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.
Key Takeaways
- 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 Background
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.
What’s Next?
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.
Footnotes
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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