On November 7, 2022, Judge Paul J. Barbadoro in the United States District Court for the District of New Hampshire granted summary judgment in favor of the Securities and Exchange Commission against the content sharing platform LBRY, in the latest case testing what constitutes a security under the federal securities laws.1 Applying the Supreme Court's Howey test, the court relied heavily on LBRY's own statements about its native token LBC in holding that LBC is a security, marking a significant victory for the SEC as it continues to ramp up enforcement against issuers of digital assets and other market participants.
Crypto market observers will surely scrutinize Judge Barbadoro's decision for its impact on other companies offering tokens for sale—but the Court's opinion broke little new ground by engaging in a fact-specific analysis guided by the same test courts have consistently applied for decades to determine what constitutes a security under federal law. Nevertheless, following key decisions against Kik2 and Telegram,3 the LBRY opinion marks another victory for the SEC as it aggressively enforces securities laws against issuers of cryptocurrencies.
- Facts matter: While the debate rages on as to whether tokens in general should be regulated as securities—or by the SEC at all—the LBRY decision continues the trend of courts focusing on the specific details of the tokens before them to determine whether they constitute investment contracts.
- That some purchasers may have "consumptive intent" in buying tokens does not mean a token is not a security, particularly where issuers' own words suggest investors should consider buying such tokens specifically because of the potential for a return on their investment. Issuers should therefore carefully consider how they describe their networks and the tokens that support them.
LBRY was formed "to harness blockchain technology to allow users to share videos, images, and other digital content without a centralized host such as YouTube." Users paid a fee in LBC, the native digital token of the LBRY blockchain, to interact with the network for anything beyond viewing free content. For example, LBC was used to publish content, create channels, tip content creators, and boost content. Users obtained LBC by mining, earning rewards for certain activities on the LBRY network, or purchasing the token on a secondary market.4
Instead of issuing LBC through an initial coin offering ("ICO"), LBC kept around 400 million tokens for itself in a "pre-mine," which were subsequently released on secondary exchanges to fund the operation. In seeking to distinguish LBC from tokens deemed securities by other courts, LBRY focused on the lack of an ICO. But as set forth below, the Court did not find this distinction dispositive.
The Court's Decision
On March 29, 2021, the SEC filed a complaint against LBRY, alleging that LBRY sold LBC as an unregistered security under Section 5(a) of the Securities Act. The SEC alleged that LBC was an "investment contract" under the U.S. Supreme Court case SEC v. Howey, which the Court framed as asking whether there is: 1) an investment of money; 2) in a common enterprise; 3) with a reasonable expectation of profit to be derived from the efforts of others. Judge Barbadoro analyzed what the Court framed as the third Howey prong, which was the only component of the test in dispute.
First, the Court examined LBRY's representations to prospective purchasers and the company's business model. Despite LBRY's "many disclaimers that it did not intend for LBC to be purchased as an investment," the Court concluded that LBRY made potential investors "aware of LBC's potential value as an investment." To that end, the Court listed multiple statements by LBRY that were "representative of LBRY's overall messaging about the growth potential for LBC," supporting the SEC's view that "potential investors would understand that LBRY was pitching a speculative value proposition for its digital token." For example, LBRY published a blog post saying "the long-term value proposition of LBRY is tremendous, but also dependent on our team staying focused on the task at hand: building this thing." In another relevant statement, a LBRY product manager posted on Reddit that LBC would only be "worth something in the future . . . if LBRY delivers on their promises."
While the Court acknowledged LBRY's disclaimers, it held that such disclaimers "cannot undo the objective economic realities of a transaction." This is consistent with the ruling in another prominent crypto case, SEC v. Telegram, where the court there observed that "[d]isclaimers, if contrary to the apparent economic reality of a transaction, may be considered by the Court but are not dispositive."5
Next, the Court concluded that any reasonable investor familiar with LBRY's business model would understand that LBRY expected LBC to increase in value through LBRY's managerial and entrepreneurial efforts. The Court cited statements from LBRY's CEO to support the conclusion that "LBRY's profitability turned on its ability to grow the value of LBC by increasing usage of the LBRY network." By "intertwining LBRY's financial fate with the commercial success of LBC, LBRY made it obvious to investors that it would work diligently to develop the Network so that LBC would increase in value."
LBRY's attempts to distinguish LBC from other tokens offered through ICOs appeared to backfire. The Court observed that "by retaining hundreds of millions of LBC for itself, LBRY also signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any LBC purchasers."
The Court also rejected LBRY's argument that LBC cannot be a security because purchasers acquired it for use on the network. Citing Howey, the Court concluded that rejecting the SEC's argument "simply because some LBC purchases were made with consumptive intent" would render the Securities Act "unable to adapt" to "the 'countless and variable schemes devised by those who seek the use of the money of others on the promise of profits' whenever a token held some consumptive utility."
Finally, the Court rejected LBRY's argument that it did not receive fair notice that LBC would be subject to securities laws. LBRY argued a lack of fair notice because the SEC "historically and consistently focused its guidance, as well as its enforcement efforts, exclusively on the issuance of digital assets in the context of an ICO." But the Court emphasized that "[t]he test outlined in Howey is necessarily a fact-specific one," and no single relevant fact (for example: whether the issuer conducted an ICO), will likely be dispositive. Without more to support its claim than this being the first enforcement action outside of an ICO, the Court rejected LBRY's fair notice argument.
We expect this trend of aggressive SEC enforcement in the crypto space to continue. Indeed, in May 2022, the SEC nearly doubled the number of attorneys in the Division of Enforcement's Crypto Assets and Cyber Unit, which, since its inception in 2017, has brought more than 80 enforcement actions in the crypto space.6
The SEC's longstanding view has been that most cryptocurrencies are securities—in fact, current SEC Chair Gary Gensler has said that he views the "vast majority" of cryptocurrencies as securities.7 That will be tested again in the Ripple litigation, where Ripple has advanced several arguments—in some cases based on a more robust record—both for why no investment contract exists and for why the company lacked fair notice that the sale of its assets was prohibited. Meanwhile, crypto issuers continue to plead with Congress and the SEC for additional guidance on crypto regulation.
Clients should continue to monitor SEC enforcement actions and announcements as the law in this space develops.
1. SEC v. LBRY, No. 21-CV-260-PB, 2022 WL 16744741 (D.N.H. Nov. 7, 2022).
2. SEC v. Kik, 492 F. Supp. 3d 169 (S.D.N.Y. 2020).
3. SEC v. Telegram, 448 F. Supp. 3d 352 (S.D.N.Y. 2020).
4. How do I earn LBRY credits (LBC)?, LBRY, http://www.lbry.com/faq/earn-credits (last visited Nov. 9, 2022).
5. 448 F. Supp. 3d at 365.
6. Press Release, SEC, SEC Nearly Doubles Size of Enforcement's Crypto Assets and Cyber Unit (May 3, 2022), https://www.sec.gov/news/press-release/2022-78.
7. Chair Gary Gensler, SEC, Remarks at the "SEC Speaks" Conference 2022, Kennedy and Crypto (Sept. 8, 2022), https://www.sec.gov/news/speech/gensler-sec-speaks-090822.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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