LBRY Token Ruling Gives SEC Ammunition in Crypto Enforcement

A federal judge’s ruling that LBRY Inc.’s sale of digital tokens violated U.S. securities law gives the SEC momentum in controlling the burgeoning market and encourages regulators to push the boundaries.

A federal court in New Hampshire this week sided with the Securities and Exchange Commission’s argument that LBRY should have registered its “LBRY Credits” with the agency before selling them because they are securities.

Whether a crypto-asset is a security product, under the SEC’s oversight, is an ongoing debate, although the agency believes many digital assets have the characteristics of a security. The Nov. 7 decision is among a handful of recent court decisions siding with the SEC, lending support to its view.

“It’s a win for the SEC,” Kesselman Brantly & Stockinger LLP attorney Abiel Garcia said of the decision. “That’s what they’ve been signaling for the last two, three years in terms of where they’re going.” The SEC will likely point to the decision in cases going forward, he said.

LBRY said on his verified Twitter account that the ruling “sets an extraordinarily dangerous precedent that makes every cryptocurrency in the United States a security.”

Legal scholars and lawyers were more cautious, saying that whether a digital asset is a security would be a case-by-case analysis. But the way the court applied the so-called Howey test — derived from a 1946 Supreme Court decision — to determine whether something is a security could sweep a number of cryptocurrencies, various lawyers said.

“What it confirms is that the SEC and federal district courts agree on how to apply the Howey test to digital assets,” Barnes & Thornburg LLP attorney David Slovick said.

Howey test

LBRY raised more than $11 million through the sale of its digital tokens, LBRY Credits, according to the SEC. The sales constituted unregistered securities offerings, the agency said.

LBRY raised the money to develop its network, which allows people to publish digital content, the SEC said.

The Howey test assesses whether there was an investment of money in a joint enterprise, with an expectation of profit from the efforts of others. LBRY’s case focused on the final treatment.

LBRY argued that, unlike some other crypto companies the SEC has targeted, it did not promote LBRY Credits as a “get-rich-quick” investment opportunity. The tokens were a currency that content creators could spend on the LBRY network, the company said.

In a May filing, it called the SEC’s case an “amazing and unprecedented overreach” that could stifle innovation by suggesting that “no token is beyond the Commission’s reach.”

Judge Paul Barbadoro of the US District Court for the District of New Hampshire did not buy LBRY’s argument.

LBRY was “acutely aware” of the token’s potential value as an investment, and made no secret in communications with potential investors — including on forums like Reddit — that they expected LBRY Credits to grow in value, Barbadoro said.

The company also kept millions of tokens for itself, issuing them to its workers as “compensatory incentives,” the SEC alleged. Barbadoro said this signaled to investors that LBRY was “motivated to work tirelessly to improve the value of its blockchain for itself” and token buyers.

“In other words, the retained stake will be understood by buyers that the latter can rely on the former to create profits for all of them,” said Patrick Daugherty, head of digital assets at Foley & Lardner LLP. “The court did not cite any legal precedents for this opinion, perhaps because there are none.”

The facts that Barbadoro pointed to as problematic for LBRY are prevalent in a number of cryptocurrency projects, some lawyers said.

The key for crypto projects is to “adopt a different approach,” said James Gatto, who leads the blockchain and fintech team at Sheppard Mullin Richter & Hampton LLP. “So many people don’t, they just follow what everyone else has done.”

More ammo

The SEC has stepped up enforcement efforts in the crypto space. In May, the agency nearly doubled the size of its Crypto Assets and Cyber ​​Unit to 50 positions, the SEC said.

Barbadoro’s ruling will bolster the agency’s confidence, giving it impetus to push the limits of its authority, lawyers said.

The ruling could serve as a precedent that the SEC could use. It also has a “in terror effect — something they can point to when they approach promoters of other token-based businesses to say, ‘You can’t do this’ or ‘You have to do it this way,'” said Usha Rodrigues, a law professor at the University of Georgia .

A focus of SEC enforcement actions has been crypto companies’ statements that the value of the token is expected to appreciate.

“That seems to be an important part of the judge’s analysis” in LBRY’s case, said BakerHostetler LLP attorney Teresa Goody Guillén.

The SEC is in the midst of litigating another closely watched case accusing Ripple Labs of misleading investors about its XRP cryptocurrency. A key question in that case is whether XRP is a security. The case may provide additional insight into which tokens will be considered securities.

Barbadoro’s ruling will be particularly relevant to tokens that have attributes of use or consumption, Daugherty said. But that “seems to be irrelevant for highly decentralized protocols” and tokens managed by decentralized autonomous organizations, or DAOs, he said.

“In these cases, there is no central person or group that token buyers are dependent on to generate profits,” said Daugherty, who also teaches digital assets at Cornell Law School. “Highly decentralized protocols and tokens, Bitcoin being the leading example, are not securities.”