ. 5837 (VM)

United States District Court, S.D. New York

Signed February 22, 2023

Phillip C. Kim, The Rosen Law Firm, New York, NY, for Plaintiff.

Abigail Wald, Kenneth Patrick Herzinger, Sean D. Unger, Erin Zatlin, Paul Hastings LLP, San Francisco, CA, Zachary Zwillinger, Paul Hastings LLP, New York, NY, for Defendant Dapper Labs, Inc.

DECISION AND ORDER

VICTOR MARRERO, United States District Judge.

Lead Plaintiff Gary Leuis ("Leuis") and named plaintiff John Austin ("Austin"), individually and on behalf of all others similarly situated (together, "Plaintiffs") bring this action against Dapper Labs, Inc. ("Dapper Labs") and its Chief Executive Officer, Roham Gharegozlou ("Gharegozlou") (together, "Defendants"), alleging that Dapper Labs violated the securities laws by offering for sale to the public certain non-fungible tokens ("NFTs") known as NBA Top Shot Moments ("Moments") without filing a registration statement with the Securities and Exchange Commission (the "SEC"). Plaintiffs assert two causes of action: (1) violations by Dapper Labs of Sections 5 (15 U.S.C. § 77e) and 12(a)(1) (15 U.S.C. § 77l) of the Securities Act of 1933 ("Securities Act") for the unregistered offer and sale of a security, to wit, Moments ("Moments"), sold on its NBA Top Shot application; and (2) violation of Securities Act Section 15 (15 U.S.C. § 77o) against Gharegozlou as control person liability for the primary violations alleged in the first cause of action.

Now before the Court is Defendants' motion to dismiss the Amended Complaint ("AC") in its entirety and with prejudice pursuant to Federal Rule of Civil Procedure 12(b)(6) ("Rule 12(b)(6)"). (See "Motion," Dkt. No. 37.) For the reasons stated below, Defendants' motion is DENIED.

I. BACKGROUND

A. FACTUAL BACKGROUND¹

Dapper Labs, founded by Gharegozlou, is a Vancouver, Canada-based corporation that develops blockchain technologies. In simplest terms, a "blockchain" is a decentralized digital ledger used to record and validate transactions. As discussed in more detail below, after a previous foray into developing blockchain-based assets on other blockchains, Dapper Labs created its own, the Flow Blockchain. Dapper Labs developed the Flow Blockchain as part of a larger so-called Flow Network, which would host applications that run atop and whose transactions are validated on the Flow Blockchain.

1. Blockchain Technology²

To better grasp Dapper Labs's business-model, understanding the technical operation of a blockchain is necessary. As already mentioned, a "blockchain" is a decentralized digital ledger.³ Blockchains may be either public, like that underlying perhaps its most famous use-case, Bitcoin, or private, like Dapper Labs's Flow Blockchain.⁴ While generally associated with the transfer of digital currencies (often called cryptocurrencies, or crypto for short), blockchains can be used not only to store information about the transfer of the currency but can also be applied to record ownership of a wide variety of more traditional assets, like stocks and bonds.

Unlike traditional ledgers, which are managed and validated by a centralized authority, blockchains are distributed and decentralized. This structure offers greater transparency as to ownership by being based on consensus as to the accuracy of the transactions consummated on the network. To reach consensus, embedded in each blockchain platform is a software protocol, or consensus mechanism, which provides governance standards over how information is added to the blockchain. Blockchain-based transactions are considered more secure and trustworthy than ledgers controlled by centralized authorities, like a bank, because adding, changing, or removing information from the blockchain is made purposefully difficult, making it harder to falsify a transaction or hack into the ledger itself.⁵

Unlike a bank that exercises complete control over validating any transaction on its ledgers, transactions on decentralized blockchains must be validated by the network of users. To encourage validation of the transactions on a blockchain, validators (called "miners") are provided incentives often in the form of cryptocurrency or cryptographic tokens, which may have additional functionality. Blockchain transactions are validated by miners through either "Proof of Work" or "Proof of Stake" methods.

For example, Bitcoin operates a "Proof of Work" blockchain. To generate a new "hash" (or ledger entry) for a block of transactions on the Bitcoin blockchain, miners engage in a mathematical (i.e., cryptographic) guessing game requiring their computers to, through brute-force computing, guess the answer to an algorithm.⁶ The miner who wins the guessing game broadcasts the new hash to the network and, once confirmed by other miners, is rewarded with Bitcoin for their efforts. In the case of other "Proof of Work" blockchains, the miner would be awarded with a token or asset associated with that blockchain, such as Ether, a crypto asset associated with the Ethereum blockchain. "Proof of Work" protocols consume large amounts of energy and computational resources.

"Proof of Stake" protocols require much less energy, making them desirable for private blockchains looking to scale quickly. "Proof of Stake" requires miners to "stake" or lock up tokens or assets that they already own. Much like a lottery system, miners with more tokens and a longer period validating transactions on the network are selected by an algorithm to validate new transactions. Once new transactions are validated, the miner earns additional tokens as a reward.

2. CryptoKitties

Moments was not Dapper Labs's first foray into blockchain technology and crypto assets. In November 2017, Dapper Labs released CryptoKitties, which was built on the Ethereum blockchain, a public blockchain using a "Proof of Work" protocol. CryptoKitties used Ethereum's "smart contract functionality . . . to allow users to breed and collect digital cats with a variety of characteristics." (AC ¶ 28.) CryptoKitties were a hit. So much so that the volume of activity, combined with Ethereum's burdensome "Proof of Work" validation, overwhelmed Ethereum's network, causing a slowdown of all transactions on the network. (See AC ¶ 29.)

3. The Flow Blockchain

Following the launch of CryptoKitties, Gharegozlou stated in an interview with USA Today that Dapper Labs had started to work on a "scaling solution" for the business. (AC ¶ 31.) Dapper Labs announced that solution in September 2019 -- the development of its own private blockchain, Flow. The Flow Blockchain uses "Proof of Stake" validation to allow the business to scale more efficiently. Dapper Labs also created a token, FLOW, which miners would be able to stake to validate transactions.⁷ Because FLOW tokens were used to validate transactions on the Flow Blockchain, FLOW are also "required for . . . all the applications on top of [the Flow Blockchain] to function." (AC ¶ 37.) Dapper Labs's website explained that FLOW tokens could be used as "[p]ayment for computation and validation services," as a "[m]edium of exchange," as a "[d]eposit for data storage," as "[c]ollateral for secondary tokens," and for "[p]articipation in governance." (AC ¶ 38.)

Dapper Labs created 1.25 billion FLOW tokens in September 2020 and distributed them to institutional investors and the public between September 2020 and October 2020. Dapper Labs also set aside several million FLOW tokens for "ecosystem development" to compensate its developers and for other purposes, as well as reserving 250 million tokens for itself. Dapper Labs raised around $18 million from the sale of FLOW tokens. However, none of the nearly 13,000 investors who purchased FLOW were from the United States, and FLOW tokens are not a registered security with the SEC. Yet, by July 2021, FLOW tokens were internationally listed on several of the major cryptocurrency exchanges. Dapper Labs stated that "as more value is created on top of the Flow [B]lockchain, more demand is generated for FLOW token." (Id.)

4. NBA Top Shot and Moments

Dapper Labs first announced its blockchain application, NBA Top Shot, in July 2019 as a joint venture between itself, the National Basketball Association ("NBA"), and the NBA Players Association ("NBAPA"). NBA Top Shot is a platform or application, owned and operated by Dapper Labs and built on top of the Flow Blockchain. The purpose of the NBA Top Shot application is primarily to provide a platform to sell "Moments," the alleged security at issue in this action.

Moments are NFTs. And NFTs are digital assets whose authenticity and ownership can be recorded on a blockchain. In this case, Moments are a digital video clip of highlights from NBA games, such as a spectacular dunk or game-winning shot. Dapper Labs creates (or, in crypto parlance, "mints") a game highlight into an NFT in collaboration with the NBA and NBAPA, who, together with Dapper Labs, control which highlights become Moments. The minting process prints the NFT with a unique identifier or serial number. So, while Dapper Labs may mint 1,000 copies of a certain basketball highlight into a Moment, only one of each serial number exists, making each Moment unique.

The first "Moments" were made available to a "select list of individuals" as part of a "closed beta" which took place on June 15, 2020. (AC ¶ 52.) On October 1, 2020, Dapper Labs launched an "open beta" for the NBA Top Shot application, for the first time allowing the public to create an NBA Top Shot account, log-in, and purchase Moments. NBA Top Shot users have been able to purchase Moments ever since.

Ownership of a Moment is limited to only the NFT itself. When a person purchases a Moment, the owner does not acquire any rights to the basketball highlight depicted by the NFT or the underlying artwork or other intellectual...