SEC v. LBRY: Is It Time for Blockchain Networks to Register Their Native Tokens? | Husch Blackwell LLP
The New Hampshire District Court recently granted summary judgment in favor of the Securities and Exchange Commission (SEC) in SEC v. LBRY, Inc., concluding that the original token of the blockchain protocol and network developed by LBRY, Inc. is a security. The decision has opened the door for digital currencies to be classified as securities under the Securities Act of 1933, despite their usefulness as a method of exchange as with fiat currencies.
In 2015, LBRY began to create and develop its network for accessing and publishing videos, images and other digital content. LBRY intended to create a decentralized publishing platform with the content owned by the users. After an initial funding through traditional venture capital methods, LBRY began the sale of its tokens to the public market. LBRY first presented its tokens as a way to interact with its software, including compensation for miners, publishing content and access to exclusive content; However, in limited public and private communications, LBRY described the rapid growth in value of its tokens and tied the future of LBRY and, in turn, the network to the value of its tokens. The SEC argued—and the court ultimately agreed—that LBRY offered and sold “investment contracts” when buyers purchased tokens, largely because of the way LBRY had offered and sold its tokens to consumers.
The SEC filed an enforcement action in March 2021, claiming that LBRY’s unregistered offering of its tokens violated Sections 5(a) and (c) of the Securities Act. In the SEC’s motion for summary judgment, it argued that the sale of LBRY’s tokens was an investment contract under the Supreme Court’s Howey test. In defense, LBRY argued (1) its tokens were not securities because they functioned as a digital currency that served key functions of the LBRY platform rather than as an investment contract and (2) a due process violation because the SEC did not give LBRY fair notice that the offering of tokens was subject to the Securities Act.
In its decision, the court presented the three outliers Howey test: (1) an investment of money (2) in a joint venture (3) with an expectation of profit to be derived from the efforts of the promoter or third party. The first two strikers were not in doubt. At first, buyers paid money in exchange for tokens – an investment of money. Second, the money was invested in a joint venture because LBRY pooled and used the money from the token sale to develop and operate the digital content sharing service they had created. Thus, the court focused primarily on the applicability of the third prong – whether LBRY created a reasonable expectation of profit to those who bought, used, held and sold tokens. To determine whether this expectation was created, the court looked primarily at LBRY’s representations to buyers over the years.
Despite LBRY’s claims to the contrary, the court found the SEC’s argument that LBRY repeatedly represented that it expected the tokens to increase in value to be a determinative factor. For example, the SEC entered into evidence a written statement by an LBRY executive to a potential investor that read: “the opportunity is obvious – buy a bunch of [tokens], put them away safely and hope that within 1-3 years we have appreciated even 10% of how much Bitcoin has in recent years. If our product has the utility we planned, a [token] should appreciate accordingly.” Externally, crypto enthusiasts published articles touting tokens as an investment, and internally LBRY labeled its tokens traders as “investors” and “speculators.” In its token pitch deck aimed at venture capital investors, a slide conveyed that ” 1 of the tokens could be worth $100 or more if LBRY becomes the protocol of choice for media distribution.”
LBRY’s representations of its tokens as an investment opportunity led the court to grant the SEC’s motion for summary judgment, agreeing that the tokens were ultimately an investment contract. This finding means that LBRY’s tokens are subject to the registration and reporting requirements under the Securities Act.
What this means for you
In rejecting LBRY’s due process argument, the Court held that LBRY was given fair notice based on the consistent use and application of Howey test for over 70 years with settled precedent. In other words, it is the responsibility of those offering digital assets to confirm whether their actions require compliance and registration under US securities laws. It is certain that the precedent set in LBRY will reverberate throughout the crypto industry as more industry participants are now on notice and must seek to comply with this new legal precedent.
[View source.]
