The Securities and Exchange Commission last week sued blockchain company LBRY Inc. for alleged selling unregistered securities in a case that could threaten Americans’ ability to buy and sell popular cryptocurrencies, including bitcoin and ether, experts say.
LBRY is a protocol based on the blockchain technology underlying bitcoin BTCUSD, +0.69% that enables participants to host video and other content and charge users to stream or download it. The decentralized network is powered in part by so-called miners, who are rewarded for helping to maintain the system with a bitcoin-like token called LBC.
According to the SEC’s complaint against LBRY Inc., the startup that works to improve the LBRY network, the company violated securities laws by selling LBC tokens in order to fund its work, without registering those tokens with the SEC as a security.
Jeremy Kauffman, CEO of LBRY denies that LBC tokens are securities at all, given that it did not conduct an initial coin offering to fund the business, and tokens were being mined and used on the network well before the company sold tokens to invest in the network.
“Under the logic advanced by the SEC…every actively developed blockchain is at risk, especially Ethereum,” he said in an email to MarketWatch. “As long as Ethereum developers are coordinating in some way while holding the token, they are in danger.”
Ether ETHUSD, +0.83% is the second most valuable cryptocurrency after bitcoin. with a market capitalization of more than $230 billion, according to Coindesk, and Ethereum is a popular platform for developing decentralized applications and smart contracts.
William Hinman, the SEC’s former director of the Division of Corporate Finance said in a 2018 speech that “current offers and sales of ether are not securities transactions,” but did not say whether past sales were. Meanwhile, Hinman no longer leads this division and the SEC has never issued any formal guidance on the question.
Federal courts use a set of rules called the Howey test to determine whether a tradeable asset is a security and therefore must be registered with the SEC. The Howey test states that a transaction becomes an investment contract if the investor has an expectation of a profit derived from the work of others on a “common enterprise.”
David Croft, who runs the blockchain and cryptocurrency practice at the law firm Meyers Roman told MarketWatch that it is unlikely LBRY will convince the courts that LBC is not a security.
“I think a lot of these offerings could be construed as securities and likely will be by the courts,” because purchasers of LBC had a reasonable expectation that the value of the digital token would increase as LBRY Inc. continued to improve the network and attract more users, he said.
Kauffman, however, has engaged in a public relations campaign to rally supporters of blockchain technology and private cryptocurrencies, arguing that the SEC is misinterpreting the law by labeling LBC a security.
“If LBRY loses this case, it will cripple the cyrptocurrency industry and create huge disincentives to build these business in the United States,” he said. “Any cryptocurrency that is actively developed would likely require substantial, expensive and intrusive regulatory compliance every time it is exchanged.”
So far, his results have been mixed. The Blockchain Association, an industry group that filed an amicus brief in a similar case the SEC brought against Kik Interactive, declined to comment for this story. Coin Center, a think tank that advocates for pro-blockchain regulation declined to come to the defense of crypto firm Ripple when it was sued in December for selling unregistered securities and also declined to comment for this story.
Adriaen Morse, a former SEC lawyer and partner at Arnall Goldan and Gregory, told MarketWatch that it would be a mistake for the industry and crypto investors to not see the LBRY suit as a threat, because under the logic of the case both bitcoin and ether could conceivably be deemed securities.
Along with his colleague and fellow SEC veteran Cory Kirchert, Morse is in the process of publishing a series of articles explaining why the crypto industry has been taking the wrong approach in its tussles with the SEC, which they allege is engaging in a “cryptocurrency suppression program,” that is actually motivated by a desire to protect the financial interests of incumbent banks and other financial institutions from the threat that cryptocurrencies pose to their businesses.
Cryptocurrencies “threaten bank products, such as checking and savings accounts, banks’ inventories of lendable funds and consequently, banks’ profits,” they wrote, adding that financial regulators are also concerned with protecting the supremacy of the U.S. dollar from the threat that private, digital currencies pose.
The SEC declined to comment for this article.
The problem with the SEC’s analysis according to Morse and Kirchert, is that they are not using the correct definition of the term “common enterprise” as it was defined in the Supreme Court case that spawned the Howey test.
“The term ‘common enterprise’ doesn’t mean that people just share the same objective and are engaged in the same effort,” Morse said. “The operative word is ‘enterprise.’”
Morse and Kirchert argued that under the definition of common enterprise being advanced by the SEC in the LBRY case, a baseball card company that used profits from the sale of its cards to organize memorabilia shows across the country or to create a website that facilitates the sale of cards on the secondary market, could be accused of selling unregistered securities. A reasonable person may expect that the creation of a robust secondary-market infrastructure for baseball cards would increase the value of baseball cards generally, but the SEC would never label baseball cards a security, they said.
Kauffman said he is “eager to have a judge resolve our case and believe that our facts sharply demonstrate what is wrong with the SEC’s approach,” and that this would count as a win for both his company and the industry as a whole. But he’s also open to settling too. “
Since our first discussions in 2018, this has been our constant position, he said. “We’ll be pragmatic on settlement terms that let us put the litigation behind us if the SEC can give us practical guidance that lets us remain in business and follow the law in the future.”