Consequences of the ongoing regulatory process of crypto

The fall of LBRY shows a wave of renewed regulatory pressure that could hit both blockchain token-issuing companies and their investors.

In November, a more than year-long court battle between the United States Securities and Exchange Commission (SEC) and blockchain development company LBRY and its LBRY Credits (LBC) token culminated in the token’s ruling as an unregistered security, despite the company’s arguments its use as a commodity within the platform.

The court’s decision in this case sets a precedent that could affect regulatory perceptions not only of blockchain-based platforms but also of cryptocurrencies.

Old Howy

Old standards don’t always apply when it comes to regulating new technologies.

The LBRY case focused primarily on the Howey test, a framework that arose as a result of a US Supreme Court case in 1946 that determines whether a transaction qualifies as a security. While assets like Bitcoin (BTC) and most stablecoins are not considered securities in this test, the decision varies based on a token’s characteristics, which are subject to change.

The SEC claimed that LBRY was aware of the “possible use” of LBRY credits as an investment, which the court fully acknowledged in its assessment.

The ruling by New Hampshire District Court Judge Paul Barbadoro found that LBRY openly expected its tokens to increase in value, leading it to expect the tokens to act as a “potential investment.”

According to Barbadoro, the fact that LBRY kept tokens for itself and also gave them to its employees as “compensation incentives” meant it intended to show investors that the company intended to increase the value of their blockchain. In other words, the conclusion was that LBRY would count on token holders understanding the company’s staking as a form of adding value to the LBRY credits.

According to comments by Patrick Daugherty, head of digital assets at Foley & Lardner LLP, to Bloomberg Law, the judge’s decision breaks new legal ground because it was based on the suspicion that stakeholders saw staking as a form of value creation – or a promise of it – in relation to the Tokens issued by the Company.

“The court did not provide any precedent for that opinion, perhaps because there is none,” Daugherty said.

In the same article, James Gatto, who leads the blockchain and fintech team at Sheppard Mullin Richter & Hampton LLP, said many of the legal issues identified in the LBRY case could be replicated in other projects, and recommended crypto companies, ” introduce a different approach” to avoid copying general legal methods used by token projects. “So many people don’t do it, they just follow what everyone has done,” he said.

Regulatory Consequences

Speaking to Cointelegraph, Jeremy Kauffman, founder and CEO of LBRY, described the implications of the court ruling in this case.

The study’s outcome had a significant financial impact on the company, which has already been declared “almost certainly dead” by its CEO.

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Initially, Kauffman highlighted the incredibly high cost of the lawsuit, noting that the company had to pay millions in legal fees and “lost tens of millions of dollars in investment funds.”

Aside from the financial cost of the process, the biggest impact of the ruling is the slowed adoption of LBC tokens, Kauffman says.

Kauffman in an interview with Reuters. Source: Reuters/Brian Snyder

“Maybe even worse [we’ve] has had significant difficulties getting taken over by third parties like SEC-feared exchanges,” he explained.

However, despite the immediate impact on LBRY, Inc. as a company, the platform’s blockchain protocol will survive this encounter with the SEC.

“LBRY is a decentralized protocol used by tens of millions of people to share content without disruption regardless of legal challenges,” Kauffman said. “LBRY as a company is almost certainly dead. But Odyssey, the most popular way to use LBRY, and the protocol itself have a bright future,” he added.

Kauffman did not hide his frustration at the outcome of the SEC complaint, blaming the government’s lack of transparency for the company’s ultimate fate.

“One thing I’ve definitely learned is not to trust the government and not to be transparent. We would have been in much better shape if we had acted more secretively and less honestly,” he said.

Given the patchy and uncertain enforcement of digital assets, the goal for blockchain services now is to anticipate all possible scenarios that might be considered an illegal move – while learning – and resolve potential issues before they escalate.

What’s next?

The court’s decision on LBRY could also affect a currently developing case. The SEC’s two-year-old lawsuit against Ripple Labs has similar elements, as the company’s arguments relate to arguments used by Kauffman’s team — such as the lack of fair notification that their token is subject to securities laws.

Daugherty told Cointelegraph that since the LBRY case has been active since 2016, it’s important to put this argument in context.

“Six years ago, the relevant period, very little was known about what is legal or not. They would have to judge it based on what they knew at the time, not when the court ruled against them,” he said.

The verdict in the Ripple case will most likely be reached by March 2023.

A U.S. Treasury Department official, who spoke to Cointelegraph on condition of anonymity, said regulators are currently at a very early stage in understanding cryptocurrencies, with a focus on protecting users.

“Right now the focus is on fraud reduction and consumer protection. But having said that, I can say that we are in a very early stage of understanding and defining the industry,” they said.

Daugherty said his advice for companies and projects in the blockchain industry is to use LBRY as a model for their legal strategy.

“The teams preparing protocols and token projects need to consider the LBRY ruling and work with attorneys who understand the ruling and what is not covered in it,” he said.

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Daugherty also recommended that token-issuing projects should take two main preventive measures to avoid LBRY’s bugs:

“One way is to decentralize the token before it is sold in the United States and another way is to avoid promoting the secondary market for the token. That alone may not be enough, but experienced lawyers can complete the picture.”

When asked for his opinion on what regulators should focus on to understand blockchain and cryptocurrencies, Kauffman said they need to “get out of the way.”

“Regulators must focus solely on stopping fraud and criminal activity. Blockchain could be a big part of America’s future if they get out of the way and let the entrepreneurs build,” he said.