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(Reuters) – Digital media company LBRY Inc asserted in a series of tweets on Monday that the entire cryptocurrency industry is now under threat, after a New Hampshire federal judge ruled that its digital tokens are securities that must be registered with the U.S. Securities and Exchange Commission.
“The language used here sets an extraordinarily dangerous precedent that makes every cryptocurrency in the U.S. a security,” LBRY tweeted. “Even after five years of fighting and a court ruling, we still honestly do not know how to legally launch a public blockchain in the U.S.”
Should the cryptocurrency industry panic?
There is no doubt that the ruling from U.S. District Judge Paul Barbadoro of Concord, granting summary judgment to the SEC, is ominous for crypto token creators concerned about SEC regulation. The judge, as my colleague Jody Godoy reported on Monday, rejected LBRY’s arguments that its tokens are a true cryptocurrency used primarily to pay for services on its blockchain-backed data network and that the SEC failed to provide fair warning that it would sue over unregistered tokens that did not enter the market in an initial coin offering.
Barbadoro held unequivocally that LBRY’s tokens were investment contracts under the U.S. Supreme Court’s 1946 test in SEC v. Howey. In the LBRY case, the judge said, the only contested element of the three-pronged Howey test was whether token purchasers were led to expect profits based on LBRY’s efforts. Barbadoro said that early investors and blockchain miners who received the tokens had such an expectation because they knew LBRY’s operations relied on the tokens’ increased value.
In perhaps the most consequential language of the ruling, Barbadoro said any reasonable purchaser of the tokens would expect LBRY to use its own stake — hundreds of millions of tokens — to boost the value of the cryptocurrency. That structure alone, the judge said, “would lead purchasers of [LBRY tokens] to expect that they too would profit from their holdings of [the tokens] as a result of LBRY’s assiduous efforts.”
That’s ominous language, considering that the LBRY model, in which blockchain developers retain a big stash of the tokens that serve as currency on their platforms, is not at all unusual.
But I’d suggest the industry wait for a decision in the SEC’s closely watched case against Ripple Labs Inc, before deciding that the sky is falling.
In summary judgment briefing underway before U.S. District Judge Analisa Torres of Manhattan, Ripple has advanced arguments that LBRY’s lawyers at Perkins Coie did not assert — including a position that seems designed eventually to appeal to the current Supreme Court’s preoccupation with historical practices.
Ripple, whose lawyers declined to provide me with a statement about the LBRY ruling, has also developed a much more robust record than LBRY to support its assertion that the SEC failed to provide fair notice about which crypto tokens it would deem to be securities.
The SEC, which declined to comment specifically on the LBRY or Ripple cases, said in an email that “digital assets that qualify as securities under the criteria long-ago set out by the Supreme Court cannot be given a pass from the securities laws.”
The commission’s summary judgment brief in the Ripple case is obviously filled with background facts about what the SEC alleges to be a years-long, $2 billion offering of unregistered securities by a company that had ample warning it was skirting the law. Nevertheless, its legal arguments for why Ripple’s tokens qualify as securities under the Howey test are quite similar to those the SEC asserted in the LBRY case.
But Ripple (and its chairman and CEO, who are also defendants in the SEC proceeding) offered different defenses than LBRY. Ripple reached back to state-law cases underlying the Supreme Court’s Howey ruling to argue that an investment contract can only be considered a security if the promoter and investor entered a contract that required the promoter to take particular actions to benefit the investor and granted the investor a specific right to share in profits generated by the promoter’s efforts. Defense counsel from Debevoise & Plimpton; Kellogg, Hansen, Todd, Figel & Frederick; Paul, Weiss, Rifkind, Wharton & Garrison; and Cleary Gottlieb Steen & Hamilton said there was no such contract between the Ripple defendants and purported investors who received tokens through donations, giveaways and even sales.
Ripple’s brief argued that even after Howey, neither the 2nd U.S. Circuit Court of Appeals nor the Supreme Court has held the sale of an asset to be an investment contract unless the promoter and purchaser had specific rights and obligations. Ripple drew an analogy between its tokens and diamonds, arguing that when DeBeers sells uncut diamonds, it is not entering into investment contracts with buyers, even if those buyers expect to profit from the diamonds they’ve bought.
In the LBRY case, remember, Barbadoro said that LBRY’s control of hundreds of millions of tokens was a signal to investors that the company would act to prop up their value. Ripple pointed again to the diamond market to argue otherwise: The SEC does not regulate diamond purchases as securities deals, Ripple said, despite DeBeers’ marketing efforts.
Ripple is also asserting a much more sweeping fair notice defense than LBRY, which argued simply that the SEC previously acted only when token issuers conducted public offerings. The New Hampshire judge said LBRY failed to show that the SEC pledged only to enforce the Howey test for tokens sold in ICOs and that the Howey test itself contained no such restriction. (LBRY counsel from Perkins Coie declined to comment on differences between their arguments and Ripple’s.)
Ripple argued in its response to the SEC’s summary judgment motion that the commission’s own files reflect years of confusion and uncertainty within the agency about how or whether to regulate cryptocurrencies. “No wonder that market participants were unsure what to think,” Ripple said. At the very least, it argued, the notice issue must be hashed out at trial.
There are, to date, nearly 700 docket entries in the Ripple case, compared with only 86 in LBRY. If the SEC wins summary judgment against Ripple, the industry will have real cause to worry.
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