Dead Canary in the LBRY
In a case watched by companies that offered and sold digital assets1 Federal District Court Judge Paul Barbadoro recently granted summary judgment for the Securities and Exchange Commission (“SEC”) against LBRY, Inc.2 This case is seen by some as a canary in the coalmine in that the decision supports the SEC’s view espoused by SEC Chairman Gary Gensler that nearly all digital assets are securities that were offered and sold in violation of the securities laws.3 For FinTech companies hoping to avoid SEC enforcement actions, the LBRY decision strongly suggests that all companies offering digital assets could be viewed by courts as satisfying the Howey test for investment contract securities.4
LBRY is a company that promised to use blockchain technology to allow users to share videos and images without the need for third-party intermediaries like YouTube or Facebook. LBRY offered and sold LBRY Credits, called LBC tokens, that would compensate participants of their blockchain network and would be spent by LBRY users on things like publishing content, tipping content creators, and purchasing paywall content. At launch, LBRY had pre-mined 400 million LBC for itself, and approximately 600 million LBC would be available in the future to compensate miners. LBRY spent about half of the 400 million LBC tokens on various endeavors, such as direct sales and using the tokens to incentivize software developers and software testers.
Judge Barbadoro concluded as a matter of law (i.e., that no reasonable jury could conclude otherwise) that the LBC tokens were securities under Section 5 of the Securities Act. Applying the Howey test, Judge Barbadoro noted the only prong of the Howey test that was disputed in the case was: Did investors buy LBC tokens “with an expectation of profits to be derived solely from the efforts of the promoter or a third party”? Judge Barbadoro answered resoundingly, “Yes.”
Most important to his conclusion that investors purchased LBC tokens with the expectations of profits solely through the efforts of the promoter (i.e., LBRY) were: the many statements made by LBRY employees and community representatives about the price of LBC and trading volume of LBC; and many statements that LBRY made about the development of its content platform, including how the platform would yield long-term value to LBC holders. Critically, however, Judge Barbadoro found that even if LBRY had made none of these statements, the LBC token would still constitute a security because “any reasonable investor who was familiar with the company’s business model would have understood the connection” between LBC value growth and LBRY’s efforts to grow the use of its network. Even if LBRY had never said a word about the LBC token, Judge Barbadoro found that the LBC token would constitute a security because LBRY retained hundreds of millions of LBC tokens for themselves, thus signaling to investors that it was committed to working to improve the value of the token.
Judge Barbadoro flatly rejected LBRY’s defense that the LBC token cannot be a security because the token has utility.5 The judge noted, “Nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” Likewise, Judge Barbadoro was unmoved by LBRY’s argument that it had no “fair notice” that the SEC would treat digital assets as unregistered securities simply because this was the first time the SEC had brought an enforcement action against an issuer of digital currency.6
In sum, if Judge Barbadoro’s reasoning is applied more broadly to the thousands of digital assets that have emerged over the last several years—including companies that tout the so called “utility” of their tokens—they will all likely be deemed digital asset securities that were offered and sold without a registration or an exemption from registration.
The LBRY decision is yet another case in which a court has concluded a digital asset is a security. Developers of digital assets must proceed with a high degree of caution. The SEC continues to display a high degree of willingness to initiate investigations and enforcement actions against issuers of digital assets that are viewed as securities under the Howey and Reeves tests, investment companies, or security-based swaps.
1 The SEC defines “digital assets” as intangible “asset[s] that [are] issued and transferred using distributed ledger or blockchain technology.” Statement on Digital Asset Securities Issuance and Trading, Division of Corporation Finance, Division of Investment Management, and Division of Trading and Markets, SEC (Nov. 16, 2018), available here.
3 See, e.g., Gary Gensler, Speech - “A ‘New’ New Era: Prepared Remarks Before the International Swaps and Derivatives Association Annual Meeting” (May 11, 2022) (“My predecessor Jay Clayton said it, and I will reiterate it: Without prejudging any one token, most crypto tokens are investment contracts under the Supreme Court’s Howey Test.”), available here. Section 5(a) of the Securities Act of 1933 (the “Securities Act”) provides that, unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly, to sell securities in interstate commerce. Section 5(c) of the Securities Act provides a similar prohibition against offers to sell or offers to buy securities unless a registration statement has been filed.
4 SEC v. W.J. Howey Co., 328 U.S. 293 (1946). This case did not address when digital assets could be deemed debt securities under the test articulated by the U.S. Supreme Court in Reves v. Ernst & Young, 494 U.S. 56, 66-67 (1990), or when digital assets could be deemed an investment company under the Investment Company Acy of 1940. See, e.g., In the Matter of Blockfi Lending, Feb. 14, 2022, available here. This case also does not address when a digital asset is a security-based swap. See, e.g., In the Matter of Plutus Financial, Inc., (July 13, 2020), available here.
5 The argument a digital asset is not a security because it has “utility” is a favorite argument of critics of the SEC’s enforcement actions against issuers of digital assets. Unfortunately, the “utility” argument appears to be of little merit when the digital asset is offered and sold to raise capital.
6 This is an argument that has been made by a number of defendants in SEC enforcement actions involving digital asset securities.