Another Victory for the SEC: A New Hampshire Judge Rules That LBRY’s Digital Token Is a Security
Over the past few years, the Securities and Exchange Commission (“SEC”) set its regulatory sights on blockchain digital tokens. And, until recently, the cryptocurrency industry has been marked by record growth and returns for blockchain digital tokenholders. It is likewise unsurprising that cryptocurrency was heralded by many to be the future of investment. Yet, substantial growth without sufficient oversight is often a recipe for disaster. Recent enforcement efforts in this space may change that.
In 2017, the SEC issued the DAO Report, which signaled its intentions to utilize the Securities Act in its regulation of digital tokens. In short, the DAO Report detailed its investigation into a German corporation’s sale of a digital token and the SEC’s ultimate determination that initial coin offerings of digital tokens were securities. The SEC cautioned, “those who would use . . . distributed ledger or blockchain-enabled means of capital raising, [should] take appropriate steps to ensure compliance with the U.S. federal securities law.” The SEC also stated that the “U.S. federal securities law may apply to various activities, including distributed ledger technology, depending on the particular facts and circumstances, without regard to the form of the organization or technology used to effectuate a particular offer or sale.” While the SEC did not take legal action in 2017, its threat of future enforcement was not hollow.
Shortly after the DAO Report, the SEC brought charges against several corporations that sold blockchain digital tokens in an initial coin offerings (ICO). In a press release, the former Co-Director of the SEC’s Enforcement Division, Stephanie Avakian, stated, “We have made it clear that companies that issue securities through ICOs are required to comply with existing statutes and rules governing the registration of securities. . . These cases tell those who are considering taking similar actions that we continue to be on the lookout for violations of the federal securities laws with respect to digital assets.” And, courts appear to agree with the SEC’s characterization of ICOs as securities. In particular, in September 2020, a district court in S.D.N.Y ruled that a public sale of a company called Kik Interactive Inc.’s digital token was a security and required a registration statement. Despite the novel nature of digital tokens, there, the Court applied the Howey test in evaluating whether the token at issue constituted a security. Similarly, to the extent that other courts have asked the same question, they too have used the Howey test. And, until November 2022, courts had only applied Howey in the context of ICOs.
But, on November 7, 2022, a federal district court in New Hampshire ruled that LBRY’s blockchain digital token constitutes a security for the purposes of the Securities Act even before an initial offering has occurred. In mid-2016, LBRY began offering and sold digital tokens to the public in exchange for contributions designed to allow LBRY to build the LBRY Network. Instead of launching through an ICO, LBRY sold LBCs on the LBRY application.
In SEC v. LBRY, the Honorable Judge Paul J. Barbadoro granted the SEC’s motion for summary judgment against LBRY. In doing so, the Court held that “no reasonable trier of fact could reject the SEC’s contention that LBRY offered [a digital token] as a security” and that LBRY did not have a triable defense that it lacked fair notice. [Insert cite] Specifically, the Court held that LBRY offered and sold unregistered securities in violation of Section 5 of the Securities Act when it sold its digital token, an essential component of LBRY’s blockchain. Like the courts before it, the LBRY court used the Howey test in evaluating whether the blockchain digital token at issue was a security.
When weighing this prickly issue, the LBRY court first looked at the definition of “security” according to the Securities Act and how courts have interpreted the term. In particular, the U.S. Supreme Court has noted that the definition of a security “encompass[es] virtually any instrument that might be sold as an investment.” Additionally, the term “security” “embodies a flexible rather than static principle, one that is capable of adaption to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profit.” Applying this definition, the Court reviewed LBRY’s representations to potential purchasers of its blockchain digital token including statements made by the COO, blog posts of LBRY’s CEO, interviews with various LBRY employees, as well as various articles and tweets published by LBRY. The statements in large part touted the rapid growth of LBC and incentivizing investors to get on board in order to help LBRY’s blockchain technology continue to improve. The LBRY court opined that “potential investors would understand that LBRY was pitching a speculative value proposition for its digital token.”
The Court also found that even if LBRY did not make these statements, “any reasonable investor who was familiar with the company’s business model would have understood the connection.” Specifically, LBRY retained 400 million LBC for itself, which signaled to investors that it was motivated to improve the value of its blockchain for itself as well as LBC purchasers. The Court reasoned that this “would lead purchasers of LBC to expect that they too would profit from their holdings of LBC as a result of LBRY’s assiduous efforts.” In short, the Court held that LBRY’s LBC was undoubtedly a security, and therefore, LBRY violated Section 5 of the Securities Act by offering and selling unregistered securities.
The Court’s holding in LBRY has could have a huge impact in the cryptocurrency arena. Based on the court’s holding, companies should be aware that any sale of a digital token that is advertised or viewed by a reasonable investor as an investment, and could implicate the Securities Act. Indeed, in 2022, the SEC brought charges and filed suits against companies for selling unregistered securities in the form of digital tokens regardless of whether the digital token implicated in an ICO.
Notably, in response to the LBRY ruling, LBRY’s CEO Jeremy Kauffman stated, this decision “threatens the entire U.S. cryptocurrency industry” by setting a standard that would deem “almost every cryptocurrency” a security. Mr. Kauffman has a point: although this issue has not been appealed and heard by a federal circuit court, one should expect increased scrutiny for cryptocurrency especially in light of the recent bankruptcy filings of major players in the industry like BlockFi and FTX. In particular, we should expect courts to move beyond the question of whether a blockchain token constitutes a security, but, also the impact of information disseminated to the public whether companies defrauded “investors” in cryptocurrency. Also, the decisions resulting from the cryptocurrency bankruptcies over the next several years will likely also shed more light on issues like cryptocurrency valuation.
Companies that are looking to create, distribute, or sell a digital token should closely scrutinize how the digital token is being promoted to potential investors and the public. Ultimately, cryptocurrency is a nascent technology and the legal system is beginning to adjust to its application. Given this SEC victory, companies should reflect on their business practices as it concerns cryptocurrency and be prepared to see more enforcement activity in this space.
 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207, 117 SEC Docket 745, 2017 WL 7184670 (July 25, 2017); https://www.sec.gov/litigation/investreport/34-81207.pdf
 Munchee Inc., Exchange Act Release No. 10445, 118 SEC Docket 5, https://www.sec.gov/litigation/admin/2017/33-10445.pdf; Gladius Network LLC, Exchange Act Release No. 10608, https://www.sec.gov/litigation/admin/2019/33-10608.pdf ; Carriereq, Inc., d/b/a Airfox, Exchange Act Release No. 10575, https://www.sec.gov/litigation/admin/2018/33-10575.pdf ; Paragon Coin, Inc., Exchange Act Release No. 10574, https://www.sec.gov/litigation/admin/2018/33-10574.pdf.
 S.E.C v. Telegram Group Inc., et al, 448 F. Supp. 3d 352 (S.D.N.Y. 2020) (granting preliminary injunction to prevent planned distribution of digital tokens because there was a substantial likelihood that the SEC would succeed in proving that plan constituted unregistered securities offering); S.E.C v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020) (holding that a company’s public sale of a cryptocurrency constituted a Security).
 The Howey test can be broken down into three parts: “(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.” S.E.C v. SG Ltd, 265 F.3d 42, 46 (CA 1, 2001) (citing S.E.C v. Howey Co, et al, 328 U.S. 293, 298-99 (2001)).
 S.E.C v. LBRY, No. 1:21-cv-00260-PB, 2022 WL 16744741, at *3 (D.N.H. Nov. 7, 2022) (quoting US Securities and Exchange Commission v. Edwards, 540 U.S. 389, 393 (2004)).
 Complaint, U.S. Sec. & Exch. Comm'n v. Dragonchain, Inc. et al, No.2:22-cv-01145; https://www.sec.gov/litigation/complaints/2022/comp25468.pdf; Complaint, U.S. Sec. & Exch. Comm'n v. The Hydro Technology Corp., et al., No. 1:22-cv-08284-LAK, https://www.sec.gov/litigation/complaints/2022/comp-pr2022-175.pdf;
 Jody Godoy, U.S. securities regulators win case against crypto company LBRY, Reuters, (Nov. 7, 2022, 1:02 EST), https://www.reuters.com/legal/transactional/us-securities-regulators-win-case-against-crypto-company-lbry-2022-11-07/