On November 7, 2022, United States District Court for the District of New Hampshire rule that the digital asset LBRY Credits (LBC), offered to buyers by LBRY, Inc., is an unregistered security for the purposes of the US federal securities laws. A summary of this decision follows the Securities and Exchange Commission (SEC) March 2021 enforcement action where the agency alleged that LBRY’s offer and sale of LBC violated Sections 5(a) and 5(c) of the Securities Act of 1933 prohibiting the offer or sale of unregistered securities in interstate commerce. Ruling for the SEC, the court determined that LBRY offered LBC as security and rejected LBRY’s argument that it did not have “fair notice.”
LBRY is the blockchain protocol on which the LBRY Network, including the Odysee media platform, is built. Blockchain is a technological system in which a list of digital records is stored in a decentralized computer network. Blockchain is the main technology of cryptocurrencies but it can be used to store a variety of information. LBC, LBRY’s original token released in 2016, is used to balance LBC miners as well as reward viewers and creators who use the LBRY Network.
In March 2021, the SEC filed an enforcement action against LBRY alleging that the company did not file the required registration for the LBC offering with the SEC. At issue in both parties’ cross-motions for summary judgment are whether LBRY offered LBC as security and whether the SEC gave LBRY fair notice that its offering complied with securities laws.
LBC As Security
In deciding whether LBRY offered LBC as security, the court relied on the definition of “investment contract” set forth in a US Supreme Court decision. SEC v. WJ Howey Co. As discussed in our previous Non-Fungible Insights post, “First US Civil Litigation Brought in Response to TerraUSD Stablecoin Crash“, below Howy test, financial instrument is an investment contract, type of security, when there are: (1) money investment; (2) in public companies; (3) with the expectation of profit; (4) originated only through the efforts of others. Here, LBRY disputes only the third and fourth prongs
(a) Representation of LBRY to Prospective Purchasers
For the SEC, the court emphasized a series of public communications by LBRY with potential buyers that LBC would grow in value through the company’s managerial and entrepreneurial efforts. The court investigated numerous LBRY blog posts, emails between company officials and potential buyers, LBRY communications with Reddit users, interviews with company officials, and essays—all content the court determined showed indications of profit expectations. For example, the court highlighted a blog statement by the CEO of LBRY, Jeremy Kauffman, where he made LBC holders when the price of LBC fell in November 2016. [their LBC] (or spend to buy some [LBRY’s] great content” and emphasized the long-term goal of LBRY which is “to build a product that is compelling enough to change people’s behavior” that can even replace YouTube and Amazon. The court held that LBRY has sent a consistent message to the owner that “the long-term value proposition of LBRY is really beyond usual,” since the launch of the LBRY Network in June 2016.
(b) LBRY Business Model
The court also stated that although LBRY has not been public about its profit expectations, LBRY’s profits certainly reflect its ability to increase the value of LBC through the company’s managerial and entrepreneurial efforts. The court explained that reasonable buyers would have known that, from the outset, LBRY’s profits would have turned on the company’s ability to increase the value of LBC by increasing the use of the LBRY Network. To support the holding, the court once again pointed to Kauffman’s previous statements and posts on the LBRY website: highlighting one post that states “since Credits only gain value when using the growing protocol, the company has an incentive to continue developing this open-source project.”
(c) Consumptive Use for LBC
Finally, the court categorically rejected LBRY’s argument that LBC could not be a security because the purchase of LBC was made for consumptive purposes. The Court rejected statements from several LBC holders explaining that they had purchased LBCs as having limited relevance in determining whether LBRY offered LBCs as security. However, the court stated that the inquiry should focus on what was offered or promised to the buyers, and the court explained that “there is nothing in the legal case that indicates that tokens with consumptive and speculative use cannot be sold as investment contracts. .”
Fair notice by the SEC
The court then considered whether LBRY received fair notice from the SEC that the offering was subject to federal securities laws. LBRY stated that there is no fair notice that the issuance of digital tokens will be subject to registration requirements because the SEC has previously focused its guidance and enforcement efforts specifically on the issuance of digital assets in the context of initial coin offerings (ICOs).
Rejecting this argument, the court noted that LBRY did not offer a persuasive reading Howy that only ICOs are subject to registration requirements. The court also noted that the SEC never proposed that companies must comply with registration requirements only when conducting an ICO. Determining that “the SEC … is based on its [enforcement action] in the direct application of the respected Supreme Court precedent” and not “a novel interpretation of the rule that by its unwritten terms prohibits appropriate actions,” the court found that LBRY received fair notice that publishing unregistered from LBC is illegal.
This ruling, although limited in its precedential impact, will likely increase the SEC’s aggressive stance on digital assets that are securities under US law. As the court noted, “this is the first case in which the SEC has tried to impose registration requirements on digital token issuers that did not conduct an ICO.” Focusing on the “economic reality” of the LBRY offering rather than the transaction form, the court concluded that participation in the ICO may be appropriate Howyanalysis, it’s just not dispositive. There are several other civil and government actions pending on the same core issue, and it remains to be seen whether other courts will take a similar position.
Digital assets, such as LBC, will face increased scrutiny and regulatory enforcement in the future as the SEC continues to focus on digital asset issuers.
We will continue to monitor developments in the digital asset and blockchain technology industry and provide our colleagues from these companies with updates as they become available.
Winston & Strawn Associate Jacob Botros and Law Clerk Uriel Lee contributed to this blog post.
The content of this article is intended to provide a general guide to the subject. Specialist advice should be sought in relation to your particular situation.