Claimed ‘win’ for LBRY in SEC case is a puff of smoke

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Publicity-hungry Twitter lawyer John Deaton recently took to the social media platform to brag about a victory he’d apparently secured for the digital asset industry, getting the U.S. Securities and Exchange Commission (SEC) to admit ‘on record’ that LBRY’s underlying LBC token is not a security.

Many hailed this as a sign that the big bad SEC had been put in its place for ‘overreaching’ and that it may be a sign that a victory is on the horizon for Ripple, the other company currently battling with the U.S. regulator over an alleged illegal securities offering.

LBRY Hearing: The Stakes for ALL Crypto https://t.co/YPbrBkw0Od

— CryptoLaw (@CryptoLawUS) January 30, 2023

However, Deaton is somewhat overstating things, and the impact on XRP and any future ‘crypto’ offering will be minimal.

What actually happened

The SEC won its case against LBRY months ago. A federal court in the U.S. ruled that LBRY’s offering of LBC tokens amounted to an unregistered securities offering and was, therefore, illegal.

The SEC’s original argument never claimed that the underlying asset—LBC—is a security. This is obvious: as Deaton points out, the question in Howey cases is never whether the underlying asset is a security, but whether the offering of the asset amounted to an investment contract. It is the investment contract which is a security. That is true of the SEC’s case against LBRY and of the SEC’s ongoing case against Ripple.

In the time since LBRY’s defeat, LBRY and the SEC have been ironing out exactly what remedies they must abide by as a result of the federal ruling. These remedies will inevitably include an injunction of some sort prohibiting LBRY agents from continuing to violate the Securities Act. The SEC proposed language to use in this injunction:

IT IS HEREBY FURTHER ORDERED, ADJUDGED, AND DECREED that LBRY and LBRY’s agents, servants, employees, attorneys, and all persons in active concert or participation with it who receive actual notice of this Final Judgment by personal service or otherwise are permanently restrained and enjoined from violating Section 5 of the Securities Act.

A key question has arisen: would this prohibit LBC bagholders from reselling the tokens on the secondary market given the ruling that their initial offering was illegal? The SEC’s proposed language is put somewhat broadly and could be read as prohibiting secondary sales as well as direct offerings from LBRY. In arguments to the court, the SEC appeared reluctant to accept that, as a rule, any conceivable secondary market offering would not also violate securities laws.

This is where Deaton came in. A ‘crypto journalist’ Naomi Rockwell has found herself with 261,500 LBC tokens acquired via the secondary market in one form or another. None of the tokens were purchased directly from LBRY. As an amicus curiae, she sought clarity from the court over whether the court’s finding regarding LBC tokens would prohibit sales on the secondary market and was represented by Deaton in doing so. If the answer is no, then the SEC’s proposed language should be rejected.

Consequently, Deaton showed up to a remedies hearing last week to put forward Rockwell’s case. According to Deaton on his own show, he brought the Judge’s attention to the much-circulated Lewis Cohen paper which researched seven decades of securities case law to arrive at the conclusion that there has never been a case in which the asset underlying an investment contract was deemed to be a security on top of the contract itself. On that basis, any injunction secured by the SEC should not prohibit LBC holders from offering the token on the secondary market.

This is where Deaton says he personally scored multiple ‘wins’ for the industry. That is overstating things, to put it mildly.

Deaton says the Judge told him that he was ‘not inclined’ to issue the SEC’s requested injunction (which Deaton claims as the first victory, despite the fact that the Judge’s comments to Deaton have no legal effect whatsoever and the Judge did not rule on the proposed remedies). To clarify the SEC’s position on resales, the Judge then turned to the SEC’s attorneys and posed a hypothetical to the effect of: ‘if LBRY issues the LBC token to an investment club (which has been established as amounting to an illegal securities offering), would a subsequent resale independent of LBRY amount to a securities offering?

Of course, on the basis of well-established precedent, the answer from the SEC was ‘no.’

‘That’s the victory that we got,’ bloviated Deaton. ‘Crypto’ Twitter celebrated.

First word from the SEC v. LBRY hearing:

The SEC admitted on the record that the token itself is not a security.

Good job Mr. Deaton! https://t.co/tRXIQs5SSu

— Jeremy Hogan (@attorneyjeremy1) January 30, 2023

Deaton’s nothingburger

As far as victories go, that’s a fairly light one: the SEC would certainly have accepted that the purest case of a fully independent resale of tokens (the initial offering of which has been deemed an illegal securities offering) does not amount to a securities offering in and of itself. The SEC never argued to the contrary. In fact, their filings to the court on the topic make it clear:

“The Commission is not seeking an order prohibiting all third parties from buying or selling LBC.”

So, Deaton getting the SEC, as he puts it, ‘on record’ as saying that the underlying LBC token is not a security is nothing: the SEC has said as much throughout the case.

Further, the SEC’s reluctance to make a blanket assessment that no secondary sale would amount to a securities offering is perfectly reasonable. The LBRY litigation has always been about the initial offering of LBC tokens by LBRY, and has never been about secondary sales. The SEC may be guilty of submitting an ambiguously worded injunction, but as the SEC’s filings make clear above, the intention was never to make any claims about the legality of secondary sales.

The court put to the SEC the easy case of a plain resale from one party to another, which the SEC rightly conceded would not amount to a securities offering, but this does not (as Deaton is pretending) mean that no secondary sale could ever amount to a securities offering. Secondary sales might well be conducted in such a way that they amount to an illegal securities offering. What matters is the character of the transaction.

So, despite being billed as a victory for token offerings and a ray of hope for XRP, the ruling does nothing to change the fact that the offering of LBRY in the first instance amounted to an offering of unregistered securities. That’s what XRP is currently under the gun over, and nothing that occurs in the LBRY case at this point will affect Ripple’s liability for its initial XRP offering. The SEC’s case against Ripple does include reference to secondary markets, but only insofar as Ripple executives promised to establish those secondary markets to drive up the price of the coin, which the SEC argues triggers the ‘expectation of profits reliant on the efforts of others’ prong of the Howey test.

XRP bagholders can take some comfort from the fact that the SEC isn’t out to stop them from ever selling their bags to the next sucker, but Ripple could be headed toward the same fate as LBRY, regardless. The legal status of direct coin offerings is the same as it ever was: they are offerings of securities that must be registered with the SEC; failure to do so is illegal.

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