Howey bout that? California judge says Bored Ape NFTs are not securities

A US Court in the Central District of California has granted a motion to dismiss on a class action lawsuit against Yuga Labs, the creator of the Bored Ape Yacht Club non-fungible tokens (NFTs), after finding that the plaintiffs failed to adequately establish that the NFTs are securities.

The court cited SEC v. W.J. Howey Co (1946) (Howey) and stated that 'although the Securities Acts do not define ‘investment contracts,’ courts ... have taken the term to mean a contract or scheme for the placing of capital or laying out of money in a way intended to secure income or profit from its employment'. The court considered each prong of the Howey test, being:

(1) an investment of money,

(2) in a common enterprise,

(3) with an expectation of profits produced by the efforts of others.

(1) Investment of money

The first prong of the Howey test requires investors to commit assets to an enterprise in a way that exposes them to financial loss. The plaintiffs alleged that their investment of fiat currencies and digital currencies into the NFTs was sufficient to satisfy the first limb.

However, the court found that the NFTs were not marketed for investment purposes but rather for consumptive uses, such as offering membership in a digital club and access to related perks. These features were not presented as opportunities for financial gain. While the plaintiffs argued that buyers were motivated by profit, the court said that subjective intention only has 'some bearing' on the analysis. The first prong of the Howey test was therefore not met.

(2) Common enterprise

The court found that the plaintiffs did not adequately allege a 'common enterprise' by showing either horizontal or vertical commonality.

In the Dapper Labs case, horizontal commonality was found because the NFTs relied on a private blockchain. That blockchain was essential to the value of the NFTs. In contrast, the NFTs in this case were recorded on the Ethereum blockchain which is not controlled by the defendants and does not depend on the NFTs for its survival.

The court also looked at the DraftKings case where horizontal commonality was found because the NFTs were sold in a proprietary marketplace controlled by the defendant. If that marketplace shut down, the 'value of the NFTs would plausibly drop to zero'. In this case, however, the plaintiffs purchased their NFTs on independent platforms such as OpenSea and Coinbase.

The plaintiffs also argued that because both the investors and defendants owned ApeCoin, the fortunes were 'linked'. However, the fact that Yuga Labs earned a fee each time an NFT was transferred (irrespective of whether its value increased, decreased or stayed the same) suggested a de-coupling of fortunes. This analysis contradicts arguments previously advanced by the SEC that such fees indicate asset is a security.

The court concluded that the:

plaintiffs have not alleged the type of “interplay” between the alleged securities and proprietary “ecosystem” that underpinned the logic of Dapper Labs and DraftKings, and therefore have not adequately alleged horizontal commonality.

(3) Expectation of profits produced by the efforts of others

The plaintiffs referred to Yuga Labs' statements about the long-term and intrinsic value of the NFTs as well as their prices and trading volumes. However, the court found these were not enough on their own to establish an expectation of profit. The court compared this to the Dapper Labs case where the use of rocket ship, stock chart and money bag emojis clearly suggested an expectation to profit.

Yuga Labs' efforts also needed to be 'undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise’. The court found that Yuga was responsible for developing and implementing the roadmap that would shape the future value of the NFTs. The court rejected the argument that buying NFTs on the secondary market prevented the plaintiffs from relying on Yuga's efforts.

Despite this particular finding in the plaintiffs' favour, the other prongs of the Howey test were not satisfied. The court held that the NFTs were not securities and granted the defendant's motion to dismiss.

Remarkably, despite the motion to dismiss being granted, the Court allowed the Plaintiffs to replead their case for the third time.

An investment is in the eye of the beholder

This decision draws an important line between NFTs marketed as investments and those designed for cultural or community use. In this case, the fact that Yuga Labs relied on decentralised infrastructure and did not squarely market the NFTs as an investment were influential in their not being classified as securities. The ruling also clarified that general statements about future plans or value do not automatically create an expectation of profit.

After the Dapper Labs and Draft Kings rulings, this judgment will give some comfort to US NFT projects seeking to build around art, culture or community, and which are not promoted as an investment scheme. While the judgment has limited application beyond US shores, the Howey test bears some similarities to the managed investment scheme test under Australian law. The Australian Courts are yet to rule on whether an NFT could be a financial product or managed investment scheme, however, this judgment is a hopeful sign that artists and creatives may not require a financial services licence in order to find new audiences in the digital economy.

Written by Steven Pettigrove and Emma Assaf