Whether utility tokens are considered “securities” under the Securities Act is a layered question that is undoubtedly project-specific. Unfortunately, the SEC has provided very little guidance to date, forcing an overhang of uncertainty on the industry and calling into question the future viability of countless projects that have not waited around for permission to innovate.

There have been few instances of these particular types of complaints going to court, but on November 7, 2022, the SEC landed a notable victory against LBRY. The ruling marks the first time that a federal court has held that a digital asset sold without an ICO is a security. It is still too early to say what the ultimate effects of the decision will be, but for anyone building or with a vested interest in the industry, the rationale behind the decision is quite terrifying and if adopted more broadly would have devastating effects across the space as we know it.

The information provided here does not, and is not intended to, constitute legal advice and is for general informational purposes only.

What Does the SEC Consider a Security?

I cover securities law basics in another article concerning NFT projects. Given the relevance, it is worth rehashing again here, but if you are already familiar with the topic feel free to skip over this section.

At a high level, everyone who sells “securities” in the U.S. is required to either register their offering with the SEC or find an exemption from registration (exemptions are less relevant for context of this article). It is therefore important for those issuing tokens to know whether what they are offering classifies as a “security” under the SEC’s definition, or else risk facing significant penalties, fines, or worse for avoiding registration.

The Howey Test…

The SEC formally defines a “security” in Section 2(a)(1) of the Securities Act of 1933. The definition is very broad and includes a variety of things, including stocks, bonds, and other forms of profit-sharing agreements. It also includes “investment contracts,” which for our purposes is how utility tokens and other digital assets are potentially picked up.

What qualifies as an investment contract? To make this determination the courts use what is called the Howey test, which was articulated by the U.S. Supreme Court in SEC v. W. J. Howey Co. Under the Howey test, an investment contract exists if there is a contract, transaction, or scheme involving (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party.

This test is broad enough to bring many non-traditional offerings like digital tokens and assets within the definition of a security, and when it comes to digital assets, typically the third prong of Howey is the most important. This prong was also the focus of the LBRY court.

…As Applied to Digital Tokens

In the aftermath of the ICO craze in 2017, the SEC came after numerous companies for conducting unregistered securities offerings. Examples include Block.one, Blockchain of Things Inc., and BitClave PTE Ltd., each of which were required to pay penalties among other consequences. Many of these ICOs closely resembled that of traditional stock offerings — e.g., coins sold to investors for a price with a specific fundraising purpose in mind.

The analysis for utility tokens is less clear. The basic case for distinguishing utility tokens from ICOs is that the former actually plays a role in the function of a project, and are often distributed into ecosystems for that purpose (without charge). Users subsequently buying/selling the token are therefore doing so not for investment/profit but rather a use case, which in theory does not meet the third prong under Howey. There is an obvious gray area here and the SEC has stated that merely calling something a “utility” token or structuring it to provide some utility does not necessarily prevent the token from being considered a security, but to date we are still without much further guidance with respect to the matter.

LBRY therefore provides important new insight into what types of projects and token structures the SEC is going after, as well as one particular court’s interpretation of how Howey applies to utility tokens.

The LBRY Decision

The LBRY protocol is a file-sharing and payment network that aims to be a decentralized alternative to traditional video and digital content-sharing sites like YouTube and Instagram. Check out Odysee for an example of the types of applications that can be built on the network. Additional background on LBRY itself is not required to understand the court’s decision and rationale. For our purposes, just be aware that the LBRY utility token, called LBRY Credits (LBC) , plays a role in some basic functions of the protocol, like serving as a currency for creators to charge viewers to stream their content or earn tips.

Without further ado, let’s take a look at the key factors that led the court to its decision. The Howey test’s third prong was at issue — i.e., was there an expectation of profits derived from the efforts of others. The court analyzed this prong from two different angles.

(1) Did the LBRY team’s communications lead users to believe that LBC was an investment that they could profit from?

Here, the court found that the LBRY team made numerous statements that led potential investors to reasonably expect that they could profit from LBC. What is noteworthy here is not necessarily the finding, but rather the types of communications relied on to substantiate it. Examples of themes are below, which many of us are familiar with.

Communication — Devs Building Toward Token’s and Network’s Envisioned Long-Term Value. Any statement by the LBRY team relating to their believing in and working toward the long-term value of the project, and by function its token, contributed to the court’s finding. This also served as clear evidence that ‘efforts of others’ occurred. Can devs do something? Not unless they want to risk being labeled a security.

“[T]he long-term value proposition of LBRY is tremendous, but also dependent on our team staying focused on the task at hand: building this thing.” — LBRY team blog post

Communication — Network Effects Creating Value. Network effects: as a protocol or project scales and becomes more popular, more users will come, leading to increased demand and value for a utility token. Any statements to this effect were interpreted as contributing to LBRY’s overall messaging to investors about the growth potential for LBC.

Because a blockchain token “has value in proportion to the usage and success of the network,” developers are incentivized to work to develop and promote new uses for blockchain. — LBRY CEO writing on the benefits of blockchain technology

“[The only way LBC will be] worth something in the future is if LBRY delivers on their promises to create a revolutionary way to share and monetize content.” — LBRY Community Manager responding to a question on Reddit

Communication — Incentive Alignment. More detail on incentive alignment is to come below. However, for now note that communications regarding founder/user incentives being aligned, in this case for wanting the LBC token price to go up, crossed the line as a factor contributing to LBC being an ‘investment’.

“[O]ver the long-term, the interests of LBRY and the holders of [LBC] are aligned.” — LBRY team from the same blog post first mentioned above

Viewing these statements as a whole, the court believed that LBRY was aware of LBC’s potential value as an investment, and made this knowledge known to potential investors. Nearly anyone associated with the LBRY team could be held accountable for these communications as well. For example, a LBRY community manager was quoted in the decision for a response made on Reddit.

Communication — Other. In LBRY’s specific case, there were also other communications that more clearly crossed the line as it concerned treating the token as an investment. For instance, LBRY’s COO at one point communicated with a potential investor regarding a private placement of LBC, where he explicitly pitched the value of the token.

“[B]uy 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.”

“[I]f our product has the utility we plan, the credits should appreciate accordingly.”

Statements like these do treat LBC more as an ‘investment’ than ‘utility token,’ however, it was the totality of the statements that led the court to infer LBRY’s overall messaging. Can the same conclusion be reached by developers just talking in a Twitter Space about how future network effects can have a positive influence on a utility token’s price? We don’t know for sure, but it is definitely not out of the question.

(2) Did LBRY’s business model treat LBC like a traditional security / fundraising mechanism, irrespective of the ‘utility’ label and function?

The second part of the court’s analysis concerned LBRY’s business model. In particular — how did the team make money to pay ongoing expenses and grow?

It is no secret in Web3 that many project founders reserve a portion of a token’s circulating supply for themselves. This might occur for a variety of reasons, like for funding expenses or for personal profits / salary. Such was the case with LBRY, which reserved 10% for themselves as well as another 30% spread across marketing, partnerships, and strategics.

The team even stated their intent with this allocation in a response to a user’s question in an AMA.

“The LBRY protocol has a built-in digital currency that allows it to function, called LBRY Credits. These Credits are very similar to bitcoins. Having a built-in digital currency creates an opportunity for a new kind of business that has never existed: the protocol-first enterprise . . . LBRY Inc. has reserved 10% of all LBRY Credits to fund continued development and provide profit for the founders. Since Credits only gain value as the use of the protocol grows, the company has an incentive to continue developing this open-source project.”

By intertwining the protocol’s and founders’ financial fate with the success of LBC, the court found it easy for investors to believe that they could also profit from the managerial efforts of the team by investing in the token. And this is important — the court stated this evidence alone was sufficient for a reasonable investor to understand that the tokens being offered represented investment opportunities, even if LBRY never said a word about it (i.e., even without the “Communications” described previously).

LBRY Takeaways

So under the LBRY court’s interpretation, how might a project structure its token to not be considered a security? Having true ‘utility’ for a token does matter, but under LBRY, it is clear utility alone is not sufficient.

Zero allocation to team members and no conversation regarding token value would be a start. However, the latter is obviously difficult to do if token value is equated with a project’s broader success and adoption, which the LBRY court seems to imply with their dialogue regarding network effects.

If it is impossible to separate the two, it becomes difficult for non-decentralized developers to move forward with a utility token under this definition. At a minimum, projects would have to be very clear that team members receive zero allocation or are not otherwise incentivized for tokens to appreciate in value, and that tokens are used for no other purpose than protocol function (i.e., not to fund ongoing expenses, etc.). Not many projects have followed this approach to date, but even with this, I am not sure most tokens would meet the LBRY standard. If developers are outwardly building a project, speculators might still believe they can profit from these efforts through eventual long-term network effects — in other words, founder token allocation might not even be needed for a court to infer incentive alignment.

Just thinking out loud — pegging utility tokens to a stable value would seemingly help in preventing any ‘expectation of profit’ since appreciation in value is then off the table. Having utility tokens locked into protocols and not otherwise freely tradable would also accomplish the same. The latter approach was taken by Pocketful of Quarters in structuring its utility token, and they actually received a no action letter from the SEC assuring them that the SEC would not pursue enforcement. However, not having tokens freely tradable partly defeats the core ethos of Web3 gaming, which is to shift ownership and control back into the hands of users and away from centralized creators.

Another thought, at least for a subset of projects like gaming, is to not launch a token until a project is in near final form and released. This approach allows developers to build without having to concern themselves with token speculators in the interim. However, ongoing development will likely always occur even after launch, so I’m not sure this approach changes much.

LBRY’s Scope of Influence

Despite LBRY’s outcome, its scope of influence remains relatively limited as of the end of 2022. The decision occurred in the United States District Court for the District of New Hampshire, and therefore is not binding on other federal courts in other states should the same issue be tried. However, it can be used as persuasive authority by these other courts when analyzing similar cases in the future.

Should the case be appealed to the appellate circuit and ultimately heard by the Supreme Court, LBRY’s influence would become more significant. It is not clear whether LBRY has the means or desire to do so though.

Final Thoughts

Although limited in terms of ultimate authority, the LBRY decision serves as an important data point to consider when analyzing tokens under Howie and U.S. securities laws. Unfortunately, it still leaves open almost more questions than it answers. For example, it is clear that LBRY’s decision to own a significant amount of LBC was, on its own, enough to trigger the third prong of Howey. However, there could be various reasons for a project to retain portions of its own token unrelated to its future appreciation in value. Such nuances are not touched on in the decision and provide complexities not very amenable to hard-and-fast rules.

In the aftermath of LBRY it therefore appears that the courts, SEC, and rapid development of Web3 have hit a major crossroad — akin to fitting a square peg in a round whole. Either the industry takes a giant leap back and builds from ground zero in compliance with a framework 70+ years old, or a new chapter is written which carves out digital assets and takes into account the industry’s particularities.

Commissioner Hester Peirce is a proponent of the latter and believes Howey leaves a lot to be desired in the context of digital assets. In an effort to provide more clarity, she proposed a legal safe harbor in April 2021 that would let a project take three years to create a “decentralized” blockchain network before having to assess whether it is in compliance with securities laws or whether a token meets the federal definition of a “security.” This safe harbor would provide some breathing room for projects that are navigating an uncertain legal space and hopefully encourage innovation in the process. Although not an answer to all of our questions, this proposal shows a glimpse of what is possible under a new framework specifically accounting for a rapidly evolving and novel space.

We are also just around the corner from the much-anticipated SEC v. Ripple Labs decision. Ripple is similarly being pursued by the SEC in federal court (Southern District of New York) for allegedly selling XRP tokens as unregistered securities. The outcome of the Ripple case will surely serve as the most significant decision on the matter to date — how and whether it ultimately builds upon LBRY we will soon see.

Legal Disclaimer

This article is provided for informational purposes only and should not be construed as legal advice on any subject matter. You should contact your attorney to obtain advice with respect to any particular issue or problem.