Takeaways From SEC v. LBRY, Inc. On What Constitutes A "Security"
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It has been a long and heated debate as to whether NFTs and certain cryptocurrencies can be deemed as securities under applicable laws and precedents. Now, the debate has become even more intriguing as several sources have indicated that the Securities and Exchange Commission (the "SEC") is looking into whether the NFTs sold by Yuga Labs (the company behind Bored Ape Yacht Club) violated any applicable securities laws. Before anything concrete is revealed from the investigation, we could first look into a recent ruling in which SEC succeeded in its action against LBRY, Inc. and see what we could take away from the ruling court's determination.
Basics of Securities Laws
In general, offerings or sales of securities are subject to registration requirements under Section 5 of the Securities Act of 1933, meaning that it would be unlawful for an individual or an entity to offer or sell securities without registering such securities first (unless certain exemptions apply). As to the determination of "what" constitutes a security, almost everyone in the NFT/crypto space has heard of the famous Howey test, which, as the Supreme Court of the United States laid out in this well-known precedent, contains three prongs that make an "investment contract" a security: (1) an investment of money; (2) in a common enterprise; (3) with the reasonable expectation of profits derived solely from the efforts of others. Accordingly, an offering, sale or contract that satisfies all three prongs of the test will be regarded as a security. (That being said, the scope of the investment contract is relatively limited by the "economic reality" test, which is typically applied to prong (3) as an objective inquiry in connection with the Howey test, along with the inquiries regarding "what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.")
Based on the Howey test, one could generally assume that prongs (1) and (2) stated above could be the ones that are easier to satisfy given that almost all types of NFT/cryptocurrencies have (a) purchasers putting in their money and (b) an entity, protocol or an "issuer" that make the concerned NFT/cryptocurrencies available. What would be the main focus, as SEC stated in its Framework for "Investment Contract" Analysis of Digital Assets, is "whether a purchaser has a reasonable expectation of profits (or other financial returns) derived from the efforts of others." As suggested in the framework, prong (3) will be considered satisfied if a "promoter, sponsor, or other third party (or affiliated group of third parties) provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts."
LBRY Ruling and Takeaways from the Ruling
As a timely example of how the Howey test is applied, the federal district court for the district of New Hampshire ruled on November 7, 2022 that LBRY, Inc. (the "LBRY") has violated Section 5 of the Securities Act of 1933 by selling LBRY Credits (i.e., LBC) without registering it as securities. This case was initiated by SEC with an enforcement action against LBRY in 2021, following which the competent authority sought and succeeded in obtaining a summary judgment from the district court. Although this ruling is unlikely to be relied on and interpreted as the precedent that renders ALL NFTs and cryptocurrencies a type of security that falls under the 33 Act's registration requirements, several takeaways from the ruling still warrant a closer look and careful consideration as those takeaways may be widely applicable to other cases.
First, what LBRY showed from its past practices did not support its argument that purchasers of LBC did not have "the reasonable expectation of profits derived solely from the efforts of others (i.e., LBRY)." When arguing whether the three prongs under the Howey test was satisfied, LBRY gave in on the first two prongs (i.e., investment of money and common enterprise) and focused on the third prong, arguing that LBC was not offered as a security because "some purchasers acquired LBC for use on the LBRY Network." Generally speaking, the utility feature of a token (along with other factors) could make such token a utility token, which, in return, might help such token "not to" be deemed as a security under securities laws so long as such token is not offered as a part of an investment contract (which is a security). (Examples can be drawn from SEC's no-action letters issued for VCOIN and TKJ Tokens. The reasons that SEC gave out for the no-action decision include (i) the platform (for which the utility token is sold) has been fully operational at the time the token is sold; (ii) upon the sale of token, the token can be used immediately for its intended purpose; (iii) restrictions have been placed on token transferability; and (iv) the token has a fixed price and has a value equal to such price.) While LBRY aimed to negate the third prong by claiming the utility aspect of the LBC and argued to the court that it had put in disclaimers specifying that LBC was not to be purchased as an investment, the court nevertheless looked into statements and posts that LBC had made from the past and noted that "[LBRY is] acutely aware of LBC's potential value as an investment" and "it made sure potential investors were too." For instance, as the court observed, LBRY "tout[ed] the rapid growth in LBC's value" in one post despite LBRY Network's "relevant infancy and limited usability" and stated to LBC's purchasers that "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." In other occasions, the COO expressly wrote that "opportunity is obvious… buy a bunch of credits, put them away safely, and hope that in 1-3 years we've appreciated even 10% of how much Bitcoin has in the past few years." All such statements, as construed by the court, constituted LBRY's representations to LBC purchasers that LBRY is putting in the efforts to build up LBC and that the purchasers could expect an increase in LBC value from such efforts.
Secondly, while the utility aspect of a token could negate the third prong in certain way as stated above, LBRY's failed to prove such utility aspect of the LBC given that it had, at the time LBRY was launched admitted that it was "the barest, minimum proof-of-concept [application] possible." The court construed such statement as the negation of the utility aspect of LBC and determined, with other objective facts, that "potential investors would understand that LBRY was pitching a speculative value proposition for its digital token" and that LBRY's message amounts to "precisely the "not-very-subtle form of economic inducement" as evidencing Howey's "expectation of profits.""
Another interesting aspect of the ruling is that the court rejected LBRY's consumptive use defense (i.e. an exception that allows a sale/offering not to be registered for its features and purposes having to do with the use of the token for personal/consumptive use as opposed to an investment: in the context of cryptocurrency, the utility aspect of LBC) , based on which LBRY argued that LBC cannot be regarded as a security even if it is offered as an investment. The court expressly stated that precedents do not suggest that "a token with both consumptive and speculative uses cannot be sold as an investment contract," reaffirming the widely-shared view stated in the foregoing paragraph that a utility token could be deemed as a non-security so long as it is not offered as a part of an investment contract. Accordingly, the court determined that "some unknown number of purchasers may have acquired LBC in part for consumptive purposes… does not change the fact… that [LBRY] was offering it as a security." The court also stated in a footnote that LBRY's alternative argument addressing "why LBRY's future LBC offerings should not be subject to Section 5's registration requirement" is rejected because "LBRY has not explained why possible future offerings of LBC should be treated differently from the company's past offerings.*" In short, the court summarily rejected LBRY's consumptive use argument, suggesting that if LBRY's future LBC offerings is to be free from registration requirements, it should, at the very least, prove to the court that the circumstances surrounding future offerings have been changed from the past and at least one out of three prongs of the Howey test is no longer met in future offerings.
All in all, while the determination of securities is made on a case-by-case basis, this ruling presents an example of how the securities laws and precedents would apply to NFTs and cryptocurrencies and brings out some considerations that might be leveraged in other cases. The world is changing and regulatory enforcement actions are evolving. It is important to keep an eye on how all of these developments would play out.
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