Cryptotoken LBC is Legally a Security, Federal Judge Declares, and Requires Regulation by the SEC

This is bad news for any virtual currency that was pre-mined, including ethereum.


The cryptotoken LBRY credits (LBC), issued by LBRY, a blockchain-based content hosting service, is legally a security according to a decision today from the U.S. District Court for New Hampshire.

In a decision for summary judgment in favor of the Securities and Exchange Commission in the case SEC v. LBRY, Inc., which began in March 2021, U.S. District Judge Paul J. Barbadoro insisted the company violated Section 5 of the Securities Act of 1933 by selling its tokens without registering with and obeying SEC requirements for the legal sale of securities.

"The only issues impeding a finding that LBRY violated Section 5 are LBRY's claim that it did not offer LBC as a security and its argument that it was not given fair notice that it needed to register its offerings," Judge Barbadoro wrote. The relevant definition is based on the Supreme Court's ruling in the 1946 case SEC v. W.J. Howey Co., which declared that a security is "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party." This definition "'embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.'"

The issue, then, is whether anyone buying LBC did so with "a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others." Judge Barbadoro found a statement in a LBRY blog post essentially proof of their guilt; they wrote "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."

To the judge, this admits that buyers of the token were expecting effort from LBRY to make that "investment" rise in value. Emails from LBRY execs to potential investors quoted in the decision, as well as postings on Reddit and public interviews from LBRY staffers, also show they were telling potential buyers/investors that their company's efforts would make the token increase in value and thus mark LBC as a regulatable security, says Judge Barbadoro.

"The fact that it informed some potential purchasers of LBC that the company was not offering its token as an investment," Judge Barbadoro asserts, is a mere "disclaimer" that "cannot undo the objective economic realities of a transaction."

For its part, among other arguments against the SEC's actions (including due process violations since the SEC has "conducted itself inconsistently and in violation of its own purported standards"), LBRY has asserted in court filings that its tokens are used by "millions" daily in their "LBRY Network–which runs on blockchain technology that requires the use of a token."

Thus, LBC are intended for use and consumption, not merely bought in expectation of profit based on LBRY's actions, and thus not securities. Judge Barbadoro believes, according to his decision, that the fact that some people use it for consumption does not mean that others are not using it as an "investment contract" and thus a legally regulatable security.

Barbadoro also shot down LBRY's claim that they had not received legally required fair notice that they were acting in violation of the Securities Act of 1933: "SEC has not based its enforcement action here on a novel interpretation of a rule that…does not expressly prohibit the relevant conduct. Instead, the SEC has based its claim on a straightforward application of a venerable Supreme Court precedent [Howey] that has been applied by hundreds of federal courts across the country over more than 70 years. While this may be the first time it has been used against an issuer of digital tokens that did not conduct an ICO [initial coin offering], LBRY is in no position to claim that it did not receive fair notice that its conduct was unlawful."

The LBC token's market value fell by nearly one-third in the past day as of posting time. Within the LBRY system, the tokens compensate miners, and, as the decision explains, "can also be spent on the LBRY Blockchain to publish content, create 'channel[s]' that associate content with a single user, tip content creators, purchase paywall content, or 'boost' channels or content in search results…Users generally must pay a fee in LBC in order to 'interact with the LBRY Network for anything beyond viewing free content.'"

LBRY Credits (LBC) are thus mostly used for the LBRY site's operation. The company runs a blockchain-based censorship-free online site for content, one that vows users will suffer no YouTube-esque takedowns. Its CEO is Jeremy Kauffman, a Libertarian Party candidate for Senate in New Hampshire. Some see hints of a political hit in the fact that this one small token-issuing company among so many has been singled out for SEC clampdown; as LBRY notes in a court filing in June 2021, the SEC has only ever brought "about 19 actions involv[ing] registration violations without fraud allegations" and that "it is a mystery why the SEC chose to pursue those matters—and why the SEC now pursues LBRY—while leaving thousands of other digital assets relatively untouched."

A rub in this decision that seems to be unnerving the crypto token community the most, a strong hint that those other digital assets might not remain "untouched" by the SEC for long, is it implies that any pre-mined token—which the issuers keep quantities of without spending money before releasing it into the marketplace at large—is thus obviously a security under SEC definition.

The relevantly unnerving part of the decision is where Judge Barbadoro writes that "a reasonable purchaser of LBC would understand that the tokens being offered represented investment opportunities—even if LBRY never said a word about it." Because "by retaining hundreds of millions of LBC for itself, LBRY also signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any LBC purchasers. This structure, which any reasonable purchaser would understand, 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."

This seems to imply that to pre-mine means to have created an unregistered security. And that means every transaction involving such tokens that were not registered with the SEC is potentially a crime. This would include the second largest market-cap virtual currency, ethereum. (SEC chief Gary Gensler already said last month before this decision that he believes ethereum is a security for different reasons.)

The SEC seeks in this case "injunctive relief, disgorgement of monies obtained through LBRY's offerings, and civil penalties."

The crypto world has feared decisions along these lines; a more well-known token called XRP, issued by Ripple, has been in an ongoing legal fight with the SEC over these same questions since 2020. While they are in a different federal court district, the Southern District for New York, and this LBRY decision is in no way a binding legal precedent over that court, it's a bad sign for how federal courts could choose to address this "are crypto tokens securities?" question.

Kauffman tweeted this morning that "Under this standard, almost every cryptocurrency, including Ethereum and Doge, are securities. The future of crypto now rests with an org worse than the SEC: the US Congress."