Alerts

US District Court Finds LBRY Tokens Are Securities

Alerts / November 11, 2022
Takeaways:
  • The Court granted the U.S. Securities and Exchange Commission’s (the SEC) motion for summary judgment, holding that LBC tokens are securities and that the offers and sales of the tokens by LBRY, Inc. (LBRY) violated the federal securities laws.
  • The Court held that based on the unique facts and circumstances in this case, the tokens are securities because purchasers bought the tokens for investment purposes based on, among other things, LBRY employees’ statements that LBC would increase in value due to LBRY’s efforts and that LBRY holds a significant amount of LBC, which the Court stated incentivizes LBRY to make efforts to increase the token value, which would reasonably lead investors to believe the same.
  • The Court’s focus on statements made by LBRY employees after launch once again highlights the need for a cryptocurrency company to be very cautious as to its statements about the company’s efforts and the token value, both before and after network launch.
  • The Court held that the SEC gave LBRY fair notice that its token offerings were subject to the securities laws and, as such, there was no due process violation.
LBRY Company Background

In 2016, crypto startup LBRY launched the LBRY network and the LBRY protocol, described by LBRY as a decentralized content sharing and publishing protocol that supports the creation of community-run digital marketplaces.[1] The same year, LBRY offered and sold native LBC tokens to the public for the purported purpose of allowing LBRY users to compensate content creators who publish content using the LBRY protocol and miners who process transactions on the LBRY network, a public, proof-of-work blockchain network.[2]

The SEC’s Complaint

In March 2021, the SEC filed a complaint against LBRY alleging that the company’s native LBC tokens are securities and that the company’s failure to register the tokens was therefore a violation of U.S. securities laws and regulations. Specifically, the SEC’s complaint alleged that the LBRY token was a type of security called an “investment contract,”[3] defined by the Supreme Court in SEC v. W.J. Howey Co. as a contract, transaction or scheme whereby a person (1) invests money (2) in a common enterprise (3) with an expectation of profits derived from the efforts of the promoter or a third party.[4] The SEC sought a permanent injunction enjoining LBRY from engaging in the “transactions, acts, practices, and courses of business” alleged in the complaint and disgorgement of all “ill-gotten gains”[5] from the alleged unlawful conduct.

Court Deems LBRY Tokens Securities

On Nov. 7, 2022, the U.S. District Court for the District of New Hampshire (Court) ruled on the parties’ cross-motions for summary judgment on the issues of (1) whether LBRY offered LBC as a security and (2) whether LBRY received fair notice that it needed to register its offerings of LBC. The Court granted the SEC’s motion for summary judgment against LBRY on both issues based on a view of the facts in the light most favorable to LBRY, finding that the LBC token was an investment contract primarily because investors expected acquiring the LBC token would result in profit as a result of the efforts of LBRY.[6]

On the issue of whether LBRY offered LBC as a security, the Court stated that only the third prong of the Howey test was in dispute, and therefore it focused its analysis on “whether the economic realities surrounding LBRY’s offerings of LBC led investors to have ‘a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’”[7] The Court first focused on “LBRY’s representations to prospective purchasers and the company’s business model.”[8] The Court found that LBRY published numerous statements that led potential investors to “reasonably expect that LBC would grow in value as the company continued to oversee the development of the LBRY Network.”[9] The Court reasoned that based on LBRY’s statements, “potential investors would understand that LBRY was pitching a speculative value proposition for its digital token,” which amounted to “precisely the ‘not-very-subtle form of economic inducement’ ... evidencing Howey’s ‘expectation of profits.’”[10] The Court cited the following representations, all of which occurred after the LBRY network launched in June 2016, as support for this conclusion:

  • a July 2016 blog post by LBRY reflecting on “LBC’s skyrocketing value” also stated that “the long-term value proposition of LBRY is tremendous, but also dependent on our team staying focused on ... building [LBRY]”;[11]
  • a July 2016 interview with LBRY’s “Technology Evangelist,” who revealed LBRY’s “powerbroking role within its ecosystem” by stating that LBRY might be able to use its “position as the ‘market maker’ of [LBC] to basically make it more expensive for people to abuse the network”;[12]
  • an August 2016 email from LBRY’s chief operating officer to a potential investor, indicating that the company was “currently negotiating private placements of LBC with several [other] investors” and inquiring whether “there is interest”;[13]
  • the same August 2016 email from LBRY’s chief operating officer explaining that the “opportunity is obvious ... buy a bunch of credits, put them away safely, and hope that in 1-3 years we’ve appreciated even 10% of how much Bitcoin has in the past few years”;[14]
  • a November 2016 blog post by the LBRY chief executive officer that explained when LBRY launched, it was “the barest, minimum proof-of-concept [application] possible” and that LBC’s token price was low because at that point “there [was] no reason to buy” LBC;[15]
  • a July 2019 Reddit post by LBRY’s community manager explaining 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”;[16] and
  • an October 2020 article published by LBRY explaining that it was creating a “token economy centered around digital content” that was “imminently achievable” with just “some tweaks.”[17]

In reaching its conclusion on the third prong of the Howey test, the Court noted that LBRY “relies on the fact that it informed some potential purchasers of LBC that the company was not offering its token as an investment.”[18] Countering this argument, the Court cited SEC v. Telegram Grp. Inc. and found that “a disclaimer cannot undo the objective economic realities of a transaction.”[19] In further support of its conclusion that the third prong of Howey was met, the Court found that LBRY was “a work in progress” that relied on the continuing efforts of LBRY to continue to build the network after launch. For example, shortly after launch, there were only three videos hosted on the LBRY network, all of which had been produced by the Company.[20]

In addition to LBRY’s statements, in analyzing the third prong of the Howey test, the Court also addressed LBRY’s business model and token allocation schedule. Specifically, the Court stated that “a reasonable purchaser of LBC would understand that the tokens being offered represented investment opportunities – even if LBRY never said a word about it,”[21] finding that “[f]rom its inception, LBRY’s profitability turned on its ability to grow the value of LBC by increasing usage of the LBRY Network,” and that “by intertwining LBRY’s financial fate with the commercial success of LBC, LBRY made it obvious to its investors that it would … develop the Network so that LBC would increase in value.”[22] The court’s reasoning appears to assert that large token allocations may deem the holder of such allocation an “active participant” on whose managerial efforts purchasers will rely to increase the value of the tokens and could therefore satisfy the third prong of Howey.

Addressing LBRY’s arguments that LBC was consumptive in nature, the Court noted that “[n]othing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.”[23]

Finally, the Court held that LBRY received fair notice that LBC was subject to the securities laws. According to the Court, the “principal problem with LBRY’s fair notice argument is that it offers nothing more to support its position than its bald claim that this is the first case in which the SEC has attempted to enforce the registration requirement against an issuer of digital tokens that did not conduct an [initial coin offering].”[24] In contrast, the Court found that the SEC relied on “Supreme Court precedent that has been applied by hundreds of federal courts across the country over more than 70 years.”[25]

Conclusion

The Court’s ruling in SEC v. LBRY, Inc. has been interpreted as a blow to the crypto ecosystem, which continues to grapple with how to launch blockchain products that rely on tokens, given the uncertain legal and regulatory environment in the United States. Notably, the Court’s ruling comes on the heels of (i) current SEC Chair Gary Gensler’s statements that the “vast majority” of cryptocurrency tokens are securities,[26] (ii) the SEC’s allegation that seven tokens listed on Coinbase are securities[27] and (iii) the near doubling of the SEC’s crypto asset enforcement staff.[28]

In addition, the results of the midterm election will shape any response by Congress and Capitol Hill regarding digital policy for the 118th Congress when it convenes on Jan. 3, 2023, but there is unlikely to be a digital asset legislative product completed during the lame-duck session. Until such time as Congress can agree on a legislative framework for digital assets, agencies will continue to use existing authorities to govern the conduct of digital asset market participants.

Thus, businesses that currently use or that plan to create or otherwise integrate cryptocurrency tokens in their business models would be well advised to ensure that they are operating within the confines of the applicable securities laws, regulations and best practices. As the SEC continues to direct enforcement resources toward the cryptocurrency sector, businesses should analyze their activities and be prepared to demonstrate their compliance. Crypto businesses should also consider taking steps to help shape the potential for federal legislation that is currently underway and will continue into the next Congress.

The BakerHostetler White Collar, Investigations, and Securities Enforcement and Litigation; Blockchain Technologies and Digital Assets; and Federal Policy teams are composed of dozens of experienced individuals, including attorneys who have served in the Department of Justice, the SEC and Congress. The Federal Policy team includes a former member of Congress as well as former senior congressional and committee staff and former executive branch officials, creating a team that leverages the combined experience and diverse backgrounds of former government officials to deliver value-added government affairs consulting services, including forward-thinking policy insights that provide clients with essential information about the politics, processes and personalities that shape legislative and regulatory actions. Our attorneys also include former U.S. attorneys, branch chiefs and unit chiefs as well as partners who have served in the SEC’s Division of Enforcement and the SEC’s Office of the General Counsel, and attorneys with extensive experience across all sectors of the blockchain and cryptocurrency markets, including investigations, Bank Secrecy Act/anti-money laundering compliance, tax, privacy, transactions, intellectual property, media and technology design, federal legislation, congressional oversight, investigations, and public policy. Please feel free to contact any of our experienced professionals if you have questions about this alert.


[1] Jeremy Kauffman, The LBRY Opens, LBRY (May 24, 2015), https://lbry.com/news/the-lbry-opens; Art in the Internet Age, LBRY (accessed Nov. 8, 2022), https://lbry.com/what; LBRY (accessed Nov. 7, 2022), https://lbry.tech/?_ga=2.245507715.682995758.1667891003-251425900.1667891003.

[2] SEC Library Complaint at 1-2:3; SEC v. LBRY, Inc., No. 1:21-cv-00260-PB, 3 (D.C. N.H. Nov. 7, 2022), https://storage.courtlistener.com/recap/gov.uscourts.nhd.56253/gov.uscourts.nhd.56253.86.0.pdf (LBRY Opinion).

[3] SEC LBRY Complaint at 7:24.

[4] 328 U.S. 293 (1964); quoted in SEC LBRY Complaint at 7:24.

[5] SEC LBRY Complaint at 15:B.

[6] LBRY Opinion at 18.

[7] Id. at 8.

[8] Id.

[9] Id. at 9.

[10] Id. at 14, citing SEC v. SG Ltd., 265 F.3d 42, 54-55 (1st Cir. 2001).

[11] Id. at 9-10.

[12] Id. at 12.

[13] Id. at 10.

[14] Id. at 10-11.

[15] Id. at 11.

[16] Id. at 12.

[17] Id. at 13.

[18] Id. at 15.

[19] Id. at 15, citing 448 F. Supp. 3d 352, 365 (S.D.N.Y. 2020).

[20] SEC LBRY Opinion at 9-10.

[21] Id. at 16 (emphasis added).

[22] Id. at 15, 17.

[23] Id. at 18.

[24] Id. at 19.

[25] Id. at 21.

[26] Gary Gensler, SEC, Prepared Remarks for Practicing Law Institute (Sept. 8, 2022), https://www.sec.gov/news/speech/gensler-sec-speaks-090822/.

[27] Lydia Beyound & Allyson Versprille, Coinbase SEC Probe Into Listed Tokens Has Crypto Traders Rattled, Bloomberg (July 27, 2022 11:57 am EDT), https://www.bloomberg.com/news/articles/2022-07-27/crypto-traders-rattled-by-sec-scrutiny-of-coinbase-listed-tokens.

[28] 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.

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