"Decentralization" is a concept that has consistently vexed the entire blockchain-enabled ecosystem in the U.S., including its counsel and regulators, wherein a lack of clarity on the exact definition of decentralization has left relevant stakeholders routinely talking past one another. As such, market participants have been eagerly waiting for the U.S. Securities and Exchange Commission (the SEC) to explain the agency's understanding of what it means for a blockchain-enabled network to be "sufficiently decentralized." Based on the SEC's recent enforcement action, it looks like the agency is getting ready to take a deep dive.
On March 29, 2021, the SEC filed charges in federal district court in New Hampshire against LBRY, Inc. ("LBRY"), the developer of a purportedly decentralized, peer-to-peer network that enables users to host and share video content. The SEC alleges that LBRY engaged in an unregistered offering of securities by raising more than $11 million through the distribution of the company's digital tokens, "LBRY Credits," starting in 2016.1 The SEC complaint asserts that the LBRY Credits are "securities," within the meaning of the Securities Act of 1933 (the "Securities Act"), and that by failing to file a registration statement or qualify for an exemption for such offering, LBRY was in violation of Sections 5(a) and 5(c) of the Securities Act. The SEC's complaint highlights its focus on the lack of actual decentralization of LBRY's networks in violation of Section 5. Given the prior lack of guidance as to how the SEC views decentralized blockchain-based networks and the rise of decentralized finance ("DeFi"), this action could provide a preview into how the SEC views this topic, as well as an opportunity by the SEC to educate the market going forward.
Blockchain and distributed ledger technology has spurred the creation of financial products that include decentralized, cryptographically secured virtual currencies like bitcoin, stablecoins tied to an asset peg, and an entire alphabet soup of fungible and non-fungible digital tokens. Yet blockchain technology is applicable beyond financial applications, with blockchain-enabled service developers also focusing on video-sharing, commodity tracking, data storage, and other non-financial applications. Although some developers' applications extend beyond finance, many of these applications still rely on tradable digital tokens.
Because these token-based assets are a form of "investment contract" governed by the Securities Act and the Securities Exchange Act of 1934, the SEC has asserted jurisdiction over them.2 Since the ICO boom in 2016 and 2017, the SEC has increased its focus on these products, bringing five enforcement actions against blockchain players in 2021 alone.3 Even five years on, the SEC is committed to leaving no stone unturned in its protection of U.S. investors, with enforcement actions in the past 12 months targeting some of the highest-profile names in the industry as well as alleged capital raises as low as $141,410.4
The LBRY Enforcement Action
As in prior actions, the SEC has determined that, because the LBRY Credits are investment contracts, they are securities. The SEC reached this conclusion based on the facts-and-circumstances test first espoused by the U.S. Supreme Court in SEC v. W.J. Howey Co., a.k.a., the Howey Test, with a focus on whether there is an expectation of profits derived based on the issuer's efforts.5
Under the Howey Test, the more likely an asset derives value from the actions of those developing and maintaining that asset, the more likely the SEC is to consider that asset a security. For example, former SEC Chairman Jay Clayton and former Director of the SEC's Division of Corporation Finance, William Hinman, though not in an official or binding capacity have each maintained that bitcoin, the digital asset de jure, is no longer considered a security because it is sufficiently decentralized.6 In contrast, the SEC has alleged that LBRY has not met that threshold, and rather than being decentralized, the value of LBRY's network upon which the LBRY Credits are exchanged (the "LBRY Network") is very much dependent on LBRY's actions. To demonstrate, the SEC highlighted the following actions taken by LBRY:
1. LBRY maintained high-profile representations via social media and blog posts to the public that LBRY was helping to drive the value of the LBRY Network;
2. LBRY continued to maintain operational, managerial, and entrepreneurial control of the LBRY Network, including through its large reserve of LBRY Credits;
3. LBRY continues to control the supply of LBRY Credits in order to stabilize the value of the LBRY Network, including by enlisting a third-party market maker as its agent to buy and sell LBRY Credits;
4. LBRY continues to control the LBRY Network's software code for its applications and the protocol;
5. LBRY continues to unilaterally make strategic and managerial decisions about the future of the LBRY Network; and
6. LBRY continues to unilaterally decide how to allocate the capital and resources it has pooled from investors to grow the LBRY Network.
In other words, without the continued involvement of LBRY, there is no more LBRY Network; the whole infrastructure would likely collapse without the implicit and continued development support of the LBRY team.7 Therefore, in the SEC's view, the so-called decentralized network is not sufficiently decentralized to pass the "efforts of others" prong of the Howey Test.
The Bigger Picture
Considered against previous Section 5 enforcement actions, the LBRY enforcement action reflects the SEC's continued commitment to strictly enforcing non-fraud registration violations for digital assets. Consistent with past form, the fact that LBRY only raised $11 million, which is a relatively low amount by SEC standards, is no bar to the SEC's willingness to open an enforcement action against a digital asset issuer; the SEC often goes after issuers in the low millions. Furthermore, the fact the LBRY engaged a third-party market maker to help stabilize the value of the LBRY Credits is an action that the SEC paid significant attention to. Market makers are required to be licensed with the Financial Industry Regulatory Authority (FINRA) and then, once licensed by FINRA, to only transact on exchanges licensed or otherwise approved to trade as an alternate trading system by the SEC. The use of a market maker is therefore a prime indication of behavior that would otherwise fall under the SEC's jurisdiction and arguably a form of market manipulation, regardless of context and industry. That behavior alone would raise red flags to the SEC, and as such it is no surprise that the behavior is an area of focus within this particular enforcement action.
That said, the enforcement action against LBRY deviates from prior actions in the SEC's emphasis that the LBRY Network was not sufficiently decentralized to enable the LBRY Credits to pass the Howey Test. In contrast, prior cases have hinged on the expectation-of-profits prong. This has been equally true for traditional companies dabbling in blockchain or fully decentralized and autonomous organizations like The DAO.8
DeFi platforms, take note. The LBRY enforcement action represents an evolution in the SEC's thinking and possibly portends what is to come under new SEC Chairman Gary Gensler, who is intimately familiar with the industry and has taught classes on cryptocurrency.9 Indeed, this change in focus from profits to networks could have substantial implications for DeFi's system of decentralized networks that represented a collective investment of at least $20.5 billion at the start of 2021,10 wherein the term "decentralized" in DeFi blockchain jargon means different things to different stakeholders.
True to past form, the SEC has opted to use an enforcement action as an opportunity for the agency to educate the market about decentralization. However, while the enforcement action against LBRY likely provides an insight into the SEC's thinking, little is done to clarify what the SEC would consider to be a "sufficiently decentralized" network in a way that could guide positive future behavior by market participants. We only yet have the ability to set presumptive guard rails for behavior based on comparable conduct cited in a complaint. While several academics have made suggestions that attempt to clarify this discrepancy through new corporate forms or codified exceptions, or have perhaps disregarded it altogether as an unreliable metric,11 the SEC itself has not made any such affirmative statements. Therefore, for digital asset stakeholders, the enforcement action against LBRY is hopefully a prelude to affirmative guidance from the SEC on decentralization that the industry is very much hungry for.
1 SEC v. LBRY, Inc., Civil Action No. 1:21-cv-00260 (D.N.H. filed March 29, 2021).
2 See, e.g., SEC's "Framework for 'Investment Contract' Analysis of Digital Assets" (Apr. 3, 2019), available at https://www.sec.gov/files/dlt-framework.pdf. See, also, Morrison & Foerster Client Alert, "SEC Issues Historic No-Action Letter and Releases Framework for 'Investment Contract' Analysis of Digital Assets" (Apr. 10, 2019), available at https://www.mofo.com/resources/insights/190410-framework-contract-analysis-digital-assets.html#_ftn3.
3 See https://www.sec.gov/spotlight/cybersecurity-enforcement-actions. In this article, what we generally refer to as "offerings of digital assets" includes "token offerings," "initial token offerings," "token launches," "token sales," "initial coin offerings," and "ICOs."
4 SEC v. Coinseed, Inc. and Delgerdalai Davaasambuu, Civil Action No. 21 Civ. 1381 (S.D.N.Y., filed February 17, 2021).
5 See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). For more information on the four prongs of the Howey Test and how the SEC is likely to run such an analysis with respect to digital assets, see, e.g., "How Howey Got Here: SEC Issues Guidance on Token Offerings," Morrison & Foerster LLP (July 26, 2017), available at: https://www.mofo.com/resources/insights/170726-howey-got-here-sec-token-offerings.html#_ftn3.
6 See Kate Rooney, SEC Chief Says Agency Won't Change Securities Laws to Cater to Cryptocurrencies, CNBC (June 11, 2018), available at: https://www.cnbc.com/2018/06/06/sec-chairman-clayton-says-agency-wont-change-definition-of-a-security.html. Additionally, bitcoin and ethereum, the digital asset silver to bitcoin's digital asset gold, has also been referenced as being "sufficiently decentralized" so as to no longer be considered a security. See William Hinman, Speech: "Digital Asset Transactions: When Howey Met Gary (Plastic)," SEC (June 14, 2018), available at: https://www.sec.gov/news/speech/speech-hinman-061418.
7 It is worth noting that the implicit reasoning adopted by the SEC in this enforcement action comports neatly with the "Bahamas Test" formulated by Professors M. Todd Henderson and Max Raskin: "Said differently: if the sellers fled to the Bahamas or ceased to show up to work—like Satoshi Nakamoto and bitcoin—would the project still be capable of existing? If the answer is "yes," then the risk of fraud is sufficiently reduced such that the instrument is not a security." See M. Todd Henderson & Max Raskin, A Regulatory Classification of Digital Assets: Toward an Operational Howey Test for Cryptocurrencies, ICOs, and Other Digital Assets, Colum. Bus. L. Rev. (2019), 443–93, at 461, available at: https://doi.org/10.7916/cblr.v2019i2.3423.
8 Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Exchange Act Release No. 81207 (July 25, 2017), available at http://www.sec.gov/litigation/investreport/34-81207.pdf ("the federal securities laws apply to those who offer and sell securities in the United States, regardless whether the issuing entity is a traditional company or a decentralized autonomous organization, regardless whether those securities are purchased using U.S. dollars or virtual currencies, and regardless whether they are distributed in certificated form or through distributed ledger technology").
9 Chairman Gensler taught a course at MIT entitled "Blockchain and Money," which is available to the public at the following link: https://ocw.mit.edu/courses/sloan-school-of-management/15-s12-blockchain-and-money-fall-2018/.
10 See Jonathan Ponciano, Ether's Market Value Surges $20 Billion in One Day While Bitcoin Prices Slow–Here's Why, Forbes (Jan. 19, 2021), available at: https://www.forbes.com/sites/jonathanponciano/2021/01/19/ether-market-value-surges-20-billion-while-bitcoin-prices-slowheres-why/?sh=e34150d65694.
11 See, e.g., Walch, Angela, "Deconstructing 'Decentralization': Exploring the Core Claim of Crypto Systems" (Jan. 30, 2019). Chapter in Crypto Assets: Legal and Monetary Perspectives (Chris Brummer, ed.), Oxford University Press, available at: https://ssrn.com/abstract=3326244.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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