SEC v. LBRY, Inc.: Federal Court Finds LBRYs Crypto Token as a Security | Patterson Belknap Webb & Tyler LLP

It is no secret that over the last several years, there has been an exponential increase in the utilization of blockchain and digital assets. Crypto trading and lending platforms have grown rapidly and the total crypto market volume recently reached $35 billion a day.[1] Many of the trading platforms have more than 100 crypto tokens trading on them.[2] However, as is by now also apparent following the rapid, sudden collapse of FTX Trading Ltd., the development of digital assets and related technology also creates many potential financial risks. Prior to the FTX collapse, President Biden asked for “strong steps” to be taken to reduce the risks associated with digital assets.[3] He specifically called out digital asset issuers, exchanges and trading platforms, and intermediaries as entities that should be subject to, and come into compliance with, regulatory and supervisory standards that govern traditional financial markets.[4] SEC Chairman Gary Gensler has consistently claimed that many of the tokens trading on the platforms meet the definition of “securities,” and thus fall within the scope of SEC regulation.[5] SEC V. LBRY, Inc. is an important example of SEC’s efforts to regulate the issuance of crypto tokens.[6]

Background

LBRY is a platform that uses blockchain technology to allow users to share videos, images, and other digital content without a centralized host like YouTube. LBRY Credits (“LBC”) is the native digital token of the LBRY Blockchain. LBC is used to (1) compensate miners, (2) publish content, (3) create channels, (4) boost channels or content in search results, (5) tip content creators, and (6) purchase paywall content. The LBRY Network was designed to eventually have a circulation of approximately 1 billion LBC while LBRY reserved 400 billion LBC for itself. LBRY sold more than 9.8 million LBC to the public through LBRY applications and 44.1 million LBC though digital asset trading platforms. LBRY relied heavily on sales and transfers of LBC for funding.

On March 29, 2021, the SEC brought an enforcement action against LBRY. The SEC claimed that LBRY’s unregistered offerings of LBC violate section 5(a) and (c) of the Securities Act. Section 5 of the Securities Act requires all issuers to register non-exempt securities with the SEC.[7] The SEC seeks injunctive relief, disgorgement of monies obtained through LBRY’s offerings, and civil penalties.

LBRY’s primary defense was that (1) it did not offer LBC as a security and (2) it was not given fair notice that it needed to register its offerings. On November 7, 2022, the U.S. District Court for the District of New Hampshire granted summary judgment in favor of the SEC, an important development in the SEC’s efforts to regulate crypto tokens.

Court’s Analysis

The Court found that Congress adopted a broad definition of “security” in the Securities Act which is not static and is capable of adapting to the changes in the schemes. The Court pointed out that the focus of the inquiry is on the objective economic realities rather than the form of the transaction. The Court then applied the Howey test to determine whether LBC was a security.

The Howey test looks at whether the transaction is an investment of money in a common enterprise with an expectation of profits to be derived solely from the efforts of the promoter or a third party.[8] Under this framework, the Court determined that the primary issue was whether LBRY’s offering of LBC led investors to have a reasonable expectation of profits to be derived from LBRY’s efforts. The Court’s analysis focused on LBRY’s representations to potential purchasers and LBRY’s business model.

In examining LBRY’s representations to potential purchasers, the Court looked at LBRY’s blog posts, LBRY’s COO’s email to potential investors, Reddit posts, interviews, and essay wrote by LBRY’s CEO. For example, in blog posts, LBRY said that “[o]ver the long-term, the interests of LBRY and the holders of [LBC] are aligned” and encouraged investors to “hold on [their LBC]” when the LBCs price was low.[9] The COO of LBRY emailed a potential investor stating that “buying a bunch of credits, put them away safely, and hope that in 1-3 years we’ve appreciated even 10% of how much Bit coin has in the past few years.”[10] LBRY commented in the Reddit Thread that the only way LBC will be “worth something in the future is if LBRY delivers on their promises to create a revolutionary way to share and monetize content.”[11] In an interview, LBRY explained that the future value of LBC would depend on “the success of [LBRY] media marketplace.”[12] The Court reasoned that these statements are representative of LBRY’s overall messaging about LBC and potential investors would understand that LBRY was pitching LBC as an investment opportunity. The Court also held that LBRY’s disclaimer that LBC was not an investment cannot undo the objective economic realities of a transaction.

Even absent these representations by LBRY, the Court found that a reasonable investor who was familiar with LBRY’s business model would have an expectation of profits from LBC to be derived from LBRY’s profitability. The Court based its analysis on the fact that LBRY’s profitability depends on the growth in the value of LBC. In a post on its website, LBRY stated that “[s]ince Credits only gain value as the use of the protocol grows, the company has an incentive to continue developing this open-source project.”[13] LBRY’s management also focused on developing the Network and increasing the value of LBC. Noticeably, the Court pointed to the fact 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.”[14] The Court held that this business structure would lead purchasers of LBC to expect that they would profit from holdings of LBC as a result of LBRY’s efforts and growth.

In its defense, LBRY argued that (1) LBC is a utility token designed for use on the LBRY Blockchain and (2) some purchasers of LBC acquired LBC at least in part with the intention of using it rather than holding it as an investment. Importantly, the Court concluded that a token with both consumptive and speculative uses can still be sold as an investment contract. The definition of “securities” under the Securities Act is broad. Accordingly, the Court determined that evidence in the record indicated that LBRY promoted LBC as an investment contract. The fact that a subset of LBC holders purchased LBC for use on the LBRY Blockchain did not, in the Court’s view, change the objective economic realities of LBRY’s offerings of LBC.

LBRY also argued that it did not receive fair notice that its offerings were subject to the securities laws. Specifically, LBRY alleged that before this action the SEC historically and consistently focused its enforcement efforts exclusively on Initial Coin Offering (“ICO”). The Court held that while participation in an ICO may be relevant in the analysis under the Howey test, it is not dispositive. The Court found that the undisputed evidence in the case left no doubt that LBRY offered LBC as a security. The Court also distinguished the case from Upton.[15] The Court reasoned that the SEC in this case did not base its enforcement action on a novel interpretation of a rule, but instead on a well-known Supreme Court precedent that has been widely applied for more than 70 years. Thus, the Court found LBRY’s fair notice claim failed.

Takeaways

This case is another successful attempt by the SEC in reining digital assets. There has been a growing number of enforcement actions against digital assets issuers. This ruling raises many important issues that participants in the digital asset industry should be aware of. While new regulations are still underdevelopment, the SEC is applying the existing laws to crypto tokens, as the SEC Chairman Gary Gensler remarked that “when a new technology comes along, our existing laws don’t just go away.”[16] Gensler further claimed that “most crypto tokens are investment contracts under the Howey Test” and “it is important that we work to get crypto tokens that are securities to be registered with the SEC.”[17] Therefore, the LBRY case is a further step of SEC’s efforts in regulating crypto tokens.

One important takeaway from this case is that the Court looked at a variety of different types of statements by the issuer to determine the objective economic realities of the transaction. The Court did not just focus on official or public statements. Instead, it looked at top executive’s private statements to potential investors, Reddit posts, blog posts, and interviews. The message to crypto token issuers is clear: they must be more careful in every statement they make to ensure that the statements do not communicate to purchasers a reasonable expectation of profits generated by the efforts of others.

Another notable aspect of the ruling is the Court’s focus on LBRY’s ownership of a significant amount of LBC. The Court pointed out the by retaining millions of LBC for itself, LBRY signaled that it was motivated to work to improve the value of LBC. The Court suggested in dicta that even absent relevant representations to purchasers, such firm structure would lead reasonable purchasers to understand that they would profit from their holdings of LBC as a result of LBRY’s efforts. This should caution issuers of crypto tokens in their design of the firm structure and whether they would like to retain a significant number of tokens for themselves.

In addition, the Court ruled that having a consumptive use is not sufficient to make a crypto token not a security. The Court concluded that a crypto token with consumptive uses can still be investment contracts. The Court did not analyze how much evidence of consumptive uses is required to prove that a crypto token is not a security. It is unclear whether the Court required consumptive use to be the only motivation for purchasers. Issuers of crypto tokens should be aware that merely having a consumptive use for its token is not a safe harbor.

Finally, the Court held that whether an ICO took place is only one factor in the analysis of whether a token is a security. Issuers of crypto tokens should note that changes in the offering structures might do little to prove that the token is not a security. The LBRY case is the first case where a federal court held that a crypto token sold without an ICO is a security. Although the case is not binding on other courts, it is likely to have an influence on the resolution of other major enforcement actions, especially the SEC’s ongoing litigation against Ripple Labs for failure to register its offerings of crypto token before the Southern District of New York.