The company’s legal woes bode poorly for NFT marketplaces.
On July 30, sports betting platform DraftKings announced that it was shutting down its NFT Marketplace as well as “Reignmakers,” its first NFT-based fantasy football game, due to “recent legal developments.” Though the company didn't specify which legal developments led to this decision, on July 2, a judge denied DraftKings' motion to dismiss a class action lawsuit alleging that DraftKings’ NFTs were actually unregistered securities.
In March 2023, after losing more than $14,000 on DraftKings NFTs, Justin Dufoe sued DraftKings for violating federal securities laws, claiming that DraftKings was issuing unregistered securities and operating an unregistered securities exchange. To quote the court filing:
Plaintiff acquired DraftKings NFTs during the Class Period and was damaged by the federal securities law violations alleged herein. Plaintiff purchased $72,263.21 of DraftKings NFTs on DK Marketplace, using United States Dollars to make the purchase, as indicated on Exhibit 1. Plaintiff sold certain NFTs at a loss on the DraftKings’ secondary market exchange, also as indicated on Exhibit 1. Plaintiff currently holds certain NFTs, which have declined in value. Plaintiff’s current losses exceed $14,000…
Due to the Defendants’ issuance, promotion, and sale of unregistered securities, Plaintiff and the Class—many of whom are retail investors who lack the technical and financial sophistication necessary to evaluate the risks associated with their investment in DraftKings NFTs and were denied the information that would have been contained in the materials required for the registration of the DraftKings NFTs—have suffered significant damages.
The TL;DR: Dufoe lost $14,000 on DraftKings NFTs and sued the company for damages, claiming that he was unable to appropriately “evaluate the risks” associated with said NFTs because, by issuing unregistered securities, DraftKings was able to withhold pertinent information. (I, personally, don’t think that one should be too surprised that they lost money buying fantasy sports NFTs in 2022, but I digress.)
On July 2nd, a judge agreed with Dufoe, allowing the lawsuit to proceed and denying DraftKings’ motion to dismiss the case, leading to the company shutting down its NFT marketplace. DraftKings is offering cash payments to compensate current Reignmakers holders.
How did DraftKings lose its motion to dismiss? Since the 1940s, courts have used “the Howey test” to determine whether or an instrument is a security, with investment contracts defined as the following: “a contract transaction or scheme whereby a person invests [their] money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by normal interests in the physical assets employed in the enterprise.”
Let’s break the Howey test into four parts, then check the judge’s explanation in the July 2nd filing. Howey test criteria:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
Obviously, NFT projects involve individuals “investing their money” (because they cost money to purchase, after all), so point one is accounted for. On point two, the judge concluded that companies reinvesting money raised from their NFT offerings into their businesses qualify as “common enterprise”:
The common enterprise requirement may be satisfied by "horizontal commonality," in other words, "the pooling of assets from multiple investors in such a manner that all share in the profits and risks of the enterprise…
Here, Dufoe has sufficiently alleged the pooling of assets requirement, because the revenue generated by the sale of NFTs was reinvested into DraftKings's business, including through the promotion of the Marketplace.
For point 3, while the company argued that DraftKings never represented to consumers that NFTs would appreciate in value, several instances, including a DraftKings podcast with Gary Vaynerchuk and DraftKings’ president Matt Kalish, proved the opposite:
Defendants used a Twitter account to share news on "the biggest risers and fallers" within the NFT Marketplace. Such marketing had the potential to encourage its audience to view DraftKings NFTs as an investment opportunity…
Statements made on the podcast hosted by Kalish and Vaynerchuk, encouraged investors to view the NFTs as profitable (alleging that DraftKings published a podcasts containing statements from entrepreneurs regarding NFTs as an investment, including "this will be the summer of people picking up some stuff on fire sale that twenty years from now was like `oh my god, how much did you pay in August 2022'")
Moreover, Plaintiffs allege that the public viewed DraftKings NFTs as an investment and purchased NFTs with such intent.
And on point four, the judge ruled that NFTs prices are largely dependent on the company’s ability to generate and maintain interest in its marketplace (i.e. the profit is derived from the efforts of others):
Although the NFTs are non-fungible assets whose prices do not uniformly rise and fall, it is still plausible for this Court to infer, and for Plaintiffs to expect, that if DraftKings drummed up additional demand for its NFTs while limiting the supply, that the value of most NFTs in the ecosystem would rise. Inversely, if DraftKings failed to maintain scarcity or generate sufficient interest in the Marketplace, the price of the NFTs would fall.
This was the second major sports-related NFT lawsuit in the last two months, with NBA Top Shot maker Dapper Labs agreeing to pay a $4 million settlement to plaintiffs in exchange for them no longer claiming their NFTs are securities, and it sets a dangerous precedent for companies that launched their own NFT marketplaces.
Let’s be real: NFTs were always objects for speculation, and the companies issuing the NFTs realized they could make money by creating marketplaces for those objects of speculation and charging fees on everything. Everyone was fine with this arrangement as long as prices were going up, prices stopped going up, and people got mad that they lost money. If you launched an NFT marketplace and ever alluded to a user’s ability to profit from your NFTs, any disgruntled user can make a strong case in a class action securities lawsuit.
I would guess that we’ll see more cases like this emerge as NFT bagholders realize that class actions lawsuits could help them recoup some of their losses.
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