Securities and Exchange Commission V. LBRY; Is Your Crypto Project Illegal? | Sheppard Mullin Richter & Hampton LLP

While the crypto community is rightly focused on the Ripple case to see how the SEC will fare in court on enforcement action alleging cryptocurrency offerings are security, a lesser-known case may clarify first. The SEC lawsuit against LBRY is scheduled to go to trial in September 2022.

LBRY is a protocol that allows anyone to build applications that interact with digital content on the LBRY network. Apps created using this protocol allow creators to upload their work to the LBRY host network, price it per stream, download it, or give it away for free. When a creator posts something to LBRY, an entry is made on the LBRY blockchain. The issue of securities results from the sale of LBRY credits as detailed below.

Complaint

In 2021, the Securities and Exchange Commission (“SEC”) filed a lawsuit 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 many investors, including US-based investors, 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 vs. WJ Howey Co., 328 U.S. 293 (1946). The Howey According to the test, an “investment contract” exists when money is invested in a joint enterprise with a reasonable expectation of benefit from the efforts of others. Whether a particular digital asset at the time of its offer or sale satisfies Howey depends on the specific facts and circumstances. In 2019, the SEC published the Framework for Analyzing “Investment Contracts” of Digital Assets (“Framework”) to help individuals determine whether their digital asset violates securities laws.

Apparently as a result of the framework’s analysis, the complaint alleges that LBRY credits were sold to the public in exchange for contributions designed to build, build and expand the LBRY network. The complaint further alleges that LBRY Credit’s sales to institutional investors caused the investor to wait a year before selling his investment. In addition, the complaint alleges that the LBRY Network used proceeds from the sale of LBRY Credits to pay for operational costs necessary to grow the LBRY Network. As alleged, LBRY received over $11 million in US dollars, bitcoins and services from buyers who participated in its bid. All of these charges and more are mentioned in the analysis of the framework.

Answer

In its response, LBRY rebuffed the agency’s claims and asserted several affirmative defenses, including a defense of selective enforcement and a violation of equal protection under the Fifth Amendment charge. LBRY claimed that when the SEC targeted it for enforcement action, the agency treated LBRY differently from other blockchain companies without justification and pursued its investigation in a manner that demonstrated selective treatment “based on malicious intent or bad faith to injure LBRY”.

Motion for judgment on the pleadings

In its response, the SEC challenged the defense saying it was a “non-starter” since LBRY admits the agency has sued 42 other blockchain creators for alleged violations of federal securities. The motion for judgment on the pleadings states that “[t]The SEC argues that LBRY’s admission necessarily precludes its selective enforcement defense because it undermines LBRY’s claim that it was treated differently than other digital currency creators in a similar situation. Citing this argument, the district court rejected LBRY’s selective execution defense.

Motion to intervene

The LBRY Inc. Foundation (the Foundation) has filed a motion to intervene seeking leave to intervene in the SEC’s case against LBRY Inc. (LBRY). In its motion, the Foundation argued that it had fundamentally different interests than LBRY in this matter, stemming from their different social goals. Specifically, the Foundation explained that it is a nonprofit corporation that strives to promote the growth and use of the LBRY protocol in a “bottom-up and community-driven” manner, and that it grants, and not sells LBC tokens, to third parties. parties in pursuit of the Foundation’s objectives. On the other hand, he argued that LBRY is a for-profit business venture that raised funds from venture capitalists and individual investors in the form of convertible promissory notes, 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 reliance on the utility of LBC tokens – whereas LBRY could continue its corporate existence without the LBC coins, the Foundation would lose its fundamental purpose if the LBC tokens lose their usefulness.

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 LBRY and the Foundation had sought the termination on the grounds that LBCs are not investment contracts, and therefore not securities. The SEC also argued that LBRY and the Foundation had the same interests because the Foundation was an “outgrowth” of LBRY that used LBRY’s resources and personnel to support its mission of promoting the growth and use of the LBRY network.

As part of its motion, the Foundation also noted that while the Foundation and LBRY dispute the presence of a “joint venture” under Howeythe Foundation’s argument goes further by challenging the SEC’s “programmatic claim” that a network can be a “company” – joint or not – under Howey. The Foundation argued that the SEC’s interpretation of Howey goes beyond the Howey Court’s position that the business enterprise that registers its securities by filing current business and financial information relevant to determining the future value of that business is the relevant entity for the purpose of the search. a ‘joint venture’. By challenging the SEC’s “newly expanded” understanding of “business” under Howey, the Foundation cited several reasons, including that: (1) LBRY is neither a commercial enterprise nor an issuer, (2) LBCs do not give rights holders over the current and future assets of LBRY, (3) the anticipated value of LBRY as a business enterprise does not determine the value of LBC, (4) the registration of LBRY does not improve an “investment decision” of LBC because the value of LBC is not linked to the value of LBRY, and (5) LBRY does not have a direct relationship through an LBC with an LBC holder like the issuer of a security has with a security holder. Unfortunately, since neither the SEC nor the court addressed the Foundation’s joint venture arguments to resolve the motion to intervene, the effectiveness of those arguments is currently unclear.

Summary judgment and trial

Motions for summary judgment were scheduled to be brought on May 4, 2022. If the case is not resolved by summary judgment, it is scheduled for trial on September 7, 2022 before United States District Judge Paul J. Barbadoro in court district of the United States. for the district of New Hampshire.

SEC Enforcement

There seems to be a perception within the blockchain space that some companies seem to be “getting away with it” with activity that could be considered illegal securities offering. However, as the LBRY court ruled, this selective enforcement defense is “a no-start as LBRY admits that the SEC has sued dozens of other digital currency creators for alleged violations of the securities”.

As the LBRY court noted, this would lead to the absurd conclusion that a law enforcement agency like the SEC should pursue every potential wrongdoer to prosecute only one. Blockchain companies considering token issuance should consider this fact before jumping into the token issuance scene.

Ripple implications

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 timeline 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 affair”). This is important because the court’s findings in the LBRY case could be cited in the Ripple case. In fact, the SEC has already attempted to include a ruling in the LBRY case as a precedent against Ripple Labs in the Ripple Case. Specifically, the SEC attempted to use LBRY’s court ruling on LBRY’s affirmative selective enforcement defense as a sword against Ripple Labs’ affirmative fair notice defense. While this doesn’t appear to have changed the court’s rulings in the Ripple case, it does demonstrate the potential interaction between the two cases, as both are awaiting a final decision and could be decided near one of the other.

Another aspect to note as the two cases progress is whether the SEC took inconsistent positions in the LBRY and Ripple cases. Ripple Labs claims the SEC did so in regards to its handling of a speech given by its former corporate finance director William Hinman. Ripple Labs noted this fact in its opposition to the SEC’s motion for a partial reconsideration of the court’s order regarding the production of notes taken by an SEC official during meetings between the SEC and Ripple Labs, as well as ‘others. In particular, Ripple Labs noted that while the SEC had previously argued, in both the Ripple and LBRY cases, that Mr. Hinman’s speech merely expressed Mr. Hinman’s “personal views”, it now takes the position that the speech was the culmination and reflected a political process within the SEC’s Corporate Finance Division. While it doesn’t appear that the Ripple court has taken a position on this issue, it still demonstrates the importance of following the SEC’s positions in both cases, as the SEC’s positions in one case could certainly have a impact on the outcome of the other case, especially if its positions within each are inconsistent.

Check back for updates on these issues.

Aurora J. William