In a case watched by companies that have offered and sold digital assets1 Federal District Court Judge Paul Barbadoro recently entered summary judgment for the Securities and Exchange Commission (“SEC”) against LBRY, Inc.2 This case is seen by some as a canary in the coal mine in that the ruling supports the SEC’s view espoused by SEC Chairman Gary Gensler that nearly all digital assets are securities that have been offered and sold in violation of securities laws.3 For FinTech companies hoping to avoid SEC enforcement action, the LBRY ruling strongly suggests that all companies offering digital assets could be considered by courts to satisfy the Howey test for securities of investment contracts.4
LBRY is a company that has promised to use blockchain technology to allow users to share videos and images without the need for third-party intermediaries like YouTube or Facebook. LBRY offered and sold LBRY credits, called LBC tokens, which would compensate participants in their blockchain network and be spent by LBRY users on things like posting content, tipping content creators, and purchasing content. paywall content. At launch, LBRY had pre-mined 400 million LBC for itself, and approximately 600 million LBC would be available in the future to compensate miners. LBRY spent about half of the 400 million LBC tokens on various activities, such as direct selling and using the tokens to incentivize software developers and software testers.
Judge Barbadoro found at law (that is, no reasonable jury could find otherwise) that the LBC tokens were securities under Section 5 of the Securities Act. Apply the Howey test, Judge Barbadoro noted that the only part of the Howey test that was challenged in the case was: did investors buy LBC tokens “in the expectation that profits would come solely from the efforts of the promoter or a third” ? Judge Barbadoro answered resoundingly: “Yes”.
The most important elements for his conclusion that investors bought LBC tokens with the expectation of profits only due to the efforts of the promoter (i.e. LBRY) were: the numerous statements made by LBRY employees and community representatives regarding LBC’s price and LBC’s trading volume; and numerous statements LBRY has made about the development of its content platform, including how the platform would provide long-term value to LBC holders. Critically, however, Judge Barbadoro found that even if LBRY had made none of these statements, the LBC token would still constitute security because “any reasonable investor familiar with the company’s business model would have understood the connection” between the growth of LBC value and LBRY’s efforts to increase the use of its network. Even though LBRY never said a word about the LBC token, Judge Barbadoro concluded that the LBC token would be a security because LBRY kept hundreds of millions of LBC tokens for themselves, thus signaling to investors that it was committed to working to improve the value of the token.
Judge Barbadoro flatly rejected LBRY’s defense that the LBC token cannot be a security because the token has utility.5 The judge noted, “There is nothing in the case law to suggest that a token for consumption and speculative purposes cannot be sold as an investment contract.” Similarly, Judge Barbadoro was unmoved by LBRY’s argument that he had no “fair notice” that the SEC would treat digital assets as unregistered securities simply because it was the first time the SEC brought an enforcement action against a digital currency issuer.6
In summary, if Judge Barbadoro’s reasoning is applied more broadly to the thousands of digital assets that have emerged over the past few years, including companies touting the so-called “usefulness” of their tokens, they will all likely be considered as digital asset securities that have been offered and sold without registration or an exemption from registration.
The LBRY decision is another case in which a court found that a digital asset is a security. Developers of digital assets should proceed with great caution. The SEC continues to show strong willingness to initiate investigations and enforcement actions against issuers of digital assets considered securities under the Howey and Reeves tests, investment firms or securities swaps .
1 The SEC defines “digital assets” as “intangible assets”[s] this [are] issued and transferred using distributed ledger or blockchain technology. Statement on Issuance and Trading of Digital Asset Securities, Division of Corporation Finance, Division of Investment Management and Division of Trading and Markets, SEC (November 16, 2018), Available here.
2 SEC vs. LBRY, Inc., No. 1:21-cv-00260-PB (DNH filed March 29, 2021), Available here. A copy of the complaint against LBRY can be found here.
3 See, for exampleGary Gensler, Speech – “A ‘New’ New Era: Prepared Remarks Before the International Swaps and Derivatives Association Annual Meeting” (May 11, 2022) (“My predecessor Jay Clayton said it, and I’ll say it again: without prejudging a token, most crypto tokens are investment contracts under the Supreme Court Howey Test. ), available here. Section 5(a) of the Securities Act of 1933 (the “Securities Act”) provides that unless a registration statement is in effect as to a security, it is unlawful for any person, directly or indirectly , to sell securities in interstate commerce . Section 5(c) of the Securities Act provides a similar prohibition against offers to sell or offers to buy securities unless a registration statement has been filed.
4 SEC vs. WJ Howey Co., 328 U.S. 293 (1946). This case did not address when digital assets could qualify as debt securities under the test set out by the U.S. Supreme Court in Reves v. Ernst & Young494 US 56, 66-67 (1990), or where digital assets could qualify as an investment company under the Investment Company Acy of 1940. See, for example, In the Matter of Blockfi Lending, 14 February 2022, Available here. This case also does not address when a digital asset is a security-based swap. See, for exampleIn the Matter of Plutus Financial, Inc., (July 13, 2020), Available here.
5 The argument that a digital asset is not a security because it has a “utility” is one of the favorite arguments of critics of SEC enforcement actions against digital asset issuers. Unfortunately, the “utility” argument seems to have little merit when the digital asset is offered and sold to raise capital.
6 This is an argument that has been made by a number of defendants in SEC enforcement actions involving digital asset securities.
Copyright ©2022 Nelson Mullins Riley & Scarborough LLPNational Law Review, Volume XII, Number 327