The US District Court in New Hampshire recently published its decision in Securities and Exchange Commission v. LBRY, Inc.[1] This case is significant to the blockchain community in that it is the first successful enforcement action by the SEC against an entity that did not raise money in an initial coin offering or an initial token offering.
The central issue in this case was whether LBRY, Inc.’s digital token, LBRY Credits (“LBC”), fit within the definition of a security. The court joined the SEC in holding that it was.
Although this case concerns US securities laws, the Court’s analysis is worth considering from a Canadian perspective, since, given the similarities in securities law between Canada and the US, it may be informative about how Canadian regulators and courts might address a similar situation. The court’s decision provides a clear example of a position a regulator can take in response to the sale of tokens by a centralized entity in a blockchain ecosystem, even if the tokens sold have demonstrable utility in the blockchain.
The token
LBRY was founded in 2015 with the goal of using blockchain technology to allow users to share videos, photos and other digital content without a centralized host like YouTube. LBC is the native digital token of the LBRY blockchain; they are used to compensate miners and can be used on the blockchain to publish content, create channels, tip content creators, buy paywall content, and boost channels or content in search results.
The LBRY network was designed to eventually have 1 billion LBC in circulation. LBRY reserved a “pre-mine” of 400 million LBC for itself to spend on spreading use and adoption of the token, setting up grants and donations to organizations that shared LBRY’s values and operating expenses. At the time of the Court’s decision, LBRY had spent approximately half of its pre-mined LBC through various transactions. It had sold more than 9.8 million LBC to the public directly through LBRY applications and another 44.1 million LBC through digital asset trading platforms. It has also spent more than 142 million LBC to incentivize users, software developers and testers, and compensate employees and contractors.
The positions
The SEC alleged that LBRY Inc. offered and sold unregistered securities in violation of the Securities Act of 1933. LBRY’s defense was that it did not have to comply with the law because the purported security, LBC, was not a security at all. Instead, LBRY argued that LBC functions as a digital currency, with demonstrable utility as an important component of the LBRY blockchain.
The decision
The SEC was successful in obtaining summary judgment against LBRY, with the court stating that “no reasonable plaintiff could reject the SEC’s claim that LBRY offered LBC as collateral.”
In its decision, the Court first attempted to define “security”. Similar to the investment contract test for a security in Canada, the ‘Howey test’ in the US indicates that a product is an investment contract (and therefore a security) if a person invests his money in a joint venture and is led to expect to profit solely from the effort to the organizer or a third party.[2] The Court noted that under the Howey test, courts must conduct an objective inquiry into the nature of the instrument or transaction offered based on what the purchasers were led to expect.
A key factor in the court’s decision related to the representations LBRY made to the public about LBC. The SEC pointed to several statements by LBRY that it claimed “led potential investors to reasonably expect that LBC would grow in value as the company continued to monitor the development of the LBRY network.” For example, following the LBRY network’s appropriate post-launch growth, LBRY released a blog stating that “the long-term value proposition of LBRY is huge, but also dependent on our team staying focused on the task at hand: building this thing” and “in the long term, the interests of LBRY and the holders of LBC are aligned.”
When LBRY pointed out that these statements represent only 0.25% of all its posts and messages, the court rejected this argument, noting that LBRY was “acutely aware of” LBC’s potential value as an investment and called its general messages a ” not very subtle “form of economic inducement” to investors. In response to LBRY’s attempt to rely on disclaimers it had given to investors to indicate that the company was not offering LBC as an investment, the court minimized their significance amid the other evidence available , stating “a disclaimer cannot undo the objective economic realities of a transaction.”
Another important element of the court’s decision focused on the fact that LBRY kept a significant number of tokens for itself, which was considered a signal that LBRY was motivated to spend efforts to improve the network and increase the value of LBC. The court reasoned that “by entwining LBRY’s financial fate with LBC’s commercial success, LBRY made it obvious to its investors that they would work hard to develop the network so that LBC would increase in value” and that they would also profit from LBRY’s efforts to to improve the network. Under the Howey test, these activities supported the conclusion that an investment in LBC was an investment in a joint venture that derived profit potential from LBRY’s efforts.
An essential aspect of LBRY’s argument was that LBC was a utility token designed to be used on the LBRY blockchain, and that some buyers of LBC bought it with the intention of using it rather than holding it as an investment. Significantly, the court ruled that “LBRY errs on both the facts and the law” on this point since “nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” The court further held that it is important to focus on what buyers were offered and not their subjective intentions in relation to how they would use the tokens.
Based on the evidence presented, the court ultimately concluded that LBRY promoted LBC as an investment that would grow in value over time through the company’s development of the LBRY network.
The impact
An important part of the LBRY decision is the clear statement that securities registration requirements will not be limited to blockchain networks that engaged in an ICO or ITO. In its conclusion on the security analysis, the court noted “LBRY does not point to any specific statement by the SEC suggesting that companies only need to comply with the registration requirement if they conduct an ICO. Nor does LBRY offer any persuasive reading of Howey that would lead a reasonable issuer to conclude that only ICOs are subject to the registration requirement.”
In addition to making history on this first point, the LBRY decision presents what, in our view, could be a notable problem for many blockchain projects, as the role of assessing whether a digital token has utility or not has been significantly reduced in the analysis of whether the sale of such token constitutes a sale of a security. The court was clear that indications that individual LBC holders purchased LBC for consumption purposes are of limited relevance to determining whether LBRY offered it as collateral. Instead, this decision suggests that where there is a central developer or promoter invested in developing a blockchain network and that entity sells tokens to the public, these facts are sufficient to conclude that an unregistered distribution of securities has occurred in violation of 1933 – the law.
Finally, LBRY is a general reminder that an assessment of whether a token is a security (whether under the Howey test or Canadian law) looks at all the facts. Developers cannot rely on non-investment disclaimers as a “Plan B” to avoid liability when other evidence suggests that a token is simultaneously marketed to the public as something that will gain value as a result of the developer’s expenditures and efforts.
Given these developments south of the border, Canadian blockchain enthusiasts and platforms are no doubt interested to see what impact LBRY might have in Canada. Whether Canadian regulators and courts will choose to take a different approach than the SEC and District Court in LBRY remains to be seen.
