The Securities and Exchange Commission (SEC), without authorization from Congress or from formal rulemaking, continues its punitive push against blockchain-based companies that sell native tokens with its recent complaint against LBRY and its native LBC cryptocurrency.
Even before Bitcoin’s 2017 price surge, widespread interest in alternative or “alt coins”—cryptocurrencies that were alternatives to Bitcoin—was taking hold. Many “alt coin” founders presold tokens to fund eventual network-type businesses. This phenomenon became known as initial coin offerings (ICOs). The practice exploded in 2017-2018.
The SEC remained mostly silent during the ICO boom but then flooded alt-coin founders with a tsunami of subpoenas beginning in 2018. To be sure, some ICOs were scams and deserved prosecution, but others were and are legitimate companies building out viable networks and providing value to purchasers and consumers.
LBRY, Inc. is one such company. It promotes an “open, free, and fair network for digital content” and boasts 10 million users. Someday it could rival YouTube, Amazon, and other video content providers. But first it risks bankruptcy in a legal fight with the government for violations that lack victims.
LBRY offered LBRY Credits (LBC) to software developers for network contributions and sold LBC on exchanges to encourage its use and fund operations. The SEC claims LBC are unregistered securities despite their actual and widespread network utility. The suit seeks a permanent injunction, disgorgement of “ill-gotten gains,” civil penalties, and other remedies. If successful, the Commission will stifle innovation and entrench incumbents while harming platform users the Commission claims to be trying to protect.
The SEC Investigation Process Is the Punishment
The SEC investigated LBRY for three years before filing suit on March 29 of this year. These inquiries are notoriously painful; they have been described by one seasoned securities lawyer as “living in hell without dying.” Thus far, the company claims the process has cost thousands of man-hours and $1 million in legal fees. But a few things are missing from the complaint. First is any claim of injury by platform users. Second is any discussion of LBRY’s decentralized nature.
Decentralization is a factor previously suggested by former SEC Corporation Finance Division Chief Bill Hinman as an escape hatch from securities-related burdens for networks where public benefits were absent. LBRY claims decentralization via hundreds of contributing developers around the globe, many unknown to the company.
Instead, the complaint rests on the decades-old Supreme Court Howey test, which covers a security type called “investment contracts.” In short, LBRY sold LBC (contribution of money), the company has contributed to platform success (a common enterprise), and LBC may rise in value with continued success (expectation of profits), so therefore LBC is a security, which leaves thus LBRY is in legal limbo.
W.J. Howey, the case’s namesake, sold plots of land containing orange groves and offered purchasers shares of the profits. Seventy-five years later, the Court’s analysis of the enterprise guides the Commission’s every crypto pronouncement. But as CEI Senior Fellow John Berlau has argued, the SEC’s Howey interpretation doesn’t reflect the realities of most crypto sales:
[E]ven under the broad reading of “investment contracts” from the Howey test, cryptocurrency appears to fall outside the statutory definition of “securities.” In Howey, the service contracts obligated the original owner to maintain the orange groves for a number of years. The court stated that “there is ordinarily no right to specific fruit” for the owners of shares in the grove. There are no such maintenance obligations in most cryptocurrency contracts, and consumers individually own the “fruit”—or coins—from day one.
Furthermore, secondary sales on exchanges, a point the complaint emphasizes, never appeared in the Court’s Howey investment-contract analysis. Berlau states, “Whether the oranges from the Howey groves could be sold in different markets was never at issue in the 1946 Supreme Court case. The Court deemed the interests in the groves to be securities because of participants’ right to a share of the profits and provisions in the specific service contracts that obligated the original owner to maintain the groves for the participants’ benefit.” Thus, the SEC’s current Howey reliance dangerously expands its authority.
SEC Crypto Policy Is a Mess
The move against LBRY, and the higher profile Ripple action, are the SEC’s latest steps to bring crypto companies under its ambit. Unfortunately, the Commission has chosen costly years-long investigations as its primary interface with these new technology players. Its most prominent non-enforcement action was the widely panned 2019 staff guidance. The 13-page document, which Commissioner Hester Peirce likened to a “Jackson Pollock painting,” only heightened calls for crypto clarity.
At present, the Commission leaves crypto entrepreneurs few good options: a) create a functioning platform with a native currency and wait for a dreaded SEC inquiry; b) go through a costly registration or qualification process with perpetual reporting obligations and annual six-to-seven-figure compliance costs; or c.) move to a different jurisdiction and don’t sell tokens to U.S. citizens.
Permissionless, open-source blockchain projects, which require developer buy-in and mass adoption, don’t gel with these options. Decentralized networks, by their nature, don’t have central points of authority but usually rely on founding teams and seed capital to gain traction.
The SEC’s Unending Prosecutions of Blockchain Companies Has Real Consequences
The SEC’s “regulation by enforcement” paradigm has stark consequences. It discourages those creating the future economy from starting U.S. blockchain companies or allowing its citizens full access. It creates roadblocks for founders trying to lure developers and programmers into new projects. It impedes the network effects that new blockchain projects need to thrive. Finally, it squelches competition. Mass adoption and regulatory capture allow tech giants to collect economic rents. Consumers seeking decentralized, censorship-resistant alternatives have fewer choices.
An SEC victory against LBRY will continue its winning streak against upstarts who sold native tokens in recent years. Other high-profile nonfraud defendants Telegram and Kik surrendered after millions in legal fees and federal court defeats.
Yet the story here is worse. LBRY only sold most LBC after its network was live and functioning. As Commissioner Peirce previously stated, “Tokens sold for use in a functioning network, rather than as investment contracts, fall outside the definition of securities.”
Given the lack of Commission clarity for decentralized platforms, the path ahead offers little room for innovation for those lacking the budgets and stomach for years-long legal fights. The SEC will no doubt tout a court victory as a win for consumers and another fulfillment of its investor-protection mandate. LBRY’s millions of users would disagree.