“We lost. Sorry everyone”: The Implications of a District Court Finding Digital Token, LBC, Is a Security

Crypto litigation, fueled by a surge of investors and market volatility, has ballooned in recent years. For example, numerous securities class actions and government subpoenas followed the May 2022 collapse of the $60 billion Terra network, along with stablecoin TerraUSD and the LUNA token. The following month, the U.S. Department of Justice announced enforcement actions in connection with a NFT scheme. Just last week, a major cryptocurrency exchange filed for bankruptcy. According to one study, the crypto industry has generated more than 200 class action lawsuits and other private litigations as of May 2022, a 50% uptick since the start of 2020.[1]

One oft-repeated question adding to the volatility of the crypto space has been who should regulate it. In that vein, the U.S. Securities and Exchange Commission (“SEC”), the U.S. Commodity Futures Trading Commission (“CFTC”), as well as state agencies such as the New York Department of Financial Services, have attempted to impose regulations. Which government entity is legally authorized and best situated to regulate the crypto space comes down to whether tokens, stablecoins, NFTs, and related products are deemed securities under the federal securities laws or commodities under the Commodity Exchange Act. Whether crypto-products are securities under the U.S. Supreme Court’s Howey test, such that they fall within the purview of the SEC, or a commodity, subject to CFTC regulation, remains unclear.

In holding that the digital token LBC qualifies as a security under the federal securities laws, a recent decision by the United States District Court for the District of New Hampshire bolsters the SEC’s authority to regulate the crypto industry. See SEC v. LBRY, Inc., 2022 U.S. Dist. LEXIS 202738 (D.N.H. Nov. 7, 2022). The SEC’s complaint asserted that LBRY, a decentralized content distribution service where users can share fully encrypted videos, images, and other digital content using blockchain technology, violated Sections 5(a) and 5(c) of the Securities Act of 1933 in offering and selling unregistered LBC tokens, designed to be used on the LBRY network. In granting summary judgment in the SEC’s favor and denying LBRY’s cross-motion for summary judgment, the district court rejected LBRY’s arguments that (i) it did not need to comply with the Securities Act because the token it offered was not actually a security; and (ii) the SEC did not violate LBRY’s right to due process.

Judge Barbadoro began his analysis by emphasizing that, when Congress adopted the Securities Act in 1933, “it enacted a definition of ‘security’ sufficiently broad to encompass virtually any instrument that might be sold as an investment.” Id. at *8. Under the U.S. Supreme Court’s Howey test, a security is evident when the following factors are present: “(1) the investment of money (2) in a common enterprise (3) with an expectation of profits to be derived solely from the efforts of the promoter or a third party.” Id. at *9. See also SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The LBRY case centered on whether the economic realities surrounding LBRY’s offerings of LBC led investors to reasonably expect that purchasing LBC tokens represented an investment opportunity. Ultimately, the court found that it did.

Despite the intricacies that characterize cryptocurrency, Judge Barbadoro provided a straightforward analysis under Howey. First, Judge Barbadoro pointed to LBRY’s representations concerning the growth potential of LBC tokens, including an email from a LBRY executive to a potential investor, stating: “[the] opportunity is obvious . . . buy a bunch of credits, put them away safely, and hope that in 1-3 years we’ve appreciated . . . .” Id. at *11. Other examples included communications on Reddit from users “trying to do [their] research before putting in [their] money.” Id. at *13. Collectively, the district court found LBRY’s statements to be representative of its overall messaging such that “potential investors would understand that LBRY was pitching a speculative value proposition for its digital token.” Id. at *16. That the statements identified by the SEC constituted less than 1% of LBRY’s posts was irrelevant. Id. at *14. Second, Judge Barbadoro found that LBRY’s business model itself bolstered the notion that LBC was a security. The court explained that not only did a “reasonable purchaser” understand that “the tokens being offered represented investment opportunities” but also “by retaining hundreds of millions of LBC for itself, LBRY . . . signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any LBC purchasers.” Id. at *19. According to Judge Barbadoro, this structure informed purchasers of LBC “to expect that they too would profit from their holdings of LBC as a result of LBRY’s assiduous efforts.” Id.

In its defense, LBRY argued that as a utility token, some purchased LBC with the intention of using it on the LBRY Network, rather than holding it as an investment. Id. at *20. Judge Barbadoro rejected this position, explaining no case law suggests this precludes the token from being an investment contract. Id. LBRY also argued that it should not be liable under the federal securities laws for an unregistered offering, because it did not receive “fair notice” that LBC would be subject to the federal securities laws as until this action, the SEC focused its registration requirements on initial coin offerings. Id. at *21-22. Judge Barbadoro rejected this argument, noting that the Howey test is “straightforward” and has been applied hundreds of times over 70 years, and thus, LBRY was “in no position to claim that it did not receive fair notice that its conduct was unlawful.” Id. at *24.

The ruling in SEC v. LBRY represents a fundamental and significant win for the SEC. Additionally, the holding is likely to encourage additional SEC actions, as it confirms that at least some tokens—even utility tokens—may be classified as securities rather than commodities. The decision appears consistent with the 2020 decision in SEC v. Kik Interactive Inc., in which a district court granted summary judgment in the SEC’s favor, finding that digital Kin tokens offered by messaging application, Kik Interactive, were securities under the Securities Act. 492 F. Supp. 3d 169 (S.D.N.Y. 2020) (granting summary judgment in favor of the SEC which asserted claims against Kik Interactive arising from an unregistered initial coin offering, where executive touted “if you set some [Kin] aside for yourself at the beginning, you could make a lot of money”). It also appears consistent with the 2019 decision in Balestra v. ATBCOIN LLC, where the district court denied defendants’ motion to dismiss and held that private plaintiffs could pursue their securities class action against ATBCOIN in connection with an unregistered initial coin offering. 380 F.Supp.3d 340 (S.D.N.Y. 2019). There, the district court found plaintiffs plausibly alleged that “potential profits stemming from the future valuation of the ATB Coins [] w[ere] entirely reliant on the success of Defendants’ new blockchain[,]” and “purchasers of ATB Coins reasonably believed that those coins would increase in value based primarily on Defendants’ entrepreneurial and managerial efforts.” Id. at 354-55 (internal quotation marks omitted).

Despite these favorable rulings for the SEC, whether the agency has jurisdiction over all aspects of the crypto space is not a foregone conclusion. The victory in SEC v. LBRY comes one year after a federal jury in Connecticut found that crypto-mining products, known as hashlets, were not securities, despite the SEC’s insistence to the contrary. Audet v. Fraser, 16-cv-00940-MPS, ECF No. 330 (D. Conn. Nov. 1, 2021) (jury finding hashlets are not securities); SEC v. Garza, No. 15-cv-1760, ECF No. 1 ¶¶ 79, 85, 91 (D. Conn. Dec. 1, 2015). Additionally, CFTC Chair Rostin Behnam continues to reiterate that Bitcoin and Ether are commodities; although SEC Chair Gary Gensler has expressed contrary views.[2] At least some members of Congress appear to be in favor of CFTC regulation evidenced by the pending Digital Commodities Consumer Protection Act.[3] And currently, in the absence of any clear division of labor, both agencies are actively pursuing violations of crypto players.

Regardless of the confusion surrounding who will be regulating this space, in light of the victory in SEC v. LBRY, we can expect the SEC will continue to pursue perceived violations under the federal securities laws in matters involving cryptocurrency. This expectation is bolstered by SEC Chair Gensler’s stated view that the vast majority of digital tokens are securities that fall under the SEC’s purview.[4] Moreover, the types of SEC actions against entities in the crypto space continue to grow. In addition to claims brought under the Securities Act for unregistered offerings, the SEC has brought a plethora of other claims, including but not limited to claims in connection with insider trading of crypto assets, claims in connection with crypto Ponzi schemes, and claims in connection with celebrities’ failures to disclose payments received for promoting cryptocurrencies. In addition to encouraging further SEC regulation in the crypto space, the decision in SEC v. LBRY may give fodder to private securities plaintiffs, many of whom have already begun to assert traditional federal securities class actions involving cryptocurrency. With several SEC and federal securities class actions pending, many of which have forthcoming decisions on motions to dismiss, we will continue to watch this space.