A federal judge’s decision that LBRY Inc.’s digital token sales violated US securities law gives the SEC momentum in policing the burgeoning market and emboldens regulators to push the boundaries.
A New Hampshire federal court this week sided with the Securities and Exchange Commission’s argument that LBRY should have registered its “LBRY Credits” with the agency before selling them because they are securities.
Whether a crypto asset is a securities product, under the SEC’s oversight, is an ongoing debate, although the agency believes many digital assets have the hallmark of a security. The Nov. 7 ruling is among a handful of recent court decisions that side with the SEC, lending support to its view.
“It’s a win for the SEC,” Kesselman Brantly & Stockinger LLP attorney Abiel Garcia said of the decision. “It’s what they’ve been signaling for the past two, three years in terms of where they’re heading.” The SEC likely will be pointing to the decision in cases going forward, he said.
LBRY said on its verified Twitter account that the ruling “sets an extraordinarily dangerous precedent that makes every cryptocurrency in the US a security.”
Legal scholars and attorneys were more circumspect, saying that whether a digital asset is a security will be a case-by-case analysis. But the way that the court applied the so-called Howey Test—derived from a 1946 Supreme Court ruling—to determine whether something is a security could sweep in a number of cryptocurrencies, various attorneys said.
“What it confirms is that the SEC and federal district courts are in agreement about how the Howey Test is going to be applied to digital assets,” Barnes & Thornburg LLP attorney David Slovick said.
Howey Test
LBRY raised more than $11 million through sales of its digital tokens, LBRY Credits, according to the SEC. The sales amounted to unregistered securities offerings, the agency said.
LBRY raised the money to help develop its network, which allows people to publish digital content, the SEC said.
The Howey Test considers whether there was an investment of money in a common enterprise, with an expectation of profits derived from others efforts. LBRY’s case focused on the final consideration.
LBRY argued that, unlike some other crypto companies the SEC has targeted, it didn’t tout LBRY Credits as a “get-rich-quick” investment opportunity. The tokens were a currency that content creators could use on the LBRY network, the company said.
In a May filing, it called the SEC’s suit a “stunning and unprecedented overreach” that could stifle innovation by suggesting that “no token is outside of the Commission’s reach.”
Judge Paul Barbadoro in the US District Court for the District of New Hampshire didn’t buy LBRY’s argument.
LBRY was “acutely aware” of the token’s potential value as an investment, and made no secret in communications with potential investors—including on forums like Reddit—that it expected LBRY Credits to grow in value, Barbadoro said.
The company also kept millions of tokens for itself, issuing them to its workers as “compensation incentives,” the SEC alleged. Barbadoro said this signaled to investors that LBRY was “motivated to work tirelessly to improve the value of its blockchain for itself” and token purchasers.
“In other words, the retained stake would be understood by purchasers that the latter could rely upon the former to create profits for all of them,” said Patrick Daugherty, head of digital assets at Foley & Lardner LLP. “The court did not cite any legal precedents for this opinion, perhaps because there are none.”
The facts that Barbadoro pointed to as being problematic for LBRY are prevalent in a number of cryptocurrency projects, some attorneys said.
The key for crypto projects is to “adopt a different approach,” said James Gatto, who leads the blockchain and fintech team at Sheppard Mullin Richter & Hampton LLP. “So many people don’t do it, they just follow what everyone has done.”
More Ammunition
The SEC has ramped up enforcement action in the crypto space. In May, the agency nearly doubled the size of its Crypto Assets and Cyber Unit to 50 positions, the SEC said.
Barbadoro’s ruling will bolster the agency’s confidence, and give it impetus to push the boundaries of its authority, attorneys said.
The ruling can serve as a precedent that the SEC can use. It also has an “in terrorem effect—something they can point to when reaching out to organizers of other token-based enterprises to say, ‘You can’t do this’ or ‘You need to do it this way,’” University of Georgia law professor Usha Rodrigues said.
One focus of SEC enforcement actions has been crypto companies’ statements that the value of the token is expected to appreciate.
“That seems to be an important part of the judge’s analysis” in LBRY’s case, BakerHostetler LLP attorney Teresa Goody Guillén said.
The SEC is in the midst of litigating another closely watched case that accuses Ripple Labs of misleading investors about its XRP crypto token. A central question in that case is whether XRP is a security. The case could provide additional insights about what tokens will be considered securities.
Barbadoro’s ruling will be especially relevant to tokens that have characteristics of use or consumption, Daugherty said. But it “would appear to be irrelevant to highly decentralized protocols” and tokens managed by decentralized autonomous organizations, or DAOs, he said.
“In those cases, there is no central person or group upon which token purchasers rely to generate profits,” said Daugherty, who also teaches about digital assets at Cornell Law School. “Highly decentralized protocols and tokens, Bitcoin being the leading example, are not securities.”
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