Early posts in this blog mentioned how former U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton famously told Congress in February 2018 that “I believe every ICO I’ve seen is a security.” His successor, current SEC Chairman Gary Gensler, has said on multiple occasions (for example, here) that he believes the vast majority of digital tokens are securities. In a decision issued on November 7, 2022, U.S. District Judge Paul J. Barbadoro held that LBRY, Inc.’s blockchain token, LBC, is indeed a security.
The SEC sued LBRY on the ground that it offered and sold unregistered securities in violation of Section 5 of the Securities Act of 1933. LBRY responded that it did not need to comply with the Securities Act because its alleged security, the LBC token, was not a security. Rather, according to LBRY, LBC functioned as a digital currency that is an essential component of the LBRY Blockchain. The token was not a security because it was not offered as an investment opportunity in LBRY’s platform but, instead, was meant to be used by content creators and audience members on its “content marketplace” that bills itself as an alternative to YouTube.
The test to be applied to determine if something is a security is the well-established Supreme Court decision in Howey. The First Circuit has broken the Howey test into three parts: “(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.” Here, only the third component of the Howey test was in dispute. Thus, the issue to be decided was whether the economic realities surrounding LBRY’s offerings of LBC led investors to have “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
The court offered a number of reasons for answering that question in the affirmative. When LBRY launched the LBRY Network in June 2016, LBC’s market capitalization was $140 million. This, despite the Network’s relative infancy and limited usability. By the following month, LBC’s market capitalization had ballooned to $1.2 billion. In response, LBRY issued a blog post reflecting on LBC’s skyrocketing value.
In August 2016, the COO of LBRY emailed a potential investor and said, “buy a bunch of credits, put them away safely, and hope that in 1-3 years we’ve appreciated even 10% of how much Bitcoin has in the past few years.” The judge also referred to a Reddit thread and other public statements from LBRY executives that linked the financial viability of its LBRY platform to the profitability of LBC.
The court said that any reasonable investor who was familiar with the company’s business model would have understood that it expected LBC to grow in value through its managerial and entrepreneurial efforts, meaning that investors were relying on — in the words of Howey — profits to be derived solely from the efforts of a third party. Further, by retaining hundreds of millions of LBC for itself, LBRY also signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any LBC purchasers. This structure, which any reasonable purchaser understood, led purchasers of LBC to expect that they too would profit from their holdings of LBC as a result of LBRY’s assiduous efforts.
The court concluded that, for all of the above reasons, LBRY promoted LBC as an investment that would grow in value over time through the company’s development of the LBRY Network. While some unknown number of purchasers may have acquired LBC in part for consumptive purposes, this did not change the fact that the objective economic realities of LBRY’s offerings of LBC established that it was offered as a security. Because, according to the court, no reasonable trier of fact could reject the SEC’s contention that LBRY offered LBC as a security, and LBRY had no triable defense that it lacked fair notice, summary judgment was granted in favor of the SEC
In response to the decision, LBRY posted the following on Twitter: “The language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the US a security, including Ethereum.”