While the blockchain crypto community is processing the latest round of “crypto contagion,” potentially lost in the busy news week was a significant legal development regarding what digital assets qualify as securities under existing federal law.
On November 8, 2022, the long-awaited decision in the U.S. Securities and Exchange Commission (“SEC”) v. LBRY, Inc. (“Library”) case was released, granting summary judgment to the SEC. This result means that there will be no trial on the facts and is a complete victory for SEC against the decentralized content sharing and publishing platform. Click on the following links to read the Full Order, Library’s Motion for Summary Judgment (“MSJ”), the SEC’s Response in Opposition to Library’s MSJ, and the transcript of oral arguments on this issue.
While this is a limited ruling from a single district court with fact-specific holdings, it demonstrates how the current interpretation of securities laws may make it difficult for blockchain-based networks to launch in the United States.
Library is a company founded with the goal of creating an open-source, censorship-resistant protocol using blockchain technology to allow users to easily publish, share, and view digital content without interference from centralized intermediaries. One of the ways that blockchain technology allows for transactions to take place in a decentralized manner is by using multiple nodes or computer systems that validate a transaction. Many blockchain networks, including the LBRY Network, generate native tokens as rewards for validating transactions.
Library raised initial capital for the development of the LBRY Network through traditional investments such as from angel and venture capital investors and not through presales of its native tokens, as was common with many ICO-era projects. In June 2016, Library launched the LBRY Network and a companion desktop application, which users could immediately use to publish and consume digital content on the LBRY Network.
The native token of the LBRY Network is called LBC. At launch, Library pre-mined 400 million LBC tokens, meaning Library was able to claim those tokens to run the LBRY Network before any individual could. The remaining 600 million LBC tokens can be mined by any individual with the necessary computing and energy required as they assist with validating transactions on the network, similar to how Bitcoin is mined.
The LBC token was designed to be necessary to access certain functions on the LBRY Network, i.e., it is consumptive. Users must pay a fee in LBC to publish content, create a channel to organize content, subscribe or purchase the ability to view certain content or boost content to the top of people’s video feeds. Users can also “tip” their favorite content creators in LBC.
Library did not sell any of its 400 million pre-mined LBC tokens until July of 2017, slightly over a year after the launch of the LBRY Network. It did, however, give away roughly 142 million tokens from launch until the action by the SEC as incentives for users and as compensation to software developers, software testers, strategic partners, employees, and contractors. In July of 2017, Library began selling its remaining tokens, both on exchange and directly through a buying portal on the Library website.
In March 2021, the SEC filed an action against Library alleging that Library’s sale of LBC tokens violated sections 5(a) and (c) of the Securities Act, 15 U.S.C. § 77(e). This was a notable case because it was one of the first brought by the SEC against a blockchain developer, which didn’t involve sales of tokens through an Initial Coin Offering (“ICO”). While many coins sold through ICOs had no immediate utility and were sold with the promise of some future utility, Library didn’t sell any of its LBC until it arguably had a working LBRY Network and limited content sharing functionality on the LBRY Network for over a year.
In its MSJ, Library presented the sworn declarations of around 300 users who declared under oath that they purchased LBC to transact on the LBRY Network and not for speculative or investment purposes. Library argued that, under the precedent set in United Hous. Found., Inc. v. Forman, 421 U.S. 837 (1975), securities laws do not apply when a buyer purchases an asset primarily to use or consume that asset. Library further pointed to the many examples of telling individuals not to buy LBC for speculative purposes, but rather for its use on the LBRY Network. Library further distinguished itself from prior SEC actions against token developers, as LBC was not sold through an ICO, nor did Library release a whitepaper to describe some theoretical future use of the token. Instead, Library launched what it argued was a fully functional blockchain network and did not sell any of the native tokens for that network until over a year later.
The SEC countered in its own MSJ, pointing to various statements by Library employees and moderators on the Library Reddit page, which indicated that the price of the LBC tokens would rise as the success of the LBRY Network rose. It also linked statements from Library around its own stake in LBC as an indication to potential buyers of LBC that they could depend on the entrepreneurial efforts of Library based on Library’s vested interest in the success of its tokens held in reserve. The SEC also pointed to the relatively low user number and limited token price to publish content on and use the LBRY Network as evidence that users primarily purchased the LBC tokens for speculative purposes.
Notably, the MSJs were limited to two issues – whether LBRY had fair notice that the SEC was taking the position that digital assets such as LBC would be treated as securities and whether purchasers of LBC were relying on the efforts of Library to achieve profits.
Under the test articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”), as interpreted in the First Circuit where New Hampshire is located, an instrument is an “investment contract” that is treated as a security if three elements are met: (1) an investment of money, in; (2) a common enterprise, with; (3) an expectation of profits to be derived solely from the efforts of the promoter or a third party. LBRY conceded the first two elements and instead focused on the fact that there was no reasonable expectation of profits derived primarily from the efforts of others. We note that this test is not consistently applied across all circuits, with some considering it to be a four-part test (expectation of profits and efforts of others being separate prongs) and many looking at different factors to determine whether there is a common enterprise.
The Court sided with the SEC, stating that “[Library] has – at key moments and despite its protestations – been acutely aware of LBC’s potential value as an investment. And it made sure potential buyers were too.” It went on to cite various statements by Library which the Court stated “amounts to precisely the ‘not-very-subtle form of economic inducement’ the First Circuit identified…as evidencing Howey’s ‘expectations of profits.’” The Court went on to hold that the statements by LBC purchasers regarding the consumptive motivations for those purchases had limited relevance in determining if Library’s sales of LBR constituted unregistered sales of securities because nothing in the case law suggested to the Court that a token with both consumptive and speculative uses cannot be a security.
Notably, in dicta, the Court held that:
“The Problem for [Library] is not just that a reasonable purchaser of LBC would understand that the tokens being offered represented investment opportunities – even if [Library] never said a word about it. It is that, by retaining hundreds of millions of LBC for itself, [Library] also signaled that it was motivated to work tirelessly to improve the value of the blockchain for itself and any LBC purchaser. This structure, which any reasonable purchaser would understand, would lead purchasers of LBC to expect that they too would profit from their holding of LBC as a result of [Library]’s assiduous efforts”
It is also worth noting that the Court did not opine on whether the LBRY Network was “sufficiently decentralized,” a term mentioned in a now somewhat infamous speech by then acting SEC Director of Corporation Finance Bill Hinman in 2018, explaining why Bitcoin and possibly ETH may not be a security even if they were at one point. Under that argument, “purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts” due to decentralization. The Court also declined to rule on if future sales of LBC would be deemed the sales of securities because future sales were not at issue in the case. No relief was specified in the ruling, but the SEC is seeking a permanent injunction, civil penalties, and disgorgement.
Ramifications of the Court’s Order
This was a significant blow to Library, as they were denied the opportunity to present their case to a jury and will now need to appeal this Order based on the current record. The CEO of Library reacted to the ruling by saying that “[t]he language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the US a security, including Ethereum.”
While this is one ruling by one judge in one district court and thus has limited precedential value, it will certainly be cited by the SEC in other cases and is likely to provide a morale boost to the SEC staff. In particular, the decision creates some precedent that could limit arguments under Howey regarding lack of an ICO, lack of marketing through a whitepaper, or the ability to consumptively utilize tokens. On the other hand, this was also a case against a lightly-funded defendant that didn’t even attempt to make numerous arguments as to LBC’s status as a security which was brought in one of the smallest court districts in the country.
With this case seemingly decided, for now, all eyes in the blockchain/web3 legal community turn to the high-profile battle between the SEC and Ripple Labs, Inc. (“Ripple”) over its release and sale of XRP tokens. The result in XRP may be different from LBRY given the large number of amicus briefs sent by industry participants, the level of skepticism to the SEC’s position seemingly voiced by the judges in the case, the defendant being well-funded, and the number of additional arguments being made.
While Library conceded various sections of the securities analysis under Howey and its progeny; Ripple has not conceded any point, which will require the Court to analyze every prong of the Howey test.
Although the SEC has argued that no new laws are needed, and projects can comply under existing SEC regulations and guidance, the fact remains that many projects that are releasing tokens for legitimate, consumptive uses are moving offshore.
The system of registration of securities – which focuses on the health and activities of the company issuing the security and not on the platform or project on which a consumptive asset is used – makes little sense in the context of consumptive assets from either the perspective of investor/user protection or the perspective of allowing the proliferation of new technologies. This movement offshore not only denies access to these projects to U.S. users, but it is also harmful to users and investors by placing these projects outside of the oversight of the U.S. regulators at a time when the renowned expertise of these regulators may be most needed.
There are now multiple examples where regulatory arbitrage has harmed retail and other users and consumers, including with respect to the initial crypto contagion caused by the collapse of Luna and Three Arrows Capital and, more recently, another meltdown of a prominent exchange. Good actors will have no choice but to play this game until a real, workable system for the launch of digital assets projects in the U.S. is developed. It makes little sense that major US exchanges are reportedly under investigation for listing assets that the SEC deems to be securities under the broadest possible interpretation of the Howey test and that Kim Kardashian gets fined for touting a cryptocurrency while millions of retail investors get directly or indirectly harmed because a project was smart enough to escape regulation. A logical, workable and not overly burdensome means of oversight could prevent projects from moving offshore to avoid a registration regime that makes absolutely no sense in this context. The best way to limit these arbitrage opportunities is to create a system where projects that want to be compliant can be compliant.
This critique also includes internal criticism from SEC commissioner Hester Peirce who recently said on Bloomberg, “[w]e’ve been unwilling to work with people in the industry and people who are interested in participating in the industry to develop guidelines that make sense for the industry. Instead, we’ve preferred to take an approach rooted in enforcement….”
Regardless of whether other courts will follow the ruling in Library, it is clear that Congressional action is needed. The alternative is continued regulation by enforcement, which leaves market participants and developers of consumptive digital assets to choose between not participating in the Web3 environment at all or accessing the environment in a way that leaves them completely unprotected.