In granting the SEC’s motion for summary judgment, a federal court ruled that sales of LBC tokens were securities transactions.

On November 7, 2022, the Securities and Exchange Commission (SEC) prevailed in a motion for summary judgment against blockchain-based streaming and publishing firm LBRY, Inc. The US District Court for the District of New Hampshire (the Court) considered the motion papers and oral argument, determining that with no triable defense, “LBRY offered LBC [LBRY Credits, the protocol’s native token] as a security.” LBRY therefore violated Sections 5(a) and (c) of the Securities Act of 1933 by offering LBC to investors without proper registration.

Key Facts and Findings

The complaint, filed in March 2021, alleged that from at least July 2016 to February 2021, LBRY offered unregistered securities in the form of LBC to consumers, many of which were based in the US. LBRY earned approximately US$12.2 million from such LBC sales.

LBRY put forth two defenses to the complaint. First, LBRY asserted that the LBC token, used to upload files and make payments on the network, “functions as a digital currency that is an essential component of the LBRY Blockchain” and therefore served primarily for use rather than for investment purposes. LBRY argued that as a “utility token,” LBC would not fall under the definition of an investment contract under the US Supreme Court’s Howey test[1] (see this Latham blog post for more information), and thus was not a security. Second, LBRY argued that it, or the market broadly, did not receive sufficient clarity regarding the treatment of various tokens as securities, and therefore it did not receive fair notice that its offering of LBC would be subject to securities laws, which would be a violation of due process.

The Court’s Considerations Under the Howey Test

The Court found neither argument persuasive and granted the SEC’s motion for summary judgment. On LBRY’s first argument — whether LBRY’s offering of LBC was a security — LBRY only disputed one element of Howey: whether token purchasers had a reasonable expectation of profits to be derived from the efforts of others (all other elements were conceded by LBRY). The Court found that LBRY’s offerings of LBC tokens were a form of capital raising to develop and operate the LBRY Network, which led token purchasers to have a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of LBRY. The Court analyzed the LBC sales by reviewing:

• the facts around LBRY’s representations and messages to prospective purchasers on the possibility of token appreciation;
• LBRY’s business model, which aligns LBRY’s and LBC holders’ interests; and
• the speculative uses of the LBC tokens.

The Court highlighted that at the time of the sales, LBC and the LBRY Network still provided very limited utility, and concluded that LBC’s general lack of utility at the time of the sales meant that “LBRY was pitching a speculative value proposition for its digital token.” The Court also noted that mere purchases of LBC for its consumptive use do not preclude transactions involving the token from being securities transactions. The economic reality indicated that the token was frequently promoted and purchased as investment, including in the transactions at issue. As such, the Court found that the offering of LBC constituted an offering and sale of securities under the federal securities laws.

Fair Notice on the Application of Securities Law

Separate from its determination under Howey, the Court also rejected LBRY’s assertion that it did not receive fair notice from the SEC that the securities laws applied to its digital asset offering. The Court stated that the Howey test is “a straightforward [and] venerable Supreme Court precedent that has been applied by hundreds of federal courts across the country over more than 70 years.” The Court concluded that this case, though involving novel technology and somewhat novel facts, did not entail a lack of fair notice. According to the Court, the Howey test is a fact-specific test and does not require a novel interpretation in order to conclude, under the facts, that the sales of LBC created an investment contract (unlike the Upton case that was heavily cited by LBRY).

Other Noteworthy Aspects of the Decision

• The securities offering did not involve an initial coin offering (ICO), but rather a period of ongoing sales between 2016 and 2021. While LBRY attempted to lean on this fact, particularly with respect to its fair notice argument, the Court did not appear persuaded that such a clean distinction could be drawn and that perhaps it was more “a matter of degree rather than kind.” The Court again pointed out that while the LBRY Network was technically functional at the time of the sales (unlike in the SEC’s Telegram and Kik cases), the functionality was highly limited.
• LBRY did not argue that the network was “sufficiently decentralized” and thus sales of the token were not a security for that reason (see here for more information on this topic). As such, neither the SEC nor the Court provided any additional insight into what constitutes “sufficient decentralization” for purposes of a Howey analysis.

With this ruling in hand, the SEC seeks permanent injunctive relief, disgorgement, and civil penalties. LBRY may appeal the decision.

Critical Takeaways for Industry Participants

The decision granting the SEC’s summary judgment holds the forceful view that “no reasonable trier of fact could reject the SEC’s contention that LBRY offered LBC as a security.”

Some key takeaways from this Court’s application of Howey to digital assets include:

• Mere utility may not suffice to prevent a token from becoming a security. If a token offers the potential for speculation and if at least a significant portion of the purchases or activity involving the token serve investment purposes, sales of such tokens by its creator may be considered securities transactions.
• Statements touting the growth potential or actual growth in a token’s value, whether via email, blog posts, social media, interviews, etc., create additional risk that a token offering will be viewed as a security.
• Disclaimers may not override the objective economic realities of a transaction.

Wider Ramification of the Ruling

Ultimately, this case does not significantly advance the jurisprudence in this area, as utility alone is not a sufficient defense and decentralization continues to be the most promising path for tokens with potential for speculation. The case certainly sets the stage for the highly anticipated ruling in SEC v. Ripple, an ongoing litigation with somewhat similar facts and defenses. In fact, the SEC’s final reply to Ripple’s motion for summary judgment (due by November 30, 2022)[2] might reference the LBRY decision. The Ripple case, likely to result in a decision on summary judgment in the next few months, will certainly be a landmark, whichever way it is decided.

Latham & Watkins will continue to report on developments in this space. 

Endnotes

[1] The Howey test is composed of three prongs: (1) the investment of money; (2) in a common enterprise; (3) with an expectation of profits to be derived solely from the efforts of the promoter or a third party.

[2] Note that the LBRY case was decided in the US District Court for the District of New Hampshire, which is in the First Circuit. The Ripple case is being litigated in the US District Court for the Southern District of New York, which is in the Second Circuit. Federal circuit court decisions are not binding precedent on any other federal circuit or district court outside of its jurisdiction, and a district court in one jurisdiction is certainly not binding on a circuit or district court in another. However, the SEC will likely trumpet the LBRY decision as persuasive precedent.