By Paul Conable and Danny Newman
If the ongoing fallout from the collapse of offshore cryptocurrency exchange, FTX, and now BlockFi wasn’t enough, crypto investors also lost a significant battle last month in the U.S. District Court of New Hampshire.
The district court sided with the SEC and found that LBRY, Inc., violated the Securities Act of 1933 in offering its crypto assets. The ruling has potentially wide-ranging implications; and prompted this tweet from LBRY: “The language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the U.S. a security, including Ethereum.”
Is LBRY’s currency a security?
The SEC contended that LBRY’s cryptocurrency LBC (LBRY credits) is an unregistered security. LBRY maintained LBC is not a security at all, but an essential component of the LBRY blockchain. LBRY further argued that the SEC did not give “fair notice” that LBC is subject to the Securities Laws and therefore it could not take enforcement action.
To reach its conclusion, the court relied on the United States Supreme Court’s Howey test, which defines a security as a “contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” In LBRY’s case, the dispute centers on the third Howey element: whether there was “an expectation of profits to be derived solely from the efforts of the promoter or a third party.”
To determine whether LBC is a security and that there was an expectation of profits to be derived solely from the efforts of the promoter or a third party, the court relied on numerous communications, including emails, blog posts, and public proclamations, from the company, from CEO Jeremy Kauffman, and from COO Josh Finer.
- “…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…over the long-term, the interests of LBRY and the holders of [LBC] are aligned.”
- An email to a potential investor, from Finer, explained that the company was “currently negotiating private placements of LBC with several [other] investors” and asked the recipient to write him back “if there is interest.”
- Finer explained how LBC are being traded on “major crypto exchanges” and that trading volume is moving at a healthy clip. The “opportunity is obvious…”
The court considered these and several other comments in its decision. It also weighed LBRY’s counter arguments that these comments, while not disavowed, “constitute only 0.25% of ‘the total number of posts and messages the company has published since its inception.’” LBRY also said it informed some potential LBC purchasers that the token was not being offered as an investment. However, the court concluded that the communication “volume” argument lacked weight; and it rejected the disclaimer argument, writing, “a disclaimer cannot undo the objective economic realities of a transaction.”
Can cryptocurrency offerors rely on a “fair notice” argument?
Unfortunately for LBRY, the court also rejected the argument that it did not have fair notice that it would be subject to state and federal securities laws. The court held: “The principal problem with LBRY’s fair notice argument is that it offers nothing more to support its position than its bald claim that this is the first case in which the SEC has attempted to enforce the registration requirement against an issuer of digital tokens that did not conduct an ICO (initial coin offering)… LBRY does not point to any specific statement by the SEC suggesting that companies need only comply with the registration requirement if they conduct an ICO. Nor does LBRY offer any persuasive reading of Howey that would cause a reasonable issuer to conclude that only ICOs are subject to the registration requirement.”
What does this mean for the crypto industry?
One district court opinion will likely not result in making “every cryptocurrency in the U.S. a security,” but it continues the trend of enforcement agencies and courts leaning more and more towards characterizing crypto assets as securities. The ruling provides more cover to regulators to levy tighter regulations and bring enforcement actions under current rules against offerors of crypto assets, particularly surrounding tokens used in the manner chosen by LBRY.
Similarly, it provides plaintiffs more fodder to potentially bring private causes of action for losses against those who issue coins or tokens. In Oregon, where courts take the broadest possible view of what constitutes a security, a written district court opinion like this will give plaintiffs ammunition to maintain securities law claims that can include award for attorneys’ fees. If a token or other asset is considered a security in other jurisdictions, it will definitely be considered a security in Oregon.
This update is prepared for the general information of our clients and friends. It should not be regarded as legal advice. If you have questions about the issues raised here, please contact Paul Conable, Danny Newman, or the attorney with whom you normally consult.