Federal Court Sides With the SEC, Sounding the Alarm for All Crypto Projects
On November 7, the United States District Court of New Hampshire (in the First Circuit Court of Appeals) granted a motion for summary judgment made by the SEC against LBRY, potentially opening the door for almost every cryptocurrency being deemed a “security” under U.S. federal law.
The decision stems from an SEC complaint filed in March 2021, which alleged that LBRY was selling an “unregistered security” through its issuance of LBRY Credit (“LBC”), the native digital token of the LBRY platform. According to the SEC’s complaint, LBRY raised more than $11 million in U.S. dollars, Bitcoin and services from “investors” between 2016 and 2020 without filing a registration statement (or otherwise complying with an available exemption from registration).
LBRY operates the decentralized content-sharing platform Odysee. LBRY’s ambitious aims to compete as a decentralized YouTube sought to incentivize participants to create or view content using LBC as a reward. Odysee offers users the ability to earn LBC for watching videos, while creators earn LBC for sharing content. According to LBRY’s website, users paid a fee in LBC to interact with Odysee for anything beyond viewing free content. Thus, LBRY argued that the LBC token was a “utility token” since it had a “consumptive use” within the LBRY ecosystem. Additionally, LBRY further argued that the LBC was not a security because it was generally not “sold” to participants, but was instead largely claimed for free or “earned” by users, while LBRY retained a large portion of the LBC token for its own account in reserve.
Arguing in support of its claims, the SEC relied upon the long-standing definition of what constitutes a “security” in the United States – the Howey Test. To determine whether or not an offering is deemed a “security,” all four prongs of the Howey Test have to be satisfied: Investors would have to make (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) to be derived solely from the efforts of the promotor or a third party.
In rendering its decision, the Court examined LBRY’s representations to prospective purchasers (including those on the secondary market) as well as its business model. While LBRY had included multiple disclaimers on its site that it did not view LBC as being securities, the Court cited multiple statements by LBRY that were “representative of LBRY’s overall messaging about the growth potential for LBC,” supporting the SEC’s view that “potential investors would understand that LBRY was pitching a speculative value proposition for its digital token.” In one blog post, LBRY stated 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.” Another post on Reddit from a product manager with LBRY stated “worth something in the future . . . if LBRY delivers on their promises.” This somewhat minimal commentary made by LBRY’s representatives as to the potential future value of the LBC token was significant.
In echoing the result from SEC v. Telegram, the Court further held that legal disclaimers, such as the ones utilized by LBRY as a means of distancing itself from having LBC being classified as a security, “cannot undo the objective economic realities of a transaction.”
Further, the Court concluded that any reasonable investor familiar with LBRY’s business model would understand that LBRY expected LBC to increase in value through LBRY’s managerial and entrepreneurial efforts. The Court’s position was bolstered by statements made by LBRY’s own CEO, Jeremy Kauffman: “LBRY’s profitability turned on its ability to grow the value of LBC by increasing usage of the LBRY network.”
In an interview with Coindesk, Kauffman responded to the Court’s ruling: “The SEC vs LBRY case establishes a precedent that threatens the entire U.S. cryptocurrency industry. Under the SEC vs LBRY standard, almost every cryptocurrency, including Ether and Dogecoin, are securities.”
The lessons here are simple:
- While LBRY is likely to appeal the decision, it appears to ratify the SEC’s position that of the thousands of cryptocurrency tokens available in the crypto market, the vast majority are securities. This also affirms the SEC’s enforcement position as to whether both sales and non-sale issuances of utility tokens may be classified as unregistered securities offerings.
- Language matters. Don’t rely on website disclaimers as a blanket line of defense against regulators. Generally speaking, if a reasonable person would acquire a token for investment purposes, or the “economic realities” of the transaction make that investment motive apparent, then the entire project could be at risk if appropriate steps to comply with the existing laws are not taken.
The full decision is linked here: https://fingfx.thomsonreuters.com/gfx/legaldocs/mopakmakkpa/SECURITIES%20LBRY%20ruling.pdf
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