This Tiny Blockchain Startup’s Tangle With SEC Could End Up as Landmark Case

It’s a blockchain startup project that few people have heard of, involving a cryptocurrency that barely anyone trades.

But the saga of LBRY is being closely tracked by lawyers who say the low-profile case now before the U.S. Securities and Exchange Commission could have massive implications for the key question of which cryptocurrencies might be deemed to be afoul of regulations and why.

The SEC’s civil lawsuit against LBRY might end up setting a regulatory precedent for hundreds of small-scale crypto projects, security lawyers interviewed by CoinDesk said. That’s true, even though LBRY’s token, LBC, has a market capitalization of just $21 million – a tiny fraction of XRP, the $39 billion cryptocurrency at the heart of the much higher profile case by the SEC against Ripple Labs.

“A judicial opinion in the LBRY case will have much more impact for people looking for clarity than the Ripple case,” said Grant Gulovsen, a third-party lawyer who advises crypto startups and who's not involved in the LBRY litigation. “There are so many, many projects that did similar things to what LBRY did compared to what Ripple did,” he said.

A suit from last March

LBRY is a blockchain-based file-sharing and payment network designed to create a publication platform that allows uncensored and unlimited digital content interaction. Financial transactions like tipping and subscription of paid content can be made on the platform through LBC, its token currency. The platform’s owner is based in Manchester, N.H.

The SEC sued LBRY last March for allegedly offering unregistered securities to raise a total of $6.2 million starting in 2016. The SEC accused LBRY of offering and selling LBC to institutional investors and using the proceeds to pay bills for operating expenses. Investments where returns are closely intertwined with a business’ managing performance are typically considered securities, regulated assets that need to be registered with the SEC.

Unlike bitcoin and some other cryptocurrencies that are more decentralized, LBC is managed by a centralized team. That is why the SEC thinks LBC should be considered a security instead of a currency. Many crypto-related regulatory disputes surround debates over the definition of securities.

LBRY also made an ambitious promise about the token’s future value that the SEC thought to be misleading. LBRY updated some changes on its platform in February 2021 and said on its website that “best is yet to come” with a rocket ship emoji the SEC thought was hinting at the potential growth of LBC.

LBC holders’ return is based purely on the potential value of the token. They don’t receive interest, dividends or governing rights.

LBRY responded to the SEC in June, writing in a court filing that “LBRY’s sales of LBC do not resemble securities in any meaningful way.”

The company even went so far as to compare the SEC’s pursuit of the case to the relentless persistence of the French inspector Javert in “Les Miserables.”

The SEC is “squeezing a new technology into an outdated and vague definition of ‘security,’” the project’s filing said.

“The Supreme Court’s ‘investment contract’ test for the definition of a ‘security’ does not extend to situations where, like here, one ‘purchases a commodity for personal consumption,’” LBRY wrote.

The SEC Policy

“Oftentimes, it’s just luck,” said Lisa Bragança, a former SEC enforcement lawyer who now acts as defense attorney for crypto startups. The Chicago-based lawyer is not involved in the LBRY case.

“The SEC doesn’t really care about what the formal fundraising process is. They look at the substance of what they did,” she said.

Ripple was sued in December 2020 for allegedly raising over $1.3 billion through an unregistered securities offering. The case is one of the biggest crypto lawsuits before the SEC and has attracted much media coverage because of the popularity of the digital asset, XRP, which is used in Ripple’s payment network. The case is also in the discovery phase at the moment.

It’s common practice for firms under the SEC’s microscope to settle allegations without going to trial, which is partly why LBRY’s case, along with Ripple’s, is so rare – offering a courtroom test of the law and regulators’ interpretation of what constitutes a security.

Initial coin offerings, similar to initial public offering in traditional stock markets, are used by many crypto projects to raise funds. The process bears hallmarks of securities offerings that merit enforcement actions.

LBRY, however, didn’t have an ICO. The project claimed that LBCs were issued just to platform users for utility purposes only. The token was meant to be fully functional and decentralized since its launch.

Gulovsen said he was surprised that the SEC even filed this case in the first place.

ICOs represented “the controversial way of fund sourcing behind most wrongdoings sought after by the SEC,” he said.

Saving crypto?

What the SEC is targeting in this case is how LBRY publicly announced to its community (investors in the crypto world) that it planned to engage with a “market maker.” A market maker is an entity that is supposed to buy and sell the company’s crypto token on a regular basis at prevailing market prices. Such an announcement is likely to increase the price of their token, striking a nerve with the SEC.

“Compared to everything that’s happening in the crypto space, LBRY belongs to those who try very hard to do the right things,” Gulovsen said.

“If LBC is a security, every other cryptocurrency is a security,” LBRY CEO Jeremy Kauffman told CoinDesk. “We are not trying to compete with the existing financial system. LBC is used for its intended purpose, not for speculative reasons.”

Keith Miller of Perkins Coie, LBRY’s defense attorney, said, “LBRY intends to vigorously defend this action. They stand by their answer to the SEC’s complaint and do not believe that LBCs are securities.”

As the case heats up, the project’s officials have cast themselves as unlikely heroes.

“HELP US SAVE CRYPTO,” LBRY called out to supporters in a pinned tweet, featuring an image with LBRY as David and the SEC as Goliath.

The SEC declined to provide a comment for this story.

The SEC’s recent move

Last month, the SEC filed a motion for an extension of the trial’s discovery phase, arguing that LBRY hadn’t produced certain documents.

The judge granted the motion in part, extending the discovery period by 30 days, but declined to move the trial start date beyond Sept. 30.

LBRY expressed frustration in a tweet: “At last minute, the SEC wants to pause our court case for another eight weeks to collect more ‘evidence.’”

“It is unusual for the plaintiffs to ask for additional time,” Bragança said. “That was a surprise. Either the SEC lawyers are running into problems at how to pursue the case, or this is a result of internal politics as they wait for the Ripple case to become the predecessor.”

Before the suit kicked off early last year, LBRY had already been under SEC investigation for three years. The LBRY team claims to have complied with the SEC in supplying nearly 1 million pages of documents along with multiple in-person testimonies. Those documents and interviews, according to the company, cost “substantial amounts of time, energy and money” that caused “significant harm” to the small business.

“Even as LBRY cooperated with the investigation and complied with subpoenas, the SEC […] threatened to seek even more voluminous materials through administrative subpoenas in order to bankrupt the company,” the company wrote in its answer to the SEC’s complaint.

Win or lose, LBRY is likely to set an example for peers. No similar case has reached a verdict so far.

Gulovsen said he is surprised that the SEC is still collecting evidence at this stage of the proceedings.