By Rodney F. Tonkovic, J.D.
In a ruling that may have significant ripple effects, a district court concluded that LBRY, Inc.'s digital token was offered as a security. The Commission charged LBRY, a digital content provider using blockchain, with conducting an unregistered offering of digital asset securities called LBC. Both parties moved for summary judgment and the court found in favor of the SEC, concluding that the record showed that LBC was promoted as an investment that would grow through the company's efforts. No reasonable trier of fact would reject the SEC's contention that LBC was offered as a security, the court said (SEC v. LBRY, Inc., November 7, 2022, Barbadoro, P.).
LBRY, Inc. used blockchain technology to allow users to share digital content, such as videos or images, without a centralized host. The company bills itself as "the first decentralized, open-source, fully encrypted content distribution service built using the same blockchain technology that underlies Bitcoin." LBRY uses a native digital token called LBRY Credits (LBC) to compensate miners, but LBC can also be spent to publish or purchase content or create channels within the LBRY Network. When LBC launched in June 2016, LBRY reserved 400 million LBC for itself.
In March 2021, the SEC charged LBY with failing to register a securities offering. According to the complaint, starting in 2016, LBRY offered and sold over 13 million LBC to investors, purportedly to fund its business and build its network. The Commission argued that LBC were offered and sold as investment contracts and, therefore, securities because the money raised was pooled in a way that the fortunes of LBC holders were intertwined with those of other holders, including LBRY itself. And, LBC holders expected a return on their investments based on LBRY's entrepreneurial or managerial efforts. The SEC seeks injunctive relief, disgorgement of money obtained through the offerings, and civil penalties.
The parties filed cross-motions for summary judgment: the SEC argued that LBRY sold unregistered securities, while LBRY contended that LBC is not a security and also that it had no notice that its offerings are subject to the securities laws. The court concluded that LBC is an investment contract and that LBC had received fair notice.
Is LBC a security? The court found that LBRY's offerings of LBC established that it was offering it as a security. First, the court noted that the SEC identified multiple statements leading potential investors to reasonably expect that LBC would grow in value—LBRY's overall messaging was about LBC's growth potential. LBRY, the court said, was "acutely aware of LBC’s potential value as an investment. And it made sure potential investors were too." In the First Circuit, such "economic inducement" is evidence of Howey's "expectation of profits;" this was the only part of the Howey test in dispute.
Even if LBRY never spoke to LBC's growth potential, the court continued, any reasonable investor familiar with its business model would have understood that LBC was expected to grow through LBRY's efforts. From the start, LBRY's profitability turned on its ability to grow LBC through increasing usage of the LBRY Network. Moreover, the fact that LBRY retained hundreds of millions of LBC for itself signaled that it was motivated to improve the value of its blockchain, the court said.
LBRY responded that some purchasers acquired LBC for consumptive, rather than speculative uses. The court rejected this argument, stating that nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract. In sum, the evidence showed that LBC was promoted as an investment that would grow over time through the company's development of the LBRY Network—the economic realities established that LBRY was offering LBC as a security.
Fair notice. LBRY argued further that it did not receive fair notice that its offerings were subject to the securities laws. In support of this argument, the company posited that the SEC has only attempted to enforce the registration requirement against an issuer of digital tokens in the ICO context. But, LBRY failed to point out any SEC statement or reading of Howey suggesting that only ICO's are subject to the registration requirement. The SEC based its claim on venerable Supreme Court precedent, the court said, and "LBRY is in no position to claim that it did not receive fair notice that its conduct was unlawful."
Ripple effects. While this case is from a district court in the First Circuit, the ruling may have some impact on other pending litigation concerning digital asset securities. In 2020, the Commission hit Ripple Labs with an enforcement action alleging that the crypto giant raised over $1.3 billion through unregistered sales of a digital asset called XRP. Like LBRY, Ripple maintains that XRP was not sold as an investment. Unlike the LBRY case, the Ripple action hinges on whether XRP was promoted as an investment in a common enterprise. When last before the Southern District of New York, the court granted summary judgment in favor of the SEC, finding that the allegations plausibly showed that the individual defendants viewed XRP as an investment and promoted it as an investment in a common enterprise. Unlike LBRY, the court allowed Ripple's fair notice defense.
The case is No. 21-cv-260.