In 1941, a Florida man hatched a plan to grow his citrus empire. But he made a critical error, and sparked a lawsuit that would have repercussions – in Manchester, New Hampshire – 81 years later.
Back then, William John Howey offered a deal. Investors could buy tracts of his land and lease it back to a company Howey controlled in order to develop and cultivate citrus groves. Howey’s company would then harvest and sell the fruit and give the landowners a share of the profits every year.
In Howey’s eyes, it was a win-win arrangement: an upfront land sale for him and a steady return for the landowners. In the eyes of the U.S. Securities and Exchange Commission, it was an unregistered investment contract and a clear violation of the federal Securities Act.
The legal battle – and the 1946 Supreme Court decision that sided with the SEC – created a key new standard for determining when a contract should be seen as a security and registered as if it were a stock or a bond.
And this month, that standard, “the Howey Test,” upended a crypto-driven file-sharing company co-founded by a well-known New Hampshire libertarian and based in Manchester.
In a ruling Nov. 7, the U.S. District Court for the District of New Hampshire applied the 1946 precedent to find that LBRY, a company co-founded by former U.S. Senate candidate Jeremy Kauffman, had been illegally selling cryptocurrency credits that should have been registered as securities.
The court ruled that just as Howey had been selling investment contracts under the guise of land sales of citrus groves, LBRY had been selling a crypto investment under the guise of a credit to access LBRY’s platform.
The ruling could create serious financial problems for the 7-year-old company. Judge Paul Barbadoro granted an SEC motion calling for the “disgorgement of all ill-gotten gains from the unlawful conduct set forth here,” a decision that, barring a settlement or an appeal, could seriously threaten LBRY’s future.
The final settlement could bar the company from operating the credits that power its internal economy, forcing it to lose a key revenue stream.
In an email Wednesday, Kauffman declined to comment on whether the company would appeal the decision or seek to settle.
“We will pursue whatever course of action is best for LBRY users and our mission to create a decentralized protocol that makes censorship impossible,” he said. The company itself may not survive, he added, “but the protocol is used daily by millions, the code is open source, and the work will continue some other way."
... the code is open source, and the work will continue some other way.
But as the company wrestles with its response, Kauffman and some legal observers argue the ruling also demonstrates the latest in a series of aggressive actions taken by the SEC against crypto-based companies. That oversight role has received new attention in the past week after the collapse of FTX, a cryptocurrency exchange that filed for bankruptcy last week after failing to return its users’ investments.
“The SEC vs LBRY case establishes a precedent that threatens the entire US cryptocurrency industry,” argued Kauffman in a tweet the day of the decision. “Under this standard, almost every cryptocurrency, including Ethereum and Doge, are securities.”
The ‘credit’ question
Founded in 2015, LBRY created a file-sharing platform allowing users to purchase and share videos and other content without corporate oversight or rules.
The platform uses blockchain technology, a type of digital ledger that tracks ownership of assets without the need for human intervention, allowing it to operate without centralized control.
A court filing on behalf of LBRY described the service as “an alternative to centralized applications, such as YouTube, which have become increasingly autocratic in their censorship and demonetization policies and processes.”
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In order to build that platform, the company’s founders self-funded the effort, and raised a “small amount” of funds from angel investors and venture capital firms, according to court filings. When the platform launched in 2016, the company also launched credits, known as LBC, which users can purchase in order to buy and upload content on the platform.
Those credits are at the heart of the SEC’s case against LBRY. The SEC argued the credits are the backbone of the company’s finances and function primarily as investment contracts, because they can rise and fall in value and can be sold for profit. The commission has pointed to statements made by Kauffman and others that noted the value of the LBRY credits was tied to the value of the company and the ability of the company’s founders to improve the company.
That distinction is crucial, according to Carol Goforth, a University of Arkansas professor and a leading U.S. scholar on cryptocurrency regulation. Cryptocurrencies such as Bitcoin do not need to be regulated as securities because their value is not tied to a company or representative, Goforth said in an interview. But crypto assets whose value depends directly on one company’s performance do meet the standard for securities, she said.
“The language that the SEC used in its 2019 framework on digital assets is whether or not there is an active participant upon whom others are relying,” Goforth said. “And in the LBRY case, the active participant was in fact the LBRY group – the group of creators for this particular token.”
But LBRY countered that the credits are not investments and have a functional purpose: to allow users to access the platform. Other credits were marketed to allow buyers to support the mission of the decentralized platform, not as investment opportunities, LBRY added in its court filings. And the company has noted that the credits were not seed investments; they were launched only after the platform was functional, and the company did not engage in a public offering of the credits.
“They waited very carefully until after it was functional to start selling it,” Goforth said. “And that was very smart. The thing that turns out in hindsight not to have been smart was to so publicly link the profitability of the investment opportunity.”
“You walk around with a big target on your back, don’t be surprised if you’re the one that gets shot at,” she added.
Kauffman disagrees with that, pointing to statements raised in the company’s court filings in which users were told not to speculate on the LBRY tokens.
“LBRY made many statements discouraging purchases for investment purposes. But, Kauffman added, “the judge said that regardless of any marketing statements, LBRY would be a security.”
SEC, Congress, and the future of crypto
In the end, Judge Barbadoro sided with the SEC. “LBRY made no secret in its communications with potential investors that it expected LBC to grow in value through its managerial and entrepreneurial efforts,” he wrote.
Additionally, Barbadoro ruled, the fact that the credits had a practical use within the LBRY platform did not mean that they couldn’t also be bought and sold as investments.
Exactly what happens next is unclear; Barbadoro has called for a status conference between the parties, a move that could lead to a settlement. In a tweet Tuesday, the company referred to a “settlement proposal” made by the SEC, but did not comment on whether it would accept one.
To Goforth, the court ruling is the latest example of a regulatory environment that works better to punish crypto companies than to help them.
The current security registration system can be prohibitive to work with for cryptotechnology companies, Goforth argues. In an email, Kauffman argued that even if LBRY had wanted to register its credits as securities, the process would be “literally impossible.”
Meanwhile, the SEC has used the 1934 Securities Act to take action against other crypto companies in the recent past. In 2020, the U.S. District Court for the Southern District of New York ruled in favor of the SEC against “Kik,” the company behind the free messaging app “Kik Messenger,” after finding that the company had issued digital “Kin” tokens that also were not registered. That decision resulted in a $5 million fine and a requirement that Kik not issue the tokens without registration.
Most SEC enforcements against crypto-related companies do not end up in court, Goforth said; the financial power of the SEC often forces smaller start-ups to settle.
“I don’t get the feeling that they are neutral to crypto assets,” Goforth said of the SEC, agreeing with Kauffman. “I also view them as being relatively hostile.”
Kauffman had stronger words. “The SEC behaves exactly as the mafia would: they threaten to use their subpoena power to cause damages, they only conduct business by phone, and they look the other way when you pay them off,” he said.
SEC Chairman Gary Gensler has defended the regulatory action, arguing he is attempting to protect investors by putting crypto currency under the same rulebook as the stock market.
“Nothing about the crypto markets is incompatible with the securities laws,” he said in September. “Investor protection is just as relevant, regardless of underlying technologies.”
Goforth and other academics who study cryptotechnologies say the answer is not to shut the SEC out of the process, but to pass better, modern regulations that are supportive of and tailored to blockchain technology. That is likely going to require legislation in Congress.
“We’ve got some decent bills that are under consideration that might get things moving,” Goforth said. “And then you have, of course, the huge, huge, huge fallout that I expect to be happening from the FTX collapse and the issues of Binance (a rival cryptocurrency exchange), and what that does to market stability, which I think we have yet to see. That, I think, might push additional pressure to get a legislative solution.”
On that point, Kauffman, a staunch libertarian, grudgingly agrees.
“The future of crypto now rests with an org worse than the SEC: the US Congress,” he wrote in a tweet.