In a recent judgment (published November 7, 2022), the United States District Court for the District of New Hampshire has ruled that the LBC token, which is designed for use on the LBRY blockchain, is a registrable security for the purposes of the US Securities Act 1933. As LBRY had not registered the token as a security, it was held to have breached the law. SeeUS Securities and Exchange Commission v. LBRY, Inc. Case No. 21-cv-260-PB.
To reach this decision, the court applied the Howey test, which I discussed in a previous post. This is a legal test used by US courts to determine what is an “investment contract”. If something is an investment contract, then it must be registered with the SEC if it is made available for purchase in interstate commerce by persons located in the US, subject to some exemptions. As the US is the single largest investment/financial market in the world, this means that US securities law in practice has a worldwide ambit and has to be complied with by issuers everywhere unless American purchasers can be excluded. Corporate issuers inside the US, which covers the operators of a large chunk of the world’s token-powered blockchain projects, are all within the SEC’s jurisdiction by definition.
LBRY resisted the SEC’s characterization of the LBC as a security, and argued that the LBC token is a digital currency – a utility token – used to pay for services by users of the LBRY blockchain, and was never intended for purchase as an investment. The court rejected this argument and followed a familiar road to reach its conclusion. The main elements of the court’s ruling include the following concepts (my interpretation):
- Howey test is intended to be broad and adaptable to new examples of investment contracts. Accordingly, new kinds of things can be continually added to that category, and the facts that there was no ICO for LBC and that it is a utility token don’t prevent it from being treated as a security if it otherwise fits the definition of a security.
- Although the bulk of LBRY’s communications to the public and potential token purchasers did not emphasize the value of the token as an investment, there were many statements that recognized that the LBRY business model included a plan that LBC was intended to increase in value over time due to the efforts of LBRY to grow and improve its blockchain. The fact that LBRY reserved a proportion of the tokens so that it could profit later from its efforts of building up the blockchain demonstrated that it expected the value of the tokens to increase over time.
- While these factors were taken as signals that the token was, in fact, a form of investment even if also was a utility token, the language used by the court indicates that it could have arrived at its conclusion even if there were no such messages or reservation of tokens, because the court relied on a doctrine called the “economic realities” test. This test allows a court to go beyond what the promoter of a security says, ignoring disclaimers, and to look at how the alleged security actually works. If the product is bought by people who expect it to increase in value “solely due to the efforts of others”, in this case, the operators of the LBRY blockchain, then it falls into the “security” category, even if it has a dual purpose as a utility token.
- The fact that the SEC had not previously applied security-registration requirements to a token that has not been launched via an ICO, even if true, by itself did not prevent the SEC from taking action against LBRY. This novelty factor did not constitute a lack of fair notice of enforcement action or the novel interpretation of an existing rule. Issuance via an ICO, by itself, doesn’t determine a token’s status as a security.
From the SEC’s point of view, it was simply enforcing a rule intended to protect consumers who buy into a profit-making scheme. LBC was just another kind on security that fitted the definition, it wasn’t registered, and so the enforcement action was appropriate. From the Court’s point of view, it was upholding a settled law: sellers of securities have to register them with the SEC unless they fall into an exempt category. It’s all as simple as that. From other people’s point of view, however, the decision marks a new stage in the US government’s hostility against blockchain projects, and may have the effect of chilling the development of new blockchain projects which are financed by the sale of tokens.
Cost and difficulty of compliance
The biggest problem with registering a token as a security is probably not resistance to the idea that regulation can be helpful and can protect people from unfair or unnecessary risks. Every time you ride in a car, you use a machine that meets certain safety standards mandated by law: for example it has seat belts and air bags, and the engine and other components comply with minimum standards. It can be driven only by a person who has a licence received after a period of training, and all users of vehicles must follow defined road rules. We are very used to this system of regulation and by and large it is successful. Considering how many vehicles there are on the roads, and how many vehicle journeys happen every day, there are a relatively small number of accidents, injuries and deaths, and few cases of cars harming people by falling apart or exploding.
The biggest problems with registering a token as a security are probably the complexity and cost of that exercise. Imagine if you had to hire a team of lawyers to register your car and pass your driver’s licensing exam. Imagine that it took years to get your car registered and cost you $500,000 to do that. What will happen in this scenario is very predictable. Many people will try to interpret the law so that they can avoid it if they can. Overall, the number of cars on the road will drop dramatically because very few people can afford the up-front costs of vehicle registration. The very wealthy (by definition) owners of existing types of vehicles will be unaffected because the system works well for them by excluding newer, less-wealthy competitors who wish to develop different – maybe better – kinds of vehicles. Whether or not the existing types of vehicles meet the needs of most people is irrelevant. The enforcement system isn’t designed to “meet people’s needs”. It is designed to “protect” people by applying rules based on certain abstract assumptions and is enforced mechanically by regulators and courts.
Reactions
Numerous commentators in the crypto world have reacted with dismay to the LBRY court decision. On Odysee (which was formerly associated with LBRY) @Cahlen points out in a video blog that the LBRY set up had no victims. Nobody complained that they were ripped off by LBRY. In fact, people were victimized, if at all, by the SEC’s enforcement action when the value of their tokens dropped because of that action. The token’s value dropped 35% in the first hour following the announcement of the decision, according to Cahlen. He also points out that the result of such enforcement cases is that the court often makes further rulings placing the blockchain operator under the supervision of the SEC, or requiring them to operate their business in certain ways. Cahlen sees these things as indicating an overall goal “to wipe out as many cryptocurrencies as possible and have a few remaining which they [the government] are in control of”. Ironically, given that the basis for the SEC’s claimed jurisdiction over LBC is that it is a security, Cahlen advocates against the use of crypto tokens like LBC as an investment.
LBRY’s own view is that the judgment is bad for the crypto industry as a whole. As reported by Decrypt, LBRY’s CEO, Jeremy Kaufman, has declared that “The language used here sets an extremely dangerous precedent that makes every cryptocurrency in the US a security. Including Ethereum.” Echoing @Cahlen’s view of the US government’s ambitions, Kaufman told Decrypt: “The SEC has very much demonstrated that they are out to damage or destroy the cryptocurrency industry in the United States.”
A legal expert cited in the Decrypt article, attorney Andrew Rossow, points out that a failing of the LBRY ruling is that the court didn’t adapt the legal concept of a “reasonable expectation of profits” to the realities of a blockchain project which is “a work in progress”. According to Rossow, LBRY had to convince people that the project had utility and, I might add, a viable future. But, by doing that, the court said that LBRY “was pitching a speculative value proposition for its digital token”: see page 14 of the judgment. Kaufman is right that the LBRY ruling will affect every blockchain project supported by a native crypto token, because all promoters of all blockchain projects make supportive comments about their project indicating that it has a long-term viability and that they intend to expend effort to make the project succeed. According to the US Federal Court, such comments amount to promoting a speculative investment.
Conclusion
The recent collapse of FTX and the subsequent drop in value of most cryptocurrencies has sparked renewed debate about the need for regulation in the crypto world. The now-notorious CEO of FTX, Sam Bankman-Fried, is quoted as having told a Vox journalist: “F--- regulators they make everything worse”, according to an IBT article by Nica Osorio. Like the case of car safety regulations discussed above, however, which are widely accepted as providing a net benefit for people, regulation doesn’t have to be stifling and destructive. And, as proved by SBF’s own conduct, an absence of regulations can lead to many people being harmed and an entire industry being tarnished.
The issues stirred up yet again by the LBRY case, in my view, show that the US government, and other governments that follow its lead, haven’t learned yet how to regulate the blockchain economy in a positive and intelligent way. They are clumsily applying old rules developed in a different era to a new set of products in a way that is making it harder and harder for promoters of token-based blockchain projects to launch and mange those projects. Not only that, are ignoring economic realities when they do so, because the biggest winners of their enforcement strategy are the owners of the rusted-on, underperforming assets of the existing financial system, who have the vast resources needed to navigate the expensive and complex compliance system that is administered by the same government. The losers are the hard-working promoters of legitimate blockchain projects who are trying to create something new and useful, and their customers, like the users of the LBRY blockchain. And, of course, everyone else in a world denied of new self-sustaining blockchain projects supported by their own tokens.
[Photo creditMain Reading room of the Library of Congress, by Carol M Highsmith (2009), a public domain image courtesy of Wikimedia Commons. This post is a basic level, educational and informational discussion of legal concepts. It does not constitute legal advice for any person, nor does it create a lawyer/client relationship with any person. Although care has been taken to ensure that the law is described correctly at the time of publication, no guarantee of accuracy is provided. The author is a lawyer involved in blockchain projects.]
