While the latest round of “crypto contagion” is being processed by the blockchain crypto community, possibly lost in the busy news week was significant legal development regarding which digital assets qualify as securities under existing federal law.
On November 8, 2022, the long-awaited decision in the United States Securities and Exchange Commission (“SEC”) v. LBRY, Inc.. (“Library”) The case was released, granting summary judgment to the SEC. This result means there will be no trial of the facts and is a complete victory for the SEC against the decentralized content sharing and publishing platform. Click on the links below to read the Complete orderLibrary Summary Judgment Petition (“MSJ”), the SEC Response in opposition to the MSJ of the libraryand the transcript of oral arguments on this issue.
While this is a limited ruling from a single district court with specific factual holdings, it demonstrates how the current interpretation of securities laws can make it difficult to launch blockchain-based networks in the United States.
Library is a company founded with the goal of creating a censorship-resistant, open-source protocol using blockchain technology to allow users to easily publish, share, and view digital content without the interference of centralized intermediaries. One of the ways that blockchain technology allows transactions to take place in a decentralized manner is through the use of multiple nodes or computer systems that validate a transaction. Many blockchain networks, including the LBRY network, generate native tokens as a reward for validating transactions.
Library raised the initial capital for the development of the LBRY network through traditional investments such as angel investors and venture capitalists, and not through the pre-sale of its native tokens, as was common in many ICO-era projects. In June 2016, Library launched the LBRY Network and a companion desktop app, 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 anyone else. The remaining 600 million LBC tokens can be mined by anyone with the necessary computing power and power, as they help validate transactions on the network, similar to how Bitcoin is mined.
The LBC token was designed to be required to access certain features on the LBRY network, namely, is consumptive. Users must pay a fee to LBC to post content, create a channel to organize content, subscribe to or purchase the ability to view certain content, or push content to the top of people’s video streams. Users can also “tip” their favorite content creators on LBC.
Library did not sell any of its 400 million pre-mined LBC tokens until July 2017, just over a year after the launch of the LBRY Network. However, it gave out approximately 142 million tokens from launch to SEC action as incentives for users and as compensation to software developers, software testers, strategic partners, employees, and contractors. In July 2017, Library began selling its remaining tokens, both in exchange and directly through a shopping portal on Library’s website.
Background of the case
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 USC § 77(e). This was a notable case because it was one of the first brought by the SEC against a blockchain developer, which did not involve the sale of tokens through an Initial Coin Offering (“ICO”). While many coins sold via ICO had no immediate utility and were sold with the promise of some future utility, Library did not sell any of its LBCs until it possibly had a working LBRY network and limited content sharing functionality on the ICO. LBRY network for over a year.
In its MSJ, Library submitted the affidavits of around 300 users who stated 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 Housing Found., Inc. v. Formn, 421 US 837 (1975), the securities laws do not apply when a buyer purchases an asset primarily to use or consume that asset. Library further noted the many examples of telling people not to buy LBC for speculative purposes, but for use on the LBRY network. Library further distinguished itself from previous SEC actions against token developers, as LBC was not sold via an ICO, nor did Library publish a whitepaper to describe any 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 responded in its own MSJ, pointing to various statements by Library employees and moderators on the Library’s Reddit page, which indicated that the price of LBC tokens would increase as the success of the LBRY Network increased. He also linked to Library’s statements about its own stake in LBC as an indication to potential LBC buyers that they might depend on Library’s entrepreneurial efforts based on Library’s vested interest in the success of their tokens on hold. The SEC also pointed to the relatively low number of users and the limited price of the token for publishing content and using the LBRY Network as evidence that users primarily purchased the LBC tokens for speculative purposes.
In particular, the MSJs limited themselves to two issues: whether LBRY received fair notice that the SEC was taking the position that digital assets like LBC would be treated as securities, and whether LBC purchasers relied on Library’s efforts to obtain Profits.
Under the test articulated in SEC v. W. J. Howey Co.., 328 US 293 (1946) (“hello”), 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; (two) a common company, with; (3) an expectation of earnings derived solely from the efforts of the promoter or a third party. LBRY conceded to the first two items and instead focused on the fact that there was no reasonable expectation of gains derived primarily from the efforts of others. We note that this test is not applied consistently across circuits, some consider it a four-part test (earnings expectation and others’ efforts are separate prongs), and many look at different factors to determine if a common venture exists. .
Library granted various sections of stock analysis under hello and his offspring; Ripple has not awarded any points, which will require the Court to analyze every aspect of the hello Test.
Although the SEC has argued that no new laws are needed and that projects can comply with existing SEC regulations and guidance, the fact remains that many projects that are releasing tokens for legitimate and consumer uses are moving overseas.
The securities registry system, which focuses on the health and activities of the company issuing the security and not the platform or project in which a consumer asset is used, makes little sense in the context of consumer assets. consumption from the perspective of the investor. / user protection or the perspective of allowing the proliferation of new technologies. This offshore move not only denies access to these projects to US users, but is also detrimental to users and investors by taking these projects out of the oversight of US regulators in a time when the recognized 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 major exchange crash. Good players will have no choice but to play this game until a real and viable system for launching digital asset projects in the US is developed. It doesn’t make much sense that major US exchanges are supposedly under investigation for listing assets that the SEC considers securities under the broadest possible interpretation of the hello test and Kim Kardashian being fined for promoting a cryptocurrency while millions of retail investors are harmed directly or indirectly because a project was smart enough to escape regulation. A logical, feasible and not excessively onerous means of supervision could prevent projects from moving abroad 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 comply they can temporize.
This critique also includes insider criticism from SEC Commissioner Hester Peirce, who recently said in Bloomberg“[w]We have not been willing to work with people in the industry and people interested in being involved in the industry to develop guidelines that make sense for the industry. Instead, we have preferred to take an approach rooted in the application…”.
Regardless of whether other courts will follow the Library ruling, it is clear that congressional action is needed. The alternative is to continue with regulation by application, leaving 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.