The Legit Ledger Podcast Ep. 14
SEC Wins Battle Against LBRY’s LBC Token
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In this episode of The Legit Ledger, Sheppard Mullin attorney Jim Gatto joins host Yasamin Parsafar to discuss the Court’s order granting summary judgment in favor of the SEC in its case against LBRY and takeaways from the Court’s order.
About Yasamin Parsafar
Yasamin Parsafar is a partner with the Intellectual Property Practice Group in Sheppard Mullin's San Francisco office, where she serves as co-leader of the firm's Blockchain & Fintech team. Her practice focuses on protecting her clients' intellectual property rights through counseling, prosecution, enforcement and litigation. Yasamin leverages her litigation experience to strengthen and protect her clients' intellectual property, manage risks and position businesses to succeed in the event of a dispute. She frequently advises and protects brands venturing into Web3 on various issues related to non-fungible tokens, the metaverse, games, online marketplaces and other platforms.
About Jim Gatto
Jim Gatto is a partner with the Intellectual Property Practice Group in Sheppard Mullin's Washington, D.C. office, where he co-leads the Blockchain & Fintech Team. His practice focuses on blockchain, interactive entertainment, digital art, AI and online gambling. He advises clients on IP strategies, development and publishing agreements, licensing and technology transaction agreements, and tech regulatory issues. Jim has been involved with blockchain since 2012 and has been recognized as a thought leader by leading organizations, including Best Lawyers in America 2021-2022; Cryptocurrency, Blockchain and Fintech Trailblazer, The National Law Journal, 2018; and Thought Leader on Blockchain & Cryptocurrencies, National Law Review, 2018.
Hi friends. Welcome to another episode of The Legit Ledger. I'm Yasamin Parsafar, the co-leader of Sheppard Mullin's blockchain team. I want to thank you all for joining and ask that if you enjoy this content to please subscribe and share with your friends. We really appreciate that and it gives us motivation to continue to produce this content.
On today's episode, we are going to be discussing developments in the SEC case against LBRY. Joining me today is the co-leader of Sheppard Mullin's blockchain team, Jim Gatto, who has published several blogs on this case which we will link in the show notes. Thanks so much for joining, Jim.
Thanks Yas, pleasure to be here.
All right, so I just want to start out by giving a little bit of background information. LBRY is a protocol that allows anyone to build applications that interact with digital content on the LBRY network. Apps built using the protocol allow creators to upload their work to the LBRY network, set a price per stream, download, or give it away for free.
LBRY credits, which were at issue in this case, is the cryptocurrency used throughout the LBRY ecosystem. Using this currency, creators can charge viewers to stream their content or to earn tips.
In 2021, the SEC filed a complaint against LBRY alleging violations of the Securities Act and specifically for LBRY's conduct and offering and selling allegedly unregistered securities when it sold LBRY credits to investors. Recently, the SEC prevailed on summary judgment against LBRY in this case and there were two key issues that were decided by the court.
The first was whether the sale of the LBRY credits constitute an investment contract and therefore security under the Howey Test. The second was whether LBRY had prevailed on its fair notice defense. Jumping right into the issues, Jim, can you please, starting with the analysis under the Howey Test for the LBRY credits, can you explain how the court analyzed and ultimately decided that issue?
Sure, so the court ultimately decided that the LBRY credits were in fact a security based on the manner in which they were issued. There really was no question that they sold these, at least some of these for money. There was no question that LBRY was in part using the money to build out the network on which the credits would be used. LBRY actually was one of the largest owners, I think it was roughly 40% of the LBC, was actually owned by the network and its employees so they found there was common interest in that if the value of the credits went up, both the purchasers as well as LBRY and its employees would benefit. Three of the components of the Howey Test were pretty clear.
One of the main arguments that LBRY made was that the token had utility and that really was kind of the main argument that they focused on with respect to the Howey Test.
They alleged that LBC, the LBRY credits, which was the cryptocurrency you mentioned, it was a utility token designed for use on the LBRY blockchain that a number of purchasers of LBC acquired it with the intention of using it on the network rather than holding it as an investment and some related arguments on that. We hear that a lot from people. They try to characterize things as a utility token saying it has a useful purpose and therefore it can't be a security.
Well, the court didn't agree with that. The court found that, they responded to LBRY's argument saying that LBRY leaped to the conclusion that LBC cannot be a security based on the fact that it has some utility, even if it was offered as an investment. Here there was evidence that they sold it to some both retail and institutional investors and a part of the proceeds, a significant part of the proceeds was used to actually build the network.
What the court said was that LBRY is mistaken about both the facts and the law and some of the highlights of what the court said was that the fact that LBRY had statements, I think they submitted some affidavits I think to support their arguments. There were statements from a subset of the LBC holders that purchased LBC for use on the blockchain of limited relevance determining whether LBRY offered it as a security. What the court was saying was even if there are some people who actually use it, that's not the end of the analysis.
The second thing the court said is the subjective intent of purchasers may have some bearing on the issue whether they entered into investment contracts, but the court must focus on what the purchasers were offered or promised.
I think this is an important point that's relevant here in that LBRY tried to say, here's some people who said they bought it for utility and not for investments. The court said you have to really look at again what the SEC says is the totality of the facts and circumstances regarding the offering. There was various citations to evidence or at least allegations that LBRY made statements that it would be using the funds to develop the network. That LBC would rise in value predicated on growth of the network. The fact that they sold, as I understood it, more of the LBRY, much more of the LBRY was sold to institutional and retail investors than any actual use.
All of these factors combined made it clear that what LBRY was offering was the prospect for investment return, notwithstanding the fact that some people might actually use it. There was a reference somewhere in the case that the actual, if you look at the number of transactions that were represented, actual use on the platform versus people that bought it on secondary markets for investment purposes, it was something like 99 to 1 or something pretty extreme like that. Based on all of those factors that the court found, notwithstanding the fact that there may be utility for LBC, that the Howey factors were pretty clearly met.
Thanks Jim. Moving on to the next issue. For people who are not familiar with this fair notice defense, the fair notice defense is an affirmative defense that's available to defendants where they lack fair notice that their conduct violated the law. This is a defense that was made both by LBRY and by Ripple in the highly anticipated SEC case against Ripple that the community is watching very closely. Before we get into the parallels to the Ripple case, can you explain how the court decided the fair notice issue with respect to LBRY?
Sure. The court noted that LBRY wasn't making, or they abandoned any broad claim that it lacked fair notice in the way in which the Howey Test was being applied to digital tokens generally, but rather they had a much more specific argument. What the court said was that LBRY argued that it lacked fair notice because until the SEC brought this action, the commission historically and consistently focused its guidance as well as it's enforcement efforts exclusively on the issuance of digital assets in the context of ICOs.
In essence, what LBRY were saying is that they were alleging they didn't do an ICO the way they did the offering and therefore they didn't have fair notice that the way they did it could constitute a security.
The court really wasn't moved much by that argument and they went on to make a couple of statements to explain why they weren't moved by it. The court said even if this is the first case in which the SEC attempted to enforce the registration or compliance with securities laws requirement against tokens that were not offered via an ICO, they note that LBRY doesn't point to any specific statements by the SEC suggesting that companies need only comply with the registration requirements if they conduct an ICO. Nor did the court say that LBRY offered any persuasive reading of Howey that would cause a reasonable issuer to conclude that only ICOs are subject to the registration requirement.
In conclusion, what the court said, the SEC has not based its enforcement action on a novel interpretation of a rule that expressly prohibits the relevant conduct. Instead, the SEC based its claim on a pretty straightforward application, the longstanding Howey case, which was Supreme Court precedent, which has been applied in hundreds of courts across the country for more than 70 years.
It concluded saying that while this may be the first time it used that test against the issuer of a digital token that was not conducted via ICO, the position that LBRY took was just unsupported and there's no basis to find that there was not fair notice.
One other aspect of this that I don't think the court specifically relied on, but if you look at the SEC's guidance entitled Framework for Investment Contract Analysis of Digital Assets, at the very beginning in the introduction it says if you are considering an initial coin offering, sometimes referred to as an ICO, or otherwise engaging in the offer, sale, or distribution of digital assets, you need to consider whether the US federal securities laws apply.
The very first sentence of the SEC guidance on this makes it clear that, or at least they state that this guidance applies to more than just ICOs. Now whether they've actually enforced or not is kind of a separate argument and kind of what LBRY was relying on, but to me it's clear the SEC in their guidance at least has made it clear that it's not limited to ICOs.
One other thing to point out, and this wasn't necessarily directly addressed by the court and it wasn't necessarily an issue specifically in this case, but just for future awareness of this for others who may be thinking about issues related to this, the guidance also said that the guidance applies to issuers and other persons and entities engaged in the marketing offer, sale, resale or distribution of any digital asset and that those entities need to analyze the relevant transactions to determine if the federal security laws apply. I think that the point there is it's not just the entity that issues the digital assets that may need to be mindful of these issues.
That's helpful, thank you Jim. The LBRY community in response to this decision has claimed that this decision is going to hurt the entire industry and that it means that all cryptocurrency will be determined to be securities. What are your thoughts on that?
Well, I disagree with that statement. I think that law and the SEC guidance is clear in that you have to look at the specific facts and circumstances of each case and ultimately under Howey, you're looking at whether or not there's an investment contract and there's a number of facts that can vary from one case to another that could change the analysis. If a company has already built the network, for example, and is not using the funds for the net- to build the network, that's one fact. Again, no one fact is dispositive. I'm just providing example facts that may play into the overall analysis.
Another is that LBRY made statements that the value of the currency was predicated on growth of the network. They mean they tied the two, which again is something that you would talk to investors about typically more so than the utility of the currency.
There's a lot of facts that could be different in another context that wouldn't lead to the same result. In fact, we already know that the SEC has issued a no-action letter for Pocketful of Quarters, that's a cryptocurrency that's used on a platform. They structured it in a way that they were able to get the SEC to do a no-action letter.
The bottom line is this. LBRY started in 2016. A lot of people adopted similar models and I would agree that if the facts are the same as they are in LBRY, then other entities that have those same facts may have the same issue.
The point is that there's different ways to go about using a cryptocurrency with your platform and the SEC and their guidance has indicated certain factors that would tend to negate the finding that there's an investment contract. I think the more you focus on having your offering meet those factors, the more likely you would avoid a finding that it's a security.
Thanks, Jim. Speaking of different facts, we know that some of the issues in this case overlap with the issues in the Ripple case, but there are different facts in that case as well. Can you speak a little bit to that as well?
Sure. Yeah, I again, not to be overly repetitive, but I mean you have to look at the facts and circumstances. I think there, as I understand it, there's different facts in the Ripple case. I think one of the facts that I think is going to come into play is that Ripple has alleged that the SEC or representatives at one point believe that Ripple was not a security. That could be, whether it's deposited or not, that may play into their fair notice argument and or other arguments. The way that Ripple was created and issued is I think different as I understand it from LBRY. I think each case, you have to look at the facts independently and come to a conclusion of whether they meet the factors under the Howey Test.
Right, and for all of our listeners out there, if you have questions about that or need help doing that type of factual analysis, we're always happy to help so please do not hesitate to reach out. I think we're at the end today. Jim, do you have anything to add before we wrap up?
No, I think, well, one thing I would just say is that we're starting to see more enforcements. We're starting to see more court cases going forward. We're continuing to get, I'd say very incremental clarity on some of these issues. I think that we're still mostly seeing regulation through enforcement, which is not ideal. A lot of people have requested that the SEC either revamp the rules or issue clearer guidance or provide a clearer path forward for entities that want to comply with the laws. We've seen situations that the SEC just has refused.
You look at whether it's the ETFs they're not approving, or certain DeFi products where they've made comments that they thought they would be a violation of securities laws, but they're not really giving clear guidance on how to comply. I think we really need greater clarity out of the SEC and or legislation because the technology is not going away. People are using it and there's a lot of people who really want to use it in a way that's legally compliant, but it's difficult in some cases to know what that involves. That's kind of a bit of a challenge for the industry right now and hopefully we can get past that sometime soon.
Right. Thank you so much, Jim. Thank you for joining us today, and I also want to thank all of our listeners for joining us. If you have any topic suggestions or would like to be a guest on our show, please do not hesitate to reach out. Our contact information is below and of course, we're always happy to help with any web three legal needs you may have. Have a great week and we will see you on next week's episode. Thank you.
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