
DraftKings has failed in its motion to dismiss a lawsuit alleging that its Reignmakers non-fungible tokens (NFTs) constitute securities and are illegal to sell without approval by the Securities & Exchange Commission (SEC). US District Court Judge Denise J. Casper found sufficient merit in plaintiff Justin Dufoe’s claims that she believes the case should proceed. However, surviving a motion to dismiss is a low bar to clear, so that doesn’t necessarily indicate how the case will end. Moreover, the parties could still agree to a settlement before the court reaches a verdict.
The Reignmakers NFTs are essentially digital sports trading cards that can also be used to participate in fantasy sports contests with real-money prizes. However, DraftKings Marketplace also provides a platform for users to buy and sell the cards. Dufoe says he lost $14,000 buying the NFTs and argues that he and other customers were encouraged to view them as investments. In its motion for dismissal, DraftKings asserted that it never marketed the cards as anything other than collectibles.
To have a case dismissed, the defendant must persuade the court that the plaintiff’s legal argument has no merit, even if all the alleged facts are assumed to be true. Here, Judge Casper determined that Dufoe raised some questions about the product that—at a minimum—deserve more careful consideration through a trial.
The judicial instrument for determining whether or not something is a security is called the Howey Test. Much of Judge Casper’s order is dedicated to assessing whether Reignmakers might plausibly pass that test.
What’s the Howey Test?
The Howey Test gets its name from the seminal 1946 case SEC vs. W. J. Howey Co.
W. J. Howey Co. was an orange grower with a novel approach to raising capital. Rather than selling shares, it sold some of its land to investors. However, most of these buyers were out-of-state and not interested in tending their own groves. So, along with the sale of the land, the company entered into contracts with the buyers to continue tending the groves on their behalf, sharing the profits from the orange sales.
The SEC took the company to court, arguing that this system was functionally the same as selling a stake in the business. Lower courts sided with W. J. Howey Co., but ultimately, the case made its way to the Supreme Court, which overturned the verdict. In the process, it established the Howey Test as a precedent for similar cases.
According to this test, an instrument qualifies as “an investment contract” if it meets three criteria:
- The investing party offers money or something else of value in return for the opportunity.
- By doing so, they buy into a “common enterprise,” where their interests become linked with the seller’s.
- There is an expectation of profit based solely on the efforts of the seller or a third party.
Anything that meets that definition falls within the SEC’s purview.
In Dufoe v. DraftKings, there’s no disagreement on the first point: customers paid money for Reignmakers NFTs. The question is whether they were buying into a “common enterprise” with DraftKings in doing so and could reasonably expect profits based on the success of its business.
According to both Dufoe and Judge Casper, the extent to which DraftKings controlled the market for trading the NFTs is fundamental to answering that question.
Are Reignmaker NFTs Decentralized or Not?
NFTs, like Bitcoin and other cryptocurrency, are based on blockchain technology. In principle, one of the advantages blockchain offers is decentralization. A user holding an NFT in their personal wallet can send it to another wallet through a distributed, public system without involving the entity that created it.
Dapper Labs, which created the NBA Top Shots NFTs, faced a similar lawsuit. That case survived a motion to dismiss and ended in a $4 million settlement—coincidentally just last month.
In filing for dismissal, DraftKings argued that its case is different. Dapper’s NFTs trade on a proprietary blockchain, while DraftKings’ trade on the public blockchain.
Nonetheless, DraftKings owns the wallets that hold the NFTs, even though it uses the public blockchain to move them around. It also retains the right to decide whether an individual can transfer those NFTs to a personal wallet. DraftKings can even retake ownership of the NFTs if the user violates its terms of service.
As a result, Judge Casper wasn’t convinced by DraftKings’ arguments about decentralization. She wrote that it was unknown without discovery whether it was viable in practice for users to move their NFTs out of DraftKings-controlled wallets or whether any had actually done so.
That question is essential to the second and third pillars of the Howey Test. Central to Dufoe’s case is the idea that the NFTs’ value hinges on the success and continued operation of DraftKings Marketplace. Judge Casper found that plausible, stating:
Thus if DraftKings shut down the Marketplace or interest in the Marketplace evaporated, the value of the NFTs would plausibly drop to zero. […]
At present, Dufoe’s allegations that DraftKings controls the primary and secondary market for its NFTs and that the NFTs values are dependent on the success of the Marketplace are sufficient to survive a motion to dismiss.