Tag Judge

Many in the virtual currency industry have been confused and bedeviled by the Securities and Exchange Commission’s (SEC) gradual and ill-explained encroachment on their world, with frequent claims from SEC Chair Gary Gensler that most cryptocurrencies should be properly seen legally as “securities” that ought to be regulated by his agency. That would potentially make lots of legit businesses suddenly illegal dealers in “unregistered securities.”

In a decision last week in an ongoing bankruptcy case of Voyager Digital Holdings, U.S. bankruptcy Judge Michael E. Wiles in the U.S. Bankruptcy Court for the Southern District of New York laid into SEC agents for their perplexing and officious manner of trying to force through their attitudes about cryptocurrencies-as-securities.

Part of the proposed bankruptcy reorganization plan for Voyager Digital Holdings would involve shifting customer accounts over to cryptocurrency exchange Binance.

The SEC objected to this Binance solution, claiming “that in its view the Debtors had the burden to prove that the rebalancing of the Debtors’ cryptocurrency portfolios…would not involve illegal purchases and sales of securities.”

The SEC did this, as Judge Wiles complains, essentially through innuendo: “The objection did not take the position that any particular cryptocurrencies are securities, or otherwise explain how or why the Debtors’ rebalancing activities might be illegal, although it did contain a vague footnote suggesting that the VGX token was one as to which some unspecified issue might exist,” Judge Wiles wrote.

“The SEC also suggested that the Debtors should be required to prove that Binance.US is not operating as a securities broker without registering as such,” he continued. “Once again, the SEC did not actually take the position that Binance.US is operating as an unregistered and unlicensed securities broker. Instead, it just suggested that the Debtors had the burden to prove the negative, without offering any evidence or even any reason to think that Binance.US actually is doing anything for which it requires further SEC registrations.”

Judge Wiles finds this situation highly aggravating, noting that “Voyager operated, and Binance.US currently operates, in a regulatory environment that at best can be described as highly uncertain.”

If the present legal environment in which companies such as Binance must operate is unknown, the future into which the judge must hope his decisions will function is even more so: “The SEC has filed some actions against particular firms with regard to particular cryptocurrencies, and those actions suggest that a wider regulatory assault may be forthcoming. The CFTC [Commodity Futures Trading Commission] seems to have taken some positions that are at odds with the SEC’s views. Just how this will all sort itself out, how the pending actions relating to cryptocurrencies will be decided, and just what issues might be raised in future regulatory actions, and how they will affect individual firms or the industry as a whole, is unknown.”

Judge Wiles is, thus, unhappy with SEC agents’ refusal to give any public certainty to the parties in this case or the industry at large about how their views will affect crypto businesses moving forward.

The SEC had not in its objections in this bankruptcy case “offered any guidance at all as to just what it was that the Debtors allegedly were supposed to prove on these issues, or how the Debtors possibly could prove what the SEC wanted them to prove without receiving any explanation at all from SEC as to just why the Debtors’ operations, or Binance.US’s operations, might raise legal issues,” Judge Wiles noted.

And when he insisted on clarification from the SEC, its agents “initially asked if it could state its position only to me on an in camera basis, but I denied that request and ruled that to the extent the SEC wanted to say something further about its objection, it ought to be stated in the public forum, where all other interested parties could hear and understand the SEC’s position.”

What Judge Wiles got on the record from the SEC folks did not satisfy him. He was merely told that SEC staff thinks that the VGX token “has aspects of a security, but that the Commission itself has not taken any position on that subject.” Similarly, the staff “believes that Binance.US is operating as a securities exchange without registering as such, though once again the Commission itself has not taken any position on that subject.”

Judge Wiles found this attempt at legal interference based on staff opinion, without the SEC itself or lawmakers having ratified the staff’s opinion as regulation or law, unconvincing and vexing. He rejected the idea that it should be his or Voyager’s responsibility to figure out what SEC staff meant about the degree to which the VGX token is a security or the extent to which Binance should be subject to SEC registration issues. He griped that vague interference like this from SEC staff was unduly delaying the resolution of this bankruptcy case, costing customers and creditors lots of money and time.

“I cannot simply put the entire case into an indeterminate and expensive deep freeze while regulators figure out whether they do or do not think there is any problem with the transactions that are being proposed,” Judge Wiles wrote. “If there is a problem, I expect a regulator to tell me that it has an actual objection (as opposed to saying that there ‘might’ be an issue), and also to tell me what the issue is and why it is an issue, so that other parties may address it and so that I may make a proper and well-considered ruling.”

“I asked the SEC’s counsel at the outset of this hearing to explain what the consequences would be if Binance.US were to be found to have been acting as an unregistered broker dealer,” Judge Wiles wrote. “I asked if that would just mean that Binance.US might have to stop certain activities while it pursued a license, or if it would mean that Binance.US would have to shut down all of its activities. The SEC said it could not answer that question.”

If Judge Wiles feels this way about the SEC’s casual but often destructive mystery-shrouded tiptoeing around the issue of regulating virtual currencies as securities in this one case, imagine how the investors and holders and businesses whose careers and fortunes are built on trying to stay legal in this industry feel.

The cryptotoken LBRY credits (LBC), issued by LBRY, a blockchain-based content hosting service, is legally a security according to a decision today from the U.S. District Court for New Hampshire.

In a decision for summary judgment in favor of the Securities and Exchange Commission in the case SEC v. LBRY, Inc., which began in March 2021, U.S. District Judge Paul J. Barbadoro insisted the company violated Section 5 of the Securities Act of 1933 by selling its tokens without registering with and obeying SEC requirements for the legal sale of securities.

“The only issues impeding a finding that LBRY violated Section 5 are LBRY’s claim that it did not offer LBC as a security and its argument that it was not given fair notice that it needed to register its offerings,” Judge Barbadoro wrote. The relevant definition is based on the Supreme Court’s ruling in the 1946 case SEC v. W.J. Howey Co., which declared that a security is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” This definition “’embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.'”

The issue, then, is whether anyone buying LBC did so with “a reasonable expectation of profit to be derived from the entrepreneurial or managerial efforts of others.” Judge Barbadoro found a statement in a LBRY blog post essentially proof of their guilt; they wrote “that the long-term value proposition of LBRY is tremendous, but also dependent on our team staying focused on the task at hand: building this thing.”

To the judge, this admits that buyers of the token were expecting effort from LBRY to make that “investment” rise in value. Emails from LBRY execs to potential investors quoted in the decision, as well as postings on Reddit and public interviews from LBRY staffers, also show they were telling potential buyers/investors that their company’s efforts would make the token increase in value and thus mark LBC as a regulatable security, says Judge Barbadoro.

“The fact that it informed some potential purchasers of LBC that the company was not offering its token as an investment,” Judge Barbadoro asserts, is a mere “disclaimer” that “cannot undo the objective economic realities of a transaction.”

For its part, among other arguments against the SEC’s actions (including due process violations since the SEC has “conducted itself inconsistently and in violation of its own purported standards”), LBRY has asserted in court filings that its tokens are used by “millions” daily in their “LBRY Network–which runs on blockchain technology that requires the use of a token.”

Thus, LBC are intended for use and consumption, not merely bought in expectation of profit based on LBRY’s actions, and thus not securities. Judge Barbadoro believes, according to his decision, that the fact that some people use it for consumption does not mean that others are not using it as an “investment contract” and thus a legally regulatable security.

Barbadoro also shot down LBRY’s claim that they had not received legally required fair notice that they were acting in violation of the Securities Act of 1933: “SEC has not based its enforcement action here on a novel interpretation of a rule that…does not expressly prohibit the relevant conduct. Instead, the SEC has based its claim on a straightforward application of a venerable Supreme Court precedent [Howey] that has been applied by hundreds of federal courts across the country over more than 70 years. While this may be the first time it has been used against an issuer of digital tokens that did not conduct an ICO [initial coin offering], LBRY is in no position to claim that it did not receive fair notice that its conduct was unlawful.”

The LBC token’s market value fell by nearly one-third in the past day as of posting time. Within the LBRY system, the tokens compensate miners, and, as the decision explains, “can also be spent on the LBRY Blockchain to publish content, create ‘channel[s]’ that associate content with a single user, tip content creators, purchase paywall content, or ‘boost’ channels or content in search results…Users generally must pay a fee in LBC in order to ‘interact with the LBRY Network for anything beyond viewing free content.'”

LBRY Credits (LBC) are thus mostly used for the LBRY site’s operation. The company runs a blockchain-based censorship-free online site for content, one that vows users will suffer no YouTube-esque takedowns. Its CEO is Jeremy Kauffman, a Libertarian Party candidate for Senate in New Hampshire. Some see hints of a political hit in the fact that this one small token-issuing company among so many has been singled out for SEC clampdown; as LBRY notes in a court filing in June 2021, the SEC has only ever brought “about 19 actions involv[ing] registration violations without fraud allegations” and that “it is a mystery why the SEC chose to pursue those matters—and why the SEC now pursues LBRY—while leaving thousands of other digital assets relatively untouched.”

A rub in this decision that seems to be unnerving the crypto token community the most, a strong hint that those other digital assets might not remain “untouched” by the SEC for long, is it implies that any pre-mined token—which the issuers keep quantities of without spending money before releasing it into the marketplace at large—is thus obviously a security under SEC definition.

The relevantly unnerving part of the decision is where Judge Barbadoro writes that “a reasonable purchaser of LBC would understand that the tokens being offered represented investment opportunities—even if LBRY never said a word about it.” Because “by retaining hundreds of millions of LBC for itself, LBRY also signaled that it was motivated to work tirelessly to improve the value of its blockchain for itself and any LBC purchasers. This structure, which any reasonable purchaser would understand, would lead purchasers of LBC to expect that they too would profit from their holdings of LBC as a result of LBRY’s assiduous efforts.”

This seems to imply that to pre-mine means to have created an unregistered security. And that means every transaction involving such tokens that were not registered with the SEC is potentially a crime. This would include the second largest market-cap virtual currency, ethereum. (SEC chief Gary Gensler already said last month before this decision that he believes ethereum is a security for different reasons.)

The SEC seeks in this case “injunctive relief, disgorgement of monies obtained through LBRY’s offerings, and civil penalties.”

The crypto world has feared decisions along these lines; a more well-known token called XRP, issued by Ripple, has been in an ongoing legal fight with the SEC over these same questions since 2020. While they are in a different federal court district, the Southern District for New York, and this LBRY decision is in no way a binding legal precedent over that court, it’s a bad sign for how federal courts could choose to address this “are crypto tokens securities?” question.

Kauffman tweeted this morning that “Under this standard, almost every cryptocurrency, including Ethereum and Doge, are securities. The future of crypto now rests with an org worse than the SEC: the US Congress.”