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

It’s no secret that over the past few years, there has been an exponential increase in the use of blockchain and digital assets. Crypto trading and lending platforms have grown rapidly and the total volume of the crypto market has recently reached $35 billion per day.[1] Many trading platforms have more than 100 trading crypto tokens.[2] However, as it is now also seen after FTX Trading Ltd. sudden collapse, the development of digital assets and related technologies also creates many potential financial risks. Before the collapse of FTX, President Biden called for “strong measures” to reduce the risks associated with digital assets.[3] They specifically mention digital asset issuers, exchanges and trading platforms, and intermediaries as entities that must comply with, and comply with, regulatory and supervisory standards that govern traditional financial markets.[4] SEC Chairman Gary Gensler has consistently stated that many trading tokens on the platform meet the definition of “securities”, and are thus within the scope of SEC regulation.[5] SEC V. LBRY, INC. is an important example of the SEC’s efforts to regulate the issuance of crypto tokens.[6]

The 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 original 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) create tip content, and (6) buy paywall content. The LBRY network is designed to eventually have around 1 billion LBCs in circulation, while LBRY has 400 billion LBCs for itself. LBRY sold more than 9.8 million LBC to the public through the LBRY app and 44.1 million LBC though the digital asset trading platform. LBRY is heavily dependent on LBC sales and transfers for funding.

On March 29, 2021, the SEC took enforcement action against LBRY. The SEC claimed that LBC’s unregistered offering of LBRY violated 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 is seeking injunctive relief, disgorgement of money obtained through the LBRY offering, and civil penalties.

LBRY’s main defenses are that (1) it did not offer LBC as security and (2) it was not given fair notice that it had to register its offer. On November 7, 2022, the US District Court for the District of New Hampshire granted summary judgment to the SEC, an important development in the SEC’s efforts to regulate crypto tokens.

Court Analysis

The Court found that Congress used a definition of “security” in the Securities Act that was not static and adaptable to changes in the scheme. The court pointed out that the focus of the inquiry is on the objective of the economic reality rather than the form of the transaction. The court then applied Howey test to determine whether LBC is a security.

At Howy The test looks at whether the transaction is an investment of money in a public company with the expectation of profit only from the efforts of the promoter or a third party.[8] In this framework, the Court determined that the main issue was whether LBRY’s offering of LBC led investors to have a reasonable expectation of profits to be made from LBRY’s efforts. The Court’s analysis focused on LBRY’s representation to potential buyers and LBRY’s business model.

In reviewing LBRY’s representations to potential buyers, the Court looked at LBRY’s blog posts, LBRY’s COO emails to potential investors, Reddit posts, interviews, and essays written by LBRY’s CEO. For example, in a blog post, LBRY said that “[o]ver long-term, interest of LBRY and its owners [LBC] aligned” and encouraged investors to “continue [their LBC]” when the price of LBCs is low.[9] The COO of LBRY sent an email to potential investors stating that “buy a lot of credits, keep them safe, and hope that in 1-3 years we have appreciated even 10% of the amount of Bit coins in the last few years.”[10] LBRY commented in a Reddit thread that the only way LBC will have “future value is if LBRY lives up to its promise to create a revolutionary way to share and monetize content.”[11] In an interview, LBRY explained that LBC’s future value will depend on “the success of [LBRY] media market.”[12] The Court held that these statements were representative of LBRY’s overall messaging about LBC and that prospective investors would understand that LBRY viewed LBC as an investment opportunity. The court also held that LBRY’s denial that LBC is not an investment cannot negate the objective economic reality of the transaction.

Despite no such representation by LBRY, the Court found that investors reasonably familiar with LBRY’s business model would have expected profits from LBC to be derived from LBRY’s profits. The judgment is based on the analysis of the fact that the profitability of LBRY depends on the growth in the value of LBC. In a post on its website, LBRY stated that “[s]Since Credit only gains value as protocol usage increases, companies have an incentive to continue developing this open source project.[13] LBRY management is also focused on expanding the Network and increasing the value of LBC. Apparently, the Court points to the fact that “by holding hundreds of millions of LBC for itself, LBRY also signals that it is motivated to work hard to increase the value of the blockchain for itself and the buyers of LBC.”[14] The Court held that this business structure would cause LBC’s purchasers to expect that they would profit from their ownership of LBC as a result of LBRY’s efforts and growth.

In defense, LBRY argued that (1) LBC is a utility token designed to be used on the LBRY Blockchain and (2) some LBC buyers acquired at least some LBC with the intention of using it rather than holding it as an investment. Importantly, the Court concluded that tokens with consumptive and speculative uses can still be sold as investment contracts. The definition of “securities” under the Securities Act is broad. Therefore, the Court determined that the evidence in the record showed that LBRY promoted LBC as an investment contract. The fact that a subset of LBC holders purchased LBC for use on the LBRY Blockchain does not, according to the Court, change the objective economic reality of LBRY’s offering of LBC.

LBRY also argued that it did not receive fair notice that the offering was subject to securities laws. Specifically, LBRY stated that prior to this action the SEC had historically and consistently focused its enforcement efforts specifically on Initial Coin Offerings (“ICOs”). The court stated that the participation in the ICO may be relevant in the analysis Howey test, it is not dispositive. The court found that the undisputed evidence in the case left no doubt that LBRY offered LBC as security. The court also distinguished the case Upton.[15] The court emphasized that the SEC in this case did not base its enforcement actions on a novel interpretation of the rules, but rather on well-known Supreme Court precedent that has been in effect for more than 70 years. Thus, the Court finds LBRY’s fair notice claim to have failed.

Takeaways

This case is another successful attempt by the SEC to deal with digital assets. There are many enforcement actions against issuers of digital assets. This decision raises many important issues that participants in the digital asset industry should be aware of. While new regulations are still underdeveloped, the SEC is enforcing existing laws for crypto tokens, as SEC Chairman Gary Gensler said that “when new technologies come, existing laws don’t just disappear.”[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 this case is a further step in the SEC’s efforts to regulate crypto tokens.

One important takeaway from this case is that the Court looked at many different types of statements by the issuer to determine the economic fairness of the transaction. The court does not focus only on official or public statements. Instead, they looked at top executives’ personal statements to potential investors, Reddit posts, blog posts, and interviews. The message for issuers of crypto tokens is clear: they must be more careful in every statement they make to ensure that these statements do not inform buyers with reasonable expectations of profits made by the efforts of others.

Another important aspect of the decision is the Court’s focus on LBRY’s ownership of a significant amount of LBC. The court pointed out that by retaining millions of LBC for himself, LBRY signaled that his motivation was to work to increase the value of LBC. The court suggested in dicta even if there is no suitable representation for the buyers, the firm’s structure will lead to buyers who are reasonably aware that they will benefit from the ownership of LBC as a result of LBRY’s efforts. This should take care of crypto token issuers in the design of their firm structure and whether they want to retain a significant amount of tokens for themselves.

Additionally, the Court ruled that consumptive use was not sufficient to make a crypto token not a security. The court concluded that crypto tokens with consumptive use can still be investment contracts. The court did not analyze how much proof of consumptive use is required to prove that a crypto token is not a security. It is unclear whether the Court required consumptive use to be the sole motivation for purchasers. Issuers of crypto tokens should be aware that mere consumptive use of their tokens is not a safe harbor.

Finally, the Court stated that ICOs are only one factor in the analysis of whether a token is a security. Issuers of crypto tokens should note that changes in the offering structure may not prove that the token is not a security. At LBRY this case is the first case where a federal court has ruled that a crypto token sold without an ICO is a security. Although the case is not in other courts, it is likely to have an impact on the resolution of other major enforcement actions, notably the SEC’s ongoing litigation against Ripple Labs for failing to register a crypto token offering before the Southern District of New York. .