‘Decentralization’ is a concept that has constantly upset the entire blockchain-enabled ecosystem in the United States, including its boards and regulators, where a lack of clarity on the exact definition of decentralization has left them relevant stakeholders talk to each other regularly. As such, market participants eagerly awaited the United States Securities and Exchange Commission (the SECOND) to explain the agency’s understanding of what it means for a blockchain-enabled network to be “sufficiently decentralized”. Based on recent SEC enforcement actions, it looks like the agency is gearing up to take a deep dive.
On March 29, 2021, the SEC filed charges in New Hampshire Federal District Court against LBRY, Inc. (“LBRY”), The developer of a supposedly decentralized peer-to-peer network that allows users to host and share video content. The SEC alleges that LBRY engaged in an unregistered securities offering by raising more than $ 11 million through the distribution of the company’s digital tokens, “LBRY Credits”, from 2016. The SEC complaint asserts that the LBRY credits are “securities” within the meaning of the Securities Act of 1933 (the “Securities Act“), And by failing to file a registration statement or to qualify for an exemption from such an offer, LBRY has violated Sections 5 (a) and 5 (c) of the Securities Act. The SEC complaint highlights the lack of actual decentralization of LBRY’s networks in violation of Section 5. Given the prior lack of guidance on how the SEC views decentralized blockchain-based networks and the rise decentralized finance (“Challenge”), This action could provide some insight into how the SEC views this topic, as well as an opportunity for the SEC to educate the market going forward.
Blockchain and distributed ledger technology has spurred the creation of financial products that include decentralized and cryptographically secured virtual currencies like bitcoin, stablecoins tied to an asset peg, and an entire alphabet soup of digital tokens. fungible and non-fungible. Yet blockchain technology is applicable beyond financial applications, with developers of blockchain-enabled services also focusing on video sharing, product tracking, data storage, and other non-financial applications. Although some developers’ apps extend beyond finance, many of these apps still rely on tradable digital tokens.
Since these token-based assets are a form of “investment contract” governed by the Securities Act and the Securities Exchange Act of 1934, the SEC asserted jurisdiction over them. Since the ICO boom in 2016 and 2017, the SEC has placed more emphasis on these products, initiating five enforcement actions against blockchain players in 2021 alone. Even five years later, the SEC has pledged to leave no stone unturned in protecting U.S. investors, with enforcement actions over the past 12 months targeting some of the industry’s most prominent names as well as fundraising. deemed capital as low as $ 141,410. .
The enforcement action of the LBRY
As in previous actions, the SEC has determined that since LBRY credits are investment contracts, they are securities. The SEC reached this conclusion on the basis of the facts and circumstances test first adopted by the United States Supreme Court in SEC v WJ Howey Co., aka, the Howey Test, with emphasis on whether there is an expectation of benefit from the issuer’s efforts.
Under the Howey Test, the more likely an asset is to derive value from the stocks of those who develop and maintain that asset, the more likely the SEC is to view that asset as a security. For example, former SEC Chairman Jay Clayton and former SEC Corporate Finance Division Director William Hinman, although not in an official or binding capacity, each maintained this bitcoin, the digital asset. . de jure, is no longer considered a security because it is sufficiently decentralized. In contrast, the SEC alleged that LBRY did not meet this threshold, and rather than being decentralized, the value of the LBRY network over which LBRY credits are traded (the “LBRY Network») Depends a lot on the actions of LBRY. To demonstrate, the SEC highlighted the following actions taken by LBRY:
1. LBRY has maintained high profile representations via social media and blog posts to the public that LBRY is helping to increase the value of the LBRY network;
2. LBRY continued to maintain operational, managerial and entrepreneurial control of the LBRY network, in particular thanks to its vast reserve of LBRY credits;
3. LBRY continues to monitor the supply of LBRY Credits in order to stabilize the value of the LBRY Network, in particular by using a third party market maker as an agent to buy and sell LBRY Credits;
4. LBRY continues to control the software code of the LBRY network for its applications and protocol;
5. LBRY continues to unilaterally take strategic and managerial decisions on the future of the LBRY network; and
6. LBRY continues to unilaterally decide how to allocate the capital and resources it has pooled with investors to develop the LBRY network.
In other words, without the continued involvement of LBRY, there is no longer an LBRY network; the entire infrastructure would likely collapse without the implicit and continued development support of the LBRY team. Therefore, in the opinion of the SEC, the so-called decentralized network is not sufficiently decentralized to pass the “efforts of others” component of the Howey Test.
The big picture
Taken against previous Section 5 enforcement actions, the LBRY enforcement action reflects the SEC’s continued commitment to strictly enforce non-fraudulent registration violations for digital assets. Consistent with the earlier form, the fact that LBRY only raised $ 11 million, which is a relatively small amount by SEC standards, does not preclude the SEC’s willingness to initiate enforcement action. against an issuer of digital assets; the SEC often attacks issuers by the millions. In addition, the fact that LBRY hired a third-party market maker to help stabilize the value of LBRY credits is an action the SEC has paid close attention to. Market makers must be approved by the Financial Sector Regulatory Authority (FINRA) and then, once cleared by FINRA, to trade only on exchanges authorized or otherwise approved to trade as an alternative trading facility by the SEC. The use of a market maker is therefore a primary indication of behavior that would otherwise fall within the purview of the SEC and arguably a form of market manipulation, regardless of context and industry. This behavior alone would raise red flags for the SEC, and as such, it is not surprising that behavior is an area of interest in this particular application measure.
That said, the enforcement action against LBRY departs from previous actions in that the SEC insists that the LBRY network was not sufficiently decentralized to allow LBRY credits to pass through. Howey Test. In contrast, the earlier cases relied on the aspect of earnings expectations. This has been just as true for traditional businesses getting into blockchain or for fully decentralized and autonomous organizations like DAO.
DeFi platforms, take note. The LBRY enforcement action represents an evolution in SEC thinking and perhaps foreshadows what will be under the leadership of new SEC Chairman Gary Gensler, who knows the industry intimately and has taught cryptocurrency course. Indeed, this shift in focus from profits to networks could have substantial implications for DeFi’s decentralized network system which represented a collective investment of at least $ 20.5 billion at the start of 2021, where the term “decentralized” in DeFi blockchain jargon means different things to different stakeholders.
True to its past form, the SEC chose to use enforcement action as an opportunity for the agency to educate the market on decentralization. However, while the enforcement action against LBRY likely provides some insight into the SEC’s thinking, little is being done to clarify what the SEC would consider a “sufficiently decentralized” network in a way that could guide positive future behavior by companies. market players. We still only have the ability to set presumed safeguards for behavior based on comparable conduct cited in a complaint. While several academics have made suggestions that attempt to clarify this gap through new forms of business or codified exceptions, or perhaps have completely ignored it as an unreliable measure, the SEC itself has not made such affirmative statements. Therefore, for digital asset stakeholders, enforcement action against LBRY is hopefully a prelude to the SEC’s affirmative advice on decentralization that the industry craves.