The United States District Court of New Hampshire recently released its decision in Securities and Exchange Commission v. LBRY, Inc. This case carries significance for blockchain communities in that it is the first successful enforcement action by the SEC against an entity that did not raise funds by an initial coin offering or initial token offering.
The central issue in this case was whether LBRY, Inc.’s digital token, LBRY Credits (“LBC”), fit within the definition of a security. The Court sided with the SEC and held that it was.
While this case relates to United States securities laws, the Court’s analysis is worth reviewing from a Canadian perspective, as, given the similarities in securities laws between Canada and the United States, it could be informative as to how Canadian regulators and courts may address a similar situation. The Court’s decision provides a clear example of a position a regulator may take in response to the sale of tokens by a centralized entity in a blockchain ecosystem, even if the tokens sold have demonstrable utility on the blockchain.
LBRY was founded in 2015 with the goal of utilizing blockchain technology to allow users to share videos, images, and other digital content without a centralized host like YouTube. LBC are the native digital token of the LBRY blockchain; they are used to compensate miners and can be spent on the blockchain to publish content, create channels, tip content creators, purchase paywall content, and boost channels or content in search results.
The LBRY network was designed to eventually have 1 billion LBC in circulation. LBRY reserved a “pre-mine” of 400 million LBC for itself to spend on spreading usage and adoption of the token, setting up grants and donations to organizations that shared LBRY’s values, and operational expenses. At the time of the Court’s decision, LBRY had spent approximately half of its pre-mined LBC through various transactions. It had sold more than 9.8 million LBC to the public directly through LBRY applications and another 44.1 million LBC through digital asset trading platforms. It has also used more than 142 million LBC to incentivize users, software developers and testers, and compensate employees and contractors.
The SEC alleged that LBRY Inc. offered and sold unregistered securities in violation of the Securities Act of 1933. LBRY’s defense was that it did not need to comply with the Act because the alleged security, LBC, was not a security at all. Instead, LBRY argued that LBC functions as a digital currency, with demonstrable utility as an essential component of the LBRY blockchain.
The SEC was successful in obtaining a summary judgement against LBRY, with the Court stating “no reasonably trier of fact could reject the SEC’s contention that LBRY offered LBC as a security.”
In reaching its decision, the Court first looked to define “security.” Similar to the investment contract test for a security in Canada, the ‘Howey test’ in the United States indicates that a product is an investment contract (and therefore a security) if a person invests their money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. The Court noted that under the Howey test, courts are to conduct an objective inquiry into the character of the instrument or transaction offered based on what the purchasers were led to expect.
One key factor in the Court’s decision related to the representations LBRY made to the public about LBC. The SEC pointed to multiple statements made by LBRY which it claimed “led potential investors to reasonably expect that LBC would grow in value as the company continued to oversee the development of the LBRY network.” For example, following the LBRY network’s expedient growth after its launch, LBRY released a blog stating “the long-term value proposition of LBRY is tremendous, but also dependent on our team staying focused on the task at hand: building this thing” and “over the long term, the interests of LBRY and the holders of LBC are aligned.”
When LBRY pointed out that these statements only represent 0.25% of all its posts and messages, the Court rejected this argument, noting that LBRY was “acutely aware” of LBC’s potential value as an investment and calling its overall messaging a “not-very subtle form of economic inducement” to investors. In response to LBRY’s attempt to rely on disclaimers it had made to investors to indicate the company was not offering LBC as an investment, the Court minimized their importance amidst the other evidence at hand, stating “a disclaimer cannot undo the objective economic realities of a transaction.”
Another important element of the Court’s decision focused on the fact that LBRY retained a significant number of the tokens for itself, which was considered a signal that LBRY was motivated to expend efforts to improve the network and increase the value of LBC. The Court reasoned that, “by intertwining LBRY’s financial fate with the commercial success of LBC, LBRY made it obvious to its investors that it would work diligently to develop the Network so that LBC would increase in value” and that they too would profit from LBRY’s efforts to improve the network. Under the Howey test, these activities supported the conclusion that an investment in LBC was an investment in a common enterprise that gained profit potential from LBRY’s efforts.
An essential aspect of LBRY’s argument was that LBC was a utility token designed to be used on the LBRY blockchain and that some purchasers of LBC acquired it with the intention of using it rather than for holding it as an investment. Significantly, the Court held that “LBRY is mistaken about both the facts and the law” on this point since “nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract.” The Court further held that it is essential to focus on what purchasers were offered and not their subjective intentions in relation to how the would use the tokens.
Based on the evidence provided, the Court ultimately concluded that LBRY promoted LBC as an investment that would grow in value over time through the company’s development of the LBRY network.
An essential takeaway from the LBRY decision is the clear proclamation that securities registration requirements will not be limited to blockchain networks that engaged in an ICO or ITO. In its conclusion on the security analysis the Court remarked “LBRY does not point to any specific statement by the SEC suggesting that companies need only comply with the registration requirement if they conduct an ICO. Nor does LBRY offer any persuasive reading of Howey that would cause a reasonable issuer to conclude that only ICOs are subject to the registration requirement.”
In addition to making history on this first point, the LBRY decision presents what, in our view, could be a notable problem for many blockchain projects as the role of considering whether or not a digital token has utility has been significantly reduced in the analysis of whether sale of such a token constitutes a sale of a security. The Court was clear that indications that some LBC holders purchased LBC for consumptive purposes is of limited relevance in determining whether LBRY offered it as a security. Instead, this decision suggests that where there is a central developer or promoter invested in developing a blockchain network and that entity sells tokens to the public, these facts are adequate to conclude that an unregistered distribution of securities has occurred in violation of the 1933 Act.
Finally, LBRY is a general reminder that an assessment of whether a token is a security (whether under the Howey test or Canadian law) looks at all the facts at hand. Developers cannot rely on non-investment disclaimers as a ‘Plan B’ to avoid responsibility when other evidence suggests a token is simultaneously being marketed to the public as something that will gain value as a result of the developer’s expenditures and efforts.
Given these developments south of the border, Canadian blockchain enthusiasts and platforms are no doubt interested to see what impacts LBRY may have in Canada. Whether Canadian regulators and courts will choose to take a different approach than the SEC and District Court in LBRY remains to be seen.