1940s precedent casts doubt on the future of file-sharing company NH

This story was originally produced by the New Hampshire Bulletin, an independent local newsroom that allows NHPR and other media outlets to republish their coverage.

In 1941, a Florida man hatched a plan to expand his citrus empire. But he made a crucial mistake, sparking a lawsuit that would have repercussions 81 years later in Manchester, New Hampshire.

It was then that William offered John Howey a deal. Investors could buy parts of his land and lease it back to a Howey-controlled company to develop and cultivate citrus groves. Howey’s company would then harvest and sell the fruit, giving the landowners a share of the profits each year.

In Howey’s eyes, it was a win-win agreement: an upfront sale of land for him and a steady return for the landowners. In the eyes of the US Securities and Exchange Commission, it was an unregistered investment contract and a clear violation of the Federal Securities Act.

The litigation — and the 1946 Supreme Court decision that sided with the SEC — created an important new standard for determining when a contract should be considered a security and registered as if it were a stock or a stock bond would trade.

And last week, that standard, “the Howey Test,” turned on its head a crypto-driven file-sharing company co-founded by a well-known New Hampshire libertarian and based in Manchester.

In a Nov. 7 ruling, the U.S. District Court for the District of New Hampshire applied 1946 precedent to find that LBRY, a company co-founded by former U.S. Senate nominee Jeremy Kauffman, had illegally sold cryptocurrency loans that had must be registered as securities.

The court ruled that just as Howey had sold investment contracts under the guise of selling citrus grove land, LBRY had sold a crypto investment under the guise of a loan 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 requesting the “return of all profits wrongfully obtained from the illegal conduct set forth herein,” a decision that, absent a settlement or appeal, could seriously jeopardize LBRY’s future.

The final settlement could prevent the company from operating the loans that power its internal economy and force 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 a settlement.

“We will follow the course of action that 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 by millions every day, the code is open source, and the work continues in other ways.”

But while the company wrestles with its response, Kauffman and some legal observers argue that the ruling also marks the latest in a series of aggressive SEC actions against crypto-based companies. This oversight role has received renewed attention over the past week after the collapse of FTX, a cryptocurrency exchange that filed for bankruptcy last week after failing to repay its users’ investments.

“The SEC vs. LBRY case sets a precedent that threatens the entire US cryptocurrency industry,” Kauffman argued in a tweet on the day of the decision. “By this standard, almost all cryptocurrencies, including Ethereum and Doge, are securities.”

The Credit Question

Founded in 2015, LBRY created a file-sharing platform that allows users to buy and share videos and other content without company oversight or rules.

The platform uses blockchain technology, a type of digital ledger that tracks asset ownership without human intervention, allowing it to operate without central control.

A court filing on behalf of LBRY described the service as “an alternative to centralized applications like YouTube, which have become increasingly autocratic in their censorship and demonstration policies and processes.”

To build this platform, the company’s founders self-funded the effort, raising 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 introduced credits, known as LBC, that users can purchase to buy and upload content on the platform.

These loans are at the center of the SEC’s case against LBRY. The SEC argued that the loans are the backbone of the company’s finances and function primarily as investment contracts because they can go up and down in value and can be sold for a profit. The Commission has drawn attention to statements by Kauffman and others noting that the value of the LBRY loans was tied to the value of the company and the ability of the company’s founders to improve the company.

This distinction is crucial, according to Carol Goforth, a professor at the University of Arkansas and the leading US scholar on cryptocurrency regulation. Cryptocurrencies like bitcoin don’t need to be regulated as a security because their value isn’t tied to a company or agent, Goforth said in an interview. But crypto assets, whose value directly depends on a company’s performance, meet the standard for securities, she said.

“The language the SEC used in its 2019 digital asset framework is whether there is an active participant that others rely on,” Goforth said. “And in the LBRY case, the active participant was actually the LBRY group — the group of creators of this particular token.”

However, LBRY countered that the credits are not investments and have a functional purpose: to allow users to access the platform. Other loans were marketed to allow buyers to support the decentralized platform’s mission, rather than as investment opportunities, LBRY added in its court filings. And the company has determined that the loans were not seed investments; They were only introduced after the platform was up and running, and the company did not participate in any public offering of the loans.

“They waited very carefully until it was operational to start selling,” Goforth said. “And that was very smart. What in hindsight turned out to be unwise was to publicly link the viability of the investment opportunity.”

“You’re walking around with a big target on your back, don’t be surprised if you get shot at,” she added.

Kauffman disagrees, citing statements in the company’s court filings that told users not to speculate on the LBRY tokens.

“LBRY has made many statements discouraging purchases for investment purposes. But, Kauffman added, “the judge said LBRY would be a security regardless of marketing claims.”

SEC, Congress and the Future of Crypto

In the end, Judge Barbadoro sided with the SEC. “…LBRY has made no secret in its communications with potential investors that it expects LBC to increase in value through its management and corporate efforts,” he wrote.

Additionally, Barbadoro ruled that just because the loans have practical use within the LBRY platform doesn’t mean they can’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 result in an agreement. In a tweet Tuesday, the company referred to a “settlement proposal” from the SEC, but didn’t say whether it would accept one.

For Goforth, the court ruling is the latest example of a regulatory environment that punishes crypto companies better than it helps them.

The current security registration system can be prohibitively expensive for crypto technology companies to work with, argues Goforth. In an email, Kauffman argued that even if LBRY wanted to register its loans as securities, the process would be “literally impossible.”

Meanwhile, the SEC has used the Securities Act of 1934 to target 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 used “Kin” digital tokens had issued were also not registered. This decision resulted in a $5 million fine and a requirement that Kik not issue the tokens without registration.

Most SEC enforcement actions against crypto-related companies do not end up in court, Goforth said; The financial strength of the SEC often forces smaller start-ups to settle here.

“I don’t feel like they are neutral on crypto assets,” Goforth said of the SEC, agreeing with Kauffman. “I also see them as relatively hostile.”

Kauffman had stronger words. “The SEC behaves exactly like the mafia: they threaten to use their subpoena powers to cause harm, they only do business over the phone, and they look the other way when you pay them,” he said.

SEC Chairman Gary Gensler has defended the regulatory moves, arguing that he is trying to protect investors by putting the cryptocurrency under the same set of rules as the stock market.

“Nothing about the crypto markets is inconsistent with securities laws,” he said in September. “Investor protection is just as relevant, regardless of the underlying technologies.”

Goforth and other academics studying crypto technologies say the answer is not to exclude the SEC from the process, but to pass better, modern regulations that support and are tailored to blockchain technology. That will likely require legislation in Congress.

“We’ve been considering some decent bills that could get things moving,” Goforth said. “And then of course you have the huge, huge, huge impact that I expect from the FTX meltdown and Binance (a competing cryptocurrency exchange) issues and what that means for market stability, which I think we have yet to see . I think that could create additional pressure to get a legal solution.”

On this point, Kauffman, a committed libertarian, grudgingly agrees.

“The future of crypto now rests with an organization worse than the SEC: the US Congress,” he wrote in a tweet.

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