It’s official: LBRY’s LBC tokens amounted to securities, a United States federal judge has ruled. As a result, the company’s issue of the LBC tokens amounted to an unlawful unregistered securities offering.
The ruling was in response to a summary judgment application by the Securities and Exchange Commission (SEC), in which it sought to have the case resolved in its favor before trial on the basis that LBRY had no prospect of success in arguing that its LBC tokens did not amount to an unregistered securities offering.
The LBRY network was designed as a blockchain-based content distribution service that was supposedly decentralized. Its LBC token, intended to compensate miners and spend on the LBRY blockchain, was launched in 2016 with a pre-mined issue of 400 million tokens.
The SEC brought an enforcement action against LBRY in 2021, claiming that the company’s offering of LBC amounted to an unregistered securities offering in violation of the Securities Act. According to them, the tokens meet the standard set out in the Howey test and are securities.
Howey, which refers to the 1946 judgment in SEC v W.J. Howey Co establishing the test for determining whether something is an investment contract and, therefore, as a security, is at the center of this ongoing battle to regulate digital assets. The test has three elements:
- There must be an investment of money.
- The investment is made in a ‘common enterprise.’
- The purchaser has a reasonable expectation of profits derived from the efforts of others.
When it comes to digital assets, the first two elements are straightforward and are typically satisfied. Most of the discussion—and most of the legal argument in digital asset securities cases which end up in court—focuses on the third element. There’s usually a reasonable expectation of profits in any digital asset purchase, but is that profit expected to be derived from the efforts of others?
According to an analysis of Howey’s applicability to digital assets published by the SEC, what is relevant is the ‘economic reality’ of the transaction and ‘what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect.’ For example, if there are essential tasks to be performed by an ‘active participant’ as opposed to a decentralized network of users, then this prong of the test is likely to be satisfied.
The SEC argued that LBRY’s offering of LBC tokens amounted to an offering of securities: they said that LBRY represented to the public that the value of LBC would appreciate if the LBRY network grew its functionality and userbase while highlighting the technical prowess and business acumen of its employees. LBRY pitch decks included representations that the value of LBC would reach billions of dollars once LBRY ‘scaled up’ its network. These factors and others, the SEC argued, meant that LBC purchasers had a reasonable expectation of profit based on the work of LBRY, and as such, the LBC tokens are securities.
The court agreed with the SEC’s assessment entirely. The judge found that even if LBRY’s public representation didn’t cause investors to have a reasonable expectation of profits from LBRY’s work (the judge found that they did), LBRY still would have failed because it had chosen to retain hundreds of millions of LBC for itself, signaling that it was motivated to work to improve the value of the LBRY blockchain for itself and any LBC holders.
“LBRY made no secret in its communications with potential investors that it expected LBC to grow in value through its managerial and entrepreneurial efforts. But even if it had never explicitly broadcast its views on the subject, any reasonable investor familiar with the company’s business model would have understood the connection.”
“No reasonable trier of fact could reject the SEC’s contention that LBRY offered LBC as a security, and LBRY does not have a triable defense that it lacked fair notice,” said the judgment.
Reaction
When the case was first filed, LBRY’s founders took the tried-and-true track of accusing the SEC of “taking efforts to suppress the blockchain industry and entrepreneurial operations like LBRY through aggressive lawsuits based on an uneven application of an outdated regulatory scheme from last century,” according to Law360.
Now having lost, LBRY said of the ruling that “the language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the U.S. a security, including Ethereum.”
Similarly, the reaction to the latest judgment from within the industry has been incredulous indignation.
“Bitcoin lawyer” John Deaton, who filed an amicus brief defending Ripple in the SEC’s case against that project, tweeted that the LBRY decision reads as though it was written by the SEC.
Jeremy Kauffman, an LBRY developer, tweeted that “the SEC vs. LBRY case establishes a precedent that threatens the entire U.S. cryptocurrency industry. Under this standard, almost every cryptocurrency, including Ethereum and Doge, are securities.”
But such complaints look somewhat ridiculous given the relative ease with which the federal court agreed with the SEC’s case and the nature of the comments coming from regulators in recent months, which suggest that most digital assets are indeed securities. SEC chair Gary Gensler told Senators late last year that many digital assets currently on the market qualify as securities under Howey, and he warned earlier this year that there are enough securities in the digital asset industry that the chances that any exchange is not dealing in securities are “quite remote.”
Reading between the lines, the outpouring of shock and consternation following the judgment seems to be less about the legal analysis employed by the court and more about what it implies about the rest of the digital asset industry: that it’s chock full of unregistered securities waiting to be brought to task by the SEC.
The likes of Mr. Deaton may complain that the judgment reads as though it was written by the SEC, but that is to be expected and even hoped for if we live in a world where the law is clear and is enforced as such.
If the SEC is successfully enforcing decades-old securities laws against digital asset projects, the answer is not to throw the laws out—the answer is for those projects to become compliant by registering with the SEC and adhering to the rules of the Securities Act, many of which are designed to protect investors.
Effect on XRP
That LBRY lost the case on a summary judgment application will rightly send a chill through anybody following the SEC’s much more well-publicized case against Ripple, where a judge is currently considering a similar application. Much of the public reaction to the LBRY ruling has been framed by that impending Ripple decision, with fear that Ripple’s hopes of prevailing against the SEC are now dead in the water.
Here, LBRY was defending itself against the SEC only on the basis that its LBC offering did not meet the third prong of the Howey test (reasonable expectation of profits derived from the efforts of others). The SEC is accusing Ripple of advertising its token as an investment, took steps to ensure that they could be resold at higher prices on secondary markets, and promised users that it would continue to develop the utility and demand for XRP. As a result, the court’s finding on that prong will certainly play a role in the XRP case (one can already hear the SEC appending the LBRY judgment to its submissions against Ripple).
Further, the court rejected LBRY’s ‘fair notice’ defense, which Ripple is also advancing. In the U.S., an affirmative defense is available where the defendant lacks fair notice that its conduct violated the law; in other words, LBRY and XRP are both arguing that the SEC failed to provide sufficient clarity on where the assets in question were securities. The court in LBRY rejected this:
The SEC has not based its enforcement action here on a novel interpretation of a rule that, by its terms, does not expressly prohibit the relevant conduct. Instead, the SEC has based its claim on a straightforward application of a venerable Supreme Court precedent that has been applied by hundreds of federal courts across the country over more than 70 years.
“While this may be the first time it has been used against an issuer of digital tokens that did not conduct an ICO, LBRY is in no position to claim that it did not receive fair notice that its conduct was unlawful.”
It seems likely that the court in Ripple will be able to dismiss the ‘fair notice’ defense using the same reasoning.
However, though the LBRY ruling will impact the XRP case, it will not be fatal. Unlike LBRY, Ripple is also challenging the SEC on the first two prongs of the test as well as the more contentious third prong. There may be more reason to assume that the court in Ripple will find that XRP met the third prong of Howey, but that would allow Ripple to hope for success on the first two—albeit those are typically less contentious.
As for LBRY, they will now be subject to an injunction preventing the company from continuing to offer and deal with the LBC tokens. They will also be subject to a disgorgement order, meaning that they will have to forfeit the profits made from the offering, as well as be forced to pay additional monetary penalties under the Securities Act.
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