While the crypto community is rightfully focused on the Ripple case to see how the SEC will fare in court on enforcements alleging cryptocurrency offerings are a security, a lesser-known case may provide clarity first. The SEC’s suit against LBRY is scheduled for trial in September 2022.
LBRY is a protocol that allows anyone to build apps that interact with digital content on the LBRY network. Apps built using this protocol allow creators to upload their work to the LBRY network of hosts, set a price per stream, download, or give it away for free. When a creator publishes something on LBRY, an entry is made on the LBRY blockchain. The securities issue arises from the sale of LBRY credits as detailed below.
Complaint
In 2021, the Securities and Exchange Commission (“SEC”) filed a complaint against LBRY, Inc. The SEC alleges that LBRY violated the Securities Act of 1933 by offering and selling unregistered securities when it sold “LBRY Credits” to numerous investors, including investors based in the United States, without registering with the SEC. The complaint alleges that the LBRY Credits were sold as investment contracts, and, therefore, securities under the Howey test. SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The Howey test holds that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. Whether a particular digital asset at the time of its offer or sale satisfies the Howey test depends on the specific facts and circumstances. In 2019, the SEC published the Framework for “Investment Contract” Analysis of Digital Assets (“Framework”) to assist individuals in determining whether their digital asset runs afoul of securities laws.
Seemingly following the Framework analysis, the complaint alleges that the LBRY Credits were sold to the public in exchange for contributions designed to build, construct, and develop the LBRY Network. The complaint further alleges that the LBRY Credit sales to institutional investors required the investor to wait one year before selling their investment. Additionally, the complaint alleges that the LBRY Network used proceeds from the sales of LBRY Credits to pay for operational costs to grow the LBRY Network. As alleged, LBRY received more than $11 million in U.S. dollars, Bitcoin, and services from purchasers who participated in its offering. All of these accusations and more are mentioned in the Framework analysis.
Answer
In its answer, LBRY pushed back on the agency’s claims and asserted several affirmative defenses including a selective enforcement defense and violation of equal protection under the Fifth Amendment accusation. LBRY claimed that when the SEC targeted it for enforcement action, the agency treated LBRY differently from other blockchain companies with no rationale and pursued its investigation in a manner that demonstrated a selective treatment “based on a malicious or bad faith intent to injure LBRY.”
Motion for Judgment on the Pleadings
In its reply, the SEC challenged the defense by saying it’s a “nonstarter” since LBRY admits the agency has sued 42 other blockchain creators for alleged federal securities violations. The motion for judgment on the pleadings states that “[t]he SEC argues that LBRY’s admission necessarily bars its selective enforcement defense because it undercuts LBRY’s assertion that it has been treated differently from other similarly situated digital currency creators.” Citing this argument, the district court dismissed LBRY’s selective enforcement defense.
Motion to Intervene
The LBRY Foundation Inc. (the Foundation) filed a motion to intervene requesting to allow its intervention in the SEC’s case against LBRY Inc. (LBRY). In its motion, the Foundation argued that it has fundamentally different interests than LBRY in this case, arising from their different corporate purposes. Specifically, the Foundation explained that it is a non-profit corporation that works to promote the growth and use of the LBRY Protocol in a “bottom-up, community-driven fashion,” and it grants, not sells LBC tokens, to third-parties in furtherance of the Foundation’s goals. On the other hand, it argued that LBRY is a for-profit, business enterprise that raised funds from venture capital firms and individual investors in the form of convertible promissory notes, and not through the sale of LBC tokens. The Foundation further argued that it likely had different litigation strategies that could result in different outcomes than those pursued by LBRY due to its dependence on the utility of the LBC tokens—whereas, LBRY could continue its corporate existence without the LBC coins, the Foundation would lose its fundamental purpose should the LBC tokens lose their utility.
The court ultimately denied the Foundation’s motion to intervene, citing the SEC’s response to the motion. One of the SEC’s arguments was that both LBRY and the Foundation sought dismissal on grounds that LBCs are not investment contracts, and thus, not securities. The SEC also argued that LBRY and the Foundation had the same interests because the Foundation was an “outgrowth” of LBRY that utilized the LBRY’s resources and personnel to support its mission of promoting growth and usage of the LBRY network.
As part of its motion, the Foundation also noted that while both the Foundation and LBRY challenge the presence of a “common enterprise” under Howey, the Foundation’s argument goes further by challenging the SEC’s “programmatic claim” that a network can be an “enterprise”—common or not—under Howey. The Foundation argued that the SEC’s interpretation of Howey goes beyond the Howey Court’s position—namely, that the business enterprise that registers its securities by filing current business and financial information relevant to determining that enterprise’s future value is the relevant entity for purposes of finding a “common enterprise.” In disputing the SEC’s “newly expanded” understanding of “enterprise” under Howey, the Foundation cited several reasons, including that: (1) LBRY is neither a business enterprise nor issuer, (2) LBCs do not give holders rights against the current and future assets of LBRY, (3) LBRY’s anticipated value as a business enterprise does not determine LBC value, (4) LBRY’s registration does not enhance an LBC “investment decision” because value of LBCs are not tied to the value of LBRY, and (5) LBRY does not have a direct relationship through an LBC with an LBC holder like an issuer of a security has with a security-holder. Unfortunately, because neither the SEC nor the court addressed the Foundation’s common enterprise arguments in resolving the motion to intervene, the efficacy of these arguments is presently unclear.
Summary Judgment and Trial
Summary judgment motions were due on May 4, 2022. If the case does not get resolved through summary judgment, it is scheduled to proceed to trial on September 7, 2022, before United States District Judge Paul J. Barbadoro in the United States District Court for the District of New Hampshire.
SEC Enforcement
There seems to be a perception within the blockchain space that some companies appear to be “getting away” with an activity that might be considered an illegal securities offering. However, as the court in LBRY held, this selective enforcement defense is a “nonstarter because LBRY admits that the SEC has sued dozens of other digital currency creators for alleged violations of the Securities Act.”
As the LBRY court noted, this would lead to the nonsensical conclusion that an enforcement agency like the SEC would have to prosecute against every potential wrongdoer to prosecute against just one. Blockchain companies that are considering issuing tokens should take heed of this fact before jumping into the token-issuing scene.
Implications on the Ripple Case
The LBRY court recently denied a request by the SEC to extend the trial date by about a month. This means that, unless there are additional scheduling changes, the LBRY case will be decided before the SEC’s lawsuit against Ripple Labs for failing to register their offer and sale of XRP, a cryptocurrency issued by Ripple Labs (“the Ripple case”). This is significant because the court’s findings in the LBRY case could be cited in the Ripple case. In fact, the SEC has already tried to include a ruling in the LBRY case as precedent against Ripple Labs in the Ripple case. Specifically, the SEC attempted to use the LBRY court’s ruling on LBRY’s selective enforcement affirmative defense as a sword against Ripple Labs’ fair notice affirmative defense. Although it does not appear to have changed the court’s rulings in the Ripple case, this demonstrates the potential interplay between the two cases as both are pending final adjudication and could be decided in close proximity to one another.
Another aspect to note as both cases proceed forward is whether the SEC has taken any inconsistent positions in the LBRY and Ripple cases. Ripple Labs claims that the SEC has done so with regard to its treatment of a speech made by its former Director of Corporation Finance William Hinman. Ripple Labs noted this fact in its opposition to the SEC’s motion for partial reconsideration of the court’s order regarding the production of notes taken by an SEC official from meetings between the SEC and Ripple Labs, as well as others. In particular, Ripple Labs noted that while the SEC previously maintained, both in the Ripple and LBRY cases, that Mr. Hinman’s speech simply expressed the “personal views” of Mr. Hinman, it was now taking the position that the speech was the culmination of and reflected a policy process within the SEC’s Division of Corporation Finance. While it does not appear that the Ripple court has taken a position on this issue, this further demonstrates the importance of tracking the SEC’s positions in both cases, as the SEC’s positions in one case could certainly impact the outcome of the other case, especially if its positions within each are inconsistent.
Copyright © 2022, Sheppard Mullin Richter & Hampton LLP.National Law Review, Volume XII, Number 151
