The Securities and Exchange Commission has been successful in bringing an enforcement action against LBRY Inc. for offering and selling unregistered securities in the form of its cryptocurrency ‘LBRY Credits’ or ‘LBC’.
In this article, we examine the enforcement action and why LBC was considered by the US District Court to be a security investment despite its purported consumptive uses on LBRY’s content platforms, and the absence of a related Initial Coin Offering.
LBRY protocol and LBC
LBRY Inc. developed the LBRY protocol, a decentralised file-sharing and payment network which uses blockchain and BitTorrent technology. The LBRY protocol powers decentralised platforms which allow creators to record digital content to the decentralised LBRY blockchain. The value proposition of the protocol is that it allows anyone to share content which cannot be deleted or moderated. LBRY Inc. also maintains a Bitcoin-like cryptocurrency called ‘LBRY credits’ or ‘LBC’.
Creators on the LBRY platforms can monetise their content and earn LBC by charging or earning tips from viewers who consume their content. This model is similar to platforms such as YouTube, Instagram, and Spotify, where creators too monetise their content through third-party advertising. Much like Bitcoin, miners who validate transactions on the LBRY protocol, including publications of content as well as financial transactions, are compensated with LBC.
The enforcement action
The Securities Exchange Commission (SEC) filed an enforcement action in a US District Court against LBRY Inc. because it considered that LBRY Inc. offered and sold unregistered securities in violation of the Securities Act.
Under section 5 of the Securities Act of 1993, all issuers of most securities must register their securities with the SEC.
As part of the enforcement action, the SEC sought injunctive relief, disgorgement, and civil penalties. This was the first case where the SEC alleged registration violations against an issuer of digital tokens that did not conduct an Initial Coin Offering (ICO).
In bringing the enforcement action under the Securities Act against LBRY Inc., the threshold issue for the SEC to overcome was to demonstrate that LBC token was in fact a ‘security’ which needed to be registered and therefore subject to the Securities Act.
The SEC argued that LBC was a security because LBRY made multiple statements online and adopted a business model which created a reasonable expectation in investors that LBC would grow in value and lead to profits for those investors.
LBRY Inc. contended that LBC was not a ‘security’ and therefore did not require registration under the Securities Act, because LBC was not intended for investment purposes, rather it was intended to function as a commodity.
LBRY Inc. also argued that it was not given fair notice that LBC were subject to securities laws because it was the first time the SEC brought an enforcement action against an issuer of tokens that had not conducted an ICO. According to LBRY Inc., the SEC has historically and consistently focused its guidance and enforcement efforts exclusively on the issuance of assets in the context of an ICO.
The Court’s findings
The US District Court applied the three-part ‘Howey Test’, to determine whether certain financial assets are securities. The test determines that a financial asset is a security if the following can be satisfied:
- there is an investment of money;
- in a common enterprise;
- with an expectation of profits to be derived solely from the efforts of the promoter or a third party.
Part 1 (the investment of money) and part 2 (a common enterprise) were not in dispute.
As for part 3, the Court decided that the characteristics pertaining to LBRY Inc.’s offerings of LBC led investors to have ‘a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others’. These characteristics included the two we have set out below.
- LBRY Inc. made statements to potential purchasers of LBC in blog posts, email, and social media, speculating on the token’s growth potential. The Court considered that these amounted to an ‘economic inducement’ through an ‘expectation of profits’.
- Even if no explicit statements had been made to potential investors by LBRY Inc., any reasonable investor who was familiar with LBRY Inc.’s business model would have had an ‘expectation of profits’. Part of this model was that LBRY Inc. had retained hundreds of millions of ‘pre-mined’ LBC for itself to fund continued development of the LBRY protocol. The Court considered that by doing so, LBRY Inc. intertwined the LBRY protocol’s financial fate with the commercial success of LBC and signalled that it was motivated to work to improve the value of its blockchain for itself. This led LBC purchasers to expect that they too would profit from their holdings of LBC because of LBRY Inc.’s efforts.
The Court considered that it was of limited relevance that some purchasers of LBC acquired it with the intention of using it rather than holding it as an investment, because nothing in the case law suggests that a token with both consumptive and speculative uses cannot be sold as an investment contract. The Court elaborated that ‘while the subjective intent of the purchasers may have some bearing on the issue of whether they entered into investment contracts, we must focus our inquiry on what the purchasers were offered or promised’.
Moreover, the Court rejected LBRY Inc.’s arguments that they were not given fair notice, because there was nothing to suggest that companies only need to comply with the registration requirement if they conduct an ICO. The Court also commented that ‘while participation in an ICO may be relevant to the analysis [in relation to the Howey test], it will not determine the outcome in a case like this, where the undisputed evidence leaves no doubt that LBRY offered and sold LBC as a security’.
What does this mean?
The SEC’s enforcement action against LBRY may signal a more aggressive push to regulate cryptocurrencies. The action demonstrates that companies offering tokens need to exercise caution when promoting the sale of coins without determining whether securities laws apply to them.
Companies in the US should be aware that coins offered without an ICO or which have a utility function are not necessarily exempt from securities laws. The LBRY action provides some guidance as to what facts courts may look at in determining whether a coin is a security.
It may also foreshadow the result of the SEC’s separate enforcement action against Ripple Labs Inc. for selling similar unregistered securities.
In Australia, it is likely that a similar outcome would have eventuated had ASIC taken action and claimed that LBRY was operating a managed investment scheme.
This article was written with the assistance of Max Ding, Law Graduate.