Blockchain Token LBC Steered A Security In Non-ICO Offering – Fin Tech

OVERVIEW

On November 7, 2022, the United States District Court for the District of New Hampshire ruled that the digital asset LBRY Credits (LBC), offered to buyers by LBRY, Inc., is an unregistered security for US federal securities law purposes. This summary judgment follows a March 2021 Securities and Exchange Commission (SEC) enforcement action in which the agency alleged that LBRY’s offer and sale of LBC violated Sections 5(a) and 5(c) of the Securities Act of 1933 which prohibit unregistered offers or sales of securities in interstate commerce. The court ruled in favor of the SEC, ruling that LBRY offered LBC as collateral and rejecting LBRY’s argument that it lacked “fair notice.”

BACKGROUND

LBRY is the blockchain protocol on which the LBRY network, including the media platform Odysee, is built. Blockchain is a technological system in which a digital list of records is stored over a decentralized network of computers. Blockchain is the primary technology of cryptocurrencies, but can be used to store a wide variety of information. LBC, LBRY’s original token released in 2016, is used to compensate LBC miners as well as reward viewers and creators for using the LBRY network.

In March 2021, the SEC filed an enforcement action against LBRY alleging that the company failed to file the required registration of its LBC offerings with the SEC. At issue on both parties’ cross motions for summary judgment was whether LBRY offered LBC as a security and whether the SEC gave LBRY reasonable notice that the offers were subject to securities laws.

PROBLEMS

LBC as a security

In ruling that LBRY offered LBC as collateral, the court relied on the definition of an “investment contract” set forth in the seminal US Supreme Court decision. SEC v. WJ Howey Co. As discussed in a previous Non-Fungible Insights post, “First Civil Litigation in the US Brought in Response to the Crash of the Stablecoin TerraUSD”, under Howey test, a financial instrument is an investment contract, a type of security, when there is: (1) investment of money; (2) in a joint venture; (3) with an expectation of profit; (4) derived solely through the efforts of others. Here, LBRY contested only the third and fourth points
Howey test.

(a) LBRY’s representations to prospective purchasers

In favor of the SEC, the court emphasized a number of LBRY’s public communications with potential buyers that LBC would grow in value through the company’s managerial and entrepreneurial efforts. The court delved into numerous LBRY blog posts, emails between company officials and potential buyers, LBRY’s communications with Reddit users, interviews with company officials and essays — all content that the court determined showed an indication of an expectation of profit. For example, the court highlighted a blog statement by LBRY’s CEO, Jeremy Kauffman, in which he positioned LBC holders when the LBC price was down in November 2016. The court noted that Kauffman publicly urged LBRY’s holders to “hold on tight” [their LBC] (or use it to buy something from [LBRY’s] great content” and emphasized LBRY’s long-term goal of “building a product compelling enough to change people’s habits” that could even replace YouTube and Amazon. The court held that LBRY had sent a consistent message to its holders that “the the long-term value proposition of LBRY is enormous,” ever since the launch of the LBRY Network in June 2016.

(b) LBRY’s business model

The court similarly held that even if LBRY had not been so public about its earnings expectations, LBRY’s profitability necessarily revolved around its ability to increase LBC’s value through the company’s management and entrepreneurial efforts. The court explained that any reasonable purchaser would understand that LBRY’s profitability from the outset would necessarily turn on the company’s ability to increase the value of LBC by increasing the use of the LBRY network. To support its holding, the court once again pointed to Kauffman’s previous statements and posts on LBRY’s website: highlighting one post that said “since Credits only gain value as use of the protocol grows, the company has an incentive to continue developing this open- source project.”

(c) Consumable Use for LBC

Finally, the court explicitly rejected LBRY’s arguments that LBC could not be a security because LBC purchases were made with consumptive intent. The court rejected statements from several LBC holders who explained that they had purchased LBC with limited relevance to determining whether LBRY offered LBC as a security. The court instead stated that the inquiry should focus on what the buyers were offered or promised, and the court made it clear that “nothing in case law indicates that a chip with both consumptive and speculative use cannot be sold as an investment contract. .”

Fair Notice from the SEC

The court then considered whether LBRY received fair notice from the SEC that the offerings were subject to federal securities laws. LBRY argued that there was a lack of fair notice that the issuance of digital tokens would be subject to registration requirements because the SEC had previously focused its guidance and enforcement efforts solely on the issuance of digital assets in the context of initial coin offerings (ICOs).

The court rejected this argument, noting that LBRY did not offer a persuasive reading of Howey that only ICOs are subject to registration requirements. The court also noted that the SEC has never suggested that companies only need to comply with registration requirements when conducting an ICO. Ruling that “the SEC … based its [enforcement action] on a simple application of venerable Supreme Court precedent” and not “a new interpretation of a rule which by its terms does not expressly prohibit the relevant conduct,” the court found that LBRY received reasonable notice that its unregistered issuance of LBC was illegal .

IMPLICATIONS

This ruling, while limited in its precedential effect, is likely to strengthen the SEC’s aggressive position regarding what digital assets constitute securities under US law. As the court noted, “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 ICO.” Focusing on the “economic realities” of LBRY’s offering rather than the transaction’s forms, the court concluded that although participation in an ICO may be relevant to Howeyanalysis, it alone is not dispositive. There are several other pending civil and state lawsuits regarding the same core issue, and it remains to be seen whether other courts will take the same position.

Digital assets, such as LBC, are likely to be subject to greater scrutiny and regulatory enforcement in the near future as the SEC continues focused efforts on digital asset issuers.

We will continue to monitor developments in the digital asset industry and blockchain technology and provide Friends of the Firm with updates as they become available.

Winston & Strawn Associate Jacob Botros and Associate Uriel Lee contributed to this blog post.

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