The Breakdown - Class-Action Lawsuit Accusing Digital Basketball Cards of Being Securities Allowed to Proceed

Episode Date: February 25, 2023

On today’s episode, NLW covers the ruling of a federal judge in New York allowing a class-action lawsuit to proceed against Dapper Labs for allegedly offering unregistered securities. He also covers a new slate of charges against Sam Bankman-Fried, disgraced founder of FTX.    “The Breakdown” is written, produced and narrated by Nathaniel Whittemore aka NLW, with editing by Michele Musso and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsor today is “Foothill Blvd” by Sam Barsh. Image credit: Westend61/Getty Images, modified by CoinDesk.  Join the discussion at discord.gg/VrKRrfKCz8. Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Join the discussion: https://discord.gg/VrKRrfKCz8   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDest. What's going on, guys? It is Friday, February 24th, and today we are talking about whether NFTs or securities, about SBF getting more charges. It is a Friday extravaganza, and I am excited to have you here. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a view or if you want to dive deeper into the conversation, come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pot.

All right, friends, happy Friday. Today we are catching up with some interesting legal developments to close out our week here. We're going to start with Dapper Labs. And for those unfamiliar, Dapper were the creators of CryptoKitties and then later NBA Topshot. In many ways, NBA Topshot was the first mainstream breakout of the NFT bowl market that brought a huge number of new people into the space around 2020, 2021. Well, recently, Dapper has been facing a class action lawsuit, which is predicated on the idea that top shots are unregistered securities.

Now, it's important to note here that this is a group of plaintiffs making this argument, not the SEC. Now, because of this, Dapper lawyers have tried to get the case thrown out on the basis of top shots clearly and obviously not being securities. On Wednesday, a number of headlines were shared on Twitter that were somewhere between intentionally and unintentionally, misleading, and which were, in either case, clickbaity and not exactly accurate. Those headlines all read some version of judge declares NBA top shots to be a security,

but that wasn't exactly true. What actually happened was that the judge hearing the case in the Southern District of New York dismissed Dapper's application to dismiss the case. That judge found that there are reasonable arguments that the NFTs in this specific case could satisfy the Howie Test. The Howey Test is, of course, the legal threshold for whether an answer. asset can be deemed an investment contract, with the implication that securities laws apply to it. The legal argument in this case is a little more in-depth than simply the idea that Dapper's

digital basketball cards are securities. The judge accepted the plaintiff's arguments that the underlying protocol's tokens create value across the NFT ecosystem. Quote, plaintiffs have alleged that, without flow tokens, no transactions on the flow blockchain can be validated. Indeed, the proof-of-stake mechanism employed by the flow blockchain requires flow to power it and incentivize miners to validate transactions. In that respect, Flows utility creates value for moments through the network's consensus as to ownership and the price of each transaction. Now, I'm not trying to get into the details here only to point out that this is a specific decision about the specifics of this case, and it involves

a company that has their own blockchain and that is working with their own blockchain, and so that should color the extent to which we think there are other precedents here that might be more concerning. Still, lawyers for Dapper Labs reiterated there rather clearly argument. They said basketball cards are not securities, Pokemon cards are not securities, baseball cards are not securities, common sense says so, the law says so, and courts say so. However, this judge said it's not that clear. Particularly, the judge noted that unlike cardboard collectibles, the value of Dapper's digital trading cards, hinges on Dapper's continuous operation of the flow blockchain, and the existence of a secondary market operated by the company.

The allegations that Dapper Labs created and maintains a private blockchain is fundamental to the court's conclusion. By privatizing the blockchain on which the moment's value depends and restricting the trade of moments to only the flow blockchain, purchasers must rely on Dapper Labs' expertise in managerial efforts, as well as its continued success in existence. The judge also noted that Dapper's marketing materials implied the expectation of profit, which is something we'll come back to in just a minute. The judge also highlighted that his interpretation was very narrow and does not imply that all NFTs are securities. Quote, it 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 and thus a security under Howie. In some, plaintiffs adequately alleged that Dapper Labs' offer of the NFT moments was an offer of an investment contract and therefore a security, required to be registered with the SEC. Still, the really important thing here and the thing that was lost in the initial discussion was that this was simply a hearing about whether the case would be thrown out without a hearing. Essentially, the judge was only asked to decide whether the argument raised by the plaintiffs was plausible. not whether it was correct. So when the judge was talking about that private blockchain and what it meant,

he wasn't saying that ultimately he agreed with the plaintiffs that that meant that Topshots were a security, but only that it was a plausible argument. The case will now go ahead and arguments will be formally heard on whether or not Topshots was offering a security. Dapper Labs tweeted, Today's order, which the court has described as a close call, only denied our motion to dismiss the complaint at the case's pleading stage. The judge did not conclude that the plaintiffs were right, and it's not a final ruling

on the case's merits. Courts have repeatedly held that consumer goods, including art and collectibles like basketball cards, are not securities under federal law. We're confident this same claim holds true for moments and other collectibles, digital or otherwise. As we argued to the court, moments are simply modernized trading cards, not financial instruments. Unlike securities, moments are unique in nature, non-fundable, and don't contain rights to any underlying financial asset. We look forward to vigorously defending our position in court as the case continues. While Twitter was initially flooded with the incorrect headlines, it didn't take long for a more thoughtful set to do some correcting. Jake Chervinsky writes, the judge didn't decide anything.

He allowed the case to proceed past a motion to dismiss because the securities claims were at least plausible, an extremely low bar and not a final ruling at all. Do I really have to say basketball cards are not securities? Now, Evan Cohen, a founder at Invest with Vincent, responded and said, frankly, the private blockchain argument is interesting, and I look forward to the actual hearing. To which Jake again responded, this dispute aside, it would be absurd if, all valuable digital assets stored on centralized databases were securities. This would turn every major video game developer, every event ticketing platform, travel

rewards program, etc., into a public reporting company regulated by the SEC. James Murphy at Meta Lawman also discussed whether it had relevance to another big securities-related trial in Ripple versus the SEC. He writes, A federal judge in New York has ruled that a complaint plausibly alleges that Dapper Labs' initial sale of NBA Topshot NFTs qualifies as a security under the Howie Test. I don't believe this ruling should impact the analysis in the Ripple case, and here's why. The Topshot decision does not address secondary market sales of the Topshot NFTs. And the judge emphasized in his opinion that the underlying facts matter because, quote,

not all NFTs offered or sold by any company will constitute a security. The judge cited the fact that Topshots trade on a private blockchain run by the issuer as a key factor in his ruling. XRP trades on a public blockchain. For this reason, the Topshot opinion could be considered net positive for Ripple, not a legal opinion, just a tweet. Now, obviously, this is still not great for Dapper as they have to go have this fight now. And in fact, the block obtained an email sent to investors on Wednesday and informed them of a further 20% reduction in head count at Dapper Labs, which follows layoffs amounting to 22% of their staff last November.

Lastly, one part of the ruling that should give social media professionals pause, the federal court judge alleged that emojis like the rocket ship emoji, the upchart emoji, and the bag of money emoji, objectively mean a financial return on investment. and so have legal consequences. Join CoinDesk's Consensus 20203, the most important conversation in crypto and Web3, happening April 26th through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders,

founders, entrepreneurs, and more. Use code Breakdown to get 15% off your past. Visit consensus.coindex.com or check the link in the show notes. Speaking of legal consequences, let's do an update on SPF. An updated indictment against Sam Bankman-Fried was unsealed on Thursday, adding four additional fraud and campaign finance charges to his criminal case, which is currently scheduled to go to trial in October. The document also adds significant additional background material on what went on at FDX. Adding to the existing fraud charges, the DOJ alleges that Sam, quote,

falsely represented to a financial institution that the account would be used for trading and market making. The indictment claims that Sam opened a company with the deliberately misleading name of North Dimension, with the aim of telling a false story to an unnamed bank that had previously been reluctant to service FTCS companies. Still, the bulk of the additions relate to campaign finance violations. The indictment claims that Sam, quote, agreed to and did make corporate contributions to candidates and committees in the Southern District of New York that were reported in the name of another person. In fleshing out the details of the charge, the DOJ claims that Sam wanted to give at least one million to a pro-LGB political action committee, but that he could not

find anyone, quote, trusted at FTX who was by or gay, to make the contribution. One unnamed executive matching the description of Nishad Singh, the former head of engineering, was allegedly urged to make the donation, while another executive did so for Republican causes which were kept, quote-unquote, dark. In July, Singh gave $1.1 million to the LGBTQ victory fund, Federal Pact, according to records from the Federal Election Commission, by far the largest donation received by the committee. The indictment claims that a political consultant working for FTX told the unnamed executive, quote, in general, you being the center-left face of our spending will mean giving you a lot of woke shit for transactional purposes.

End quote. Before the midterms, quote, an internal Alameda spreadsheet noted over 100 million in political contributions, even though Federal Election Commission records reflect no political contributions by Alameda for the 2022 midterm elections to candidates or PACs. The indictment states that, quote, Bankman Freed's use of straw donors allowed him to evade contribution limits on individual donations to candidates to whom he had already donated. More fun times as we get more of the story of this as more people turn on Sam.

Speaking of SBF and by way of following up on our discussion of Custodia Bank, and their denied Federal Reserve application a couple of days ago. On Wednesday, Caitlin Long tweeted 136 federally insured banks that had, quote, ongoing or planned crypto asset related activities, and yet the White House and Fed denies and then disparages custodia bank for daring to ask the Fed for permission to do the same. She then writes, this is getting even more interesting. This is in the FDIC's new Inspector General report. 11 FTIC insured banks, quote, may have had involvement in alleged wire transfer fraud involving FTC.

So to give a little context on what Caitlin was discussing, the latest report from the Office of the Inspector General on the challenges facing the Federal Deposit Insurance Corporation or FDIC had some interesting wrinkles regarding the banking regulators' interaction with the crypto industry. As Caitlin pointed out, the report states that 136 federally insured banks had been identified as having ongoing or planned crypto asset-related activities. Statements from FDIC acting chairman Martin Groomberg in October had suggested that number was around 80. And all of this seems to indicate that the interest in starting to deal with crypto is really strong within the traditional banking industry and far beyond those who have just taken the

plunge. The report highlighted issues with banks that had dealt with FTX, saying, quote, the recent bankruptcy of crypto asset exchange FTCX revealed that 11 banks were doing business with FTCS and may have had involvement in alleged wire transfer fraud, which includes Moonstone Bank where an FTC's affiliated company invested $11.5 million, doubling the bank's asset size of $5.7 million. The report also detailed the Silvergate bank run, claiming that dealing with the crypto industry, quote, presented risks for the FDIC in supervising banks and resolving failed institutions. The report's recommendations for the FDIC were to ensure that banks under its supervision, quote, regularly assess the fluctuations in crypto asset values used as collateral.

Further, the FDIC should maintain expertise in digital assets in order to manage bank resolutions for failed institutions. Now, rounding out with one more enforcement action, the New York Attorney General has sued crypto exchange CoinX, alleging that it is an unregistered securities broker and commodity broker dealer under state law. The Hong Kong-based exchange did not register with the SEC, the CFTC, were state regulators before offering crypto services in New York. The lawsuit claimed that assorted tokens offered by the exchange qualified as securities

and or commodities under state law citing New York's Martin Act. The lawsuit said, quote, the tokens each fall within the Martin Act's definition of commodities, which includes any foreign currency or any other good article or material. CoinX is engaged in the business of selling and offering to sell commodities through accounts, agreements or contracts to account in New York, primarily for investment purposes. Now, the Martin Act is typically viewed as legislation directed at financial fraud, rather than unregistered dealings.

with the lawsuit being particularly concerned with representations made by Coinex about being a crypto exchange despite lacking registration. In a statement, New York Attorney General Latisha James said, quote, our laws are designed to protect New Yorkers, and when companies ignore them, they put residents, investors, and businesses at risk. The days of crypto companies like Coinex acting like the rules do not apply to them are over. The Attorney General's office claimed that CoinX had failed to comply with the previous subpoena, and the lawsuit is asking CoinX to block New York customers, cease doing business in New York, and provide payment of restitution, disgorgement of profits, and legal fees. I don't know, this one is a little weird to me.

It seemed like the Attorney General's office created a Kinex account with a New York-based computer and internet address, and alleged it was able to trade on the platform. But ultimately, this isn't a U.S. exchange, and so I think maybe the lesson is just that U.S. regulators don't care about where your exchange is based, but only whether their constituents are able to actually trade on it. I think overall, the big takeaway is that this is one more example of the onslaught of enforcement actions happening right now. I don't think this one has anyone particularly concerned. It's just more a part of this larger trend. And speaking of this larger trend, there are still so many things to get into. We got more bank regulator warnings or

clarifications. We got another follow-up on custodia from the Federal Reserve and much, much more. But alas, that will have to wait for the weekly recap tomorrow. For now, I want to say thanks again for listening to the show. I appreciate it. And until tomorrow, be safe and take care of each other. Peace.