Michael Klein
The US Securities Commission and the crypto community have been locked in a years-long tussle over whether the securities regulator has jurisdiction over digital assets.
Integral to the SEC’s purview over crypto is whether tokens are securities, commodities or something else entirely. The SEC lawsuit against Ripple Labs Inc has been one of the main battlegrounds that promised an answer to this key question.
XRP – sometimes a security, sometimes it isn’t
Last week, US District Judge Analisa Torres made a ruling in the case that Ripple’s digital token XRP is not always a security. The order concluded that XRP buyers who purchased XRP on an exchange were not engaged in a securities transaction.
The decision could have major implications for the industry, not least for US digital asset exchange Coinbase Global Inc which was sued by the SEC in June for allegedly offering unregistered securities.
However, many legal uncertainties remain, because the judge ruled that the token linked to Ripple was a security when it was it was sold directly to institutional investors, yet it was not when offered to the public on exchanges.
In its lawsuit against Ripple launched in 2020, the SEC claims the company’s XRP token issue was an unregistered securities offering.
The judge separated three instances of token issuances. She found that the sale of $728.9 million of XRP to institutional investors constituted a securities offering, but the purchase of $757.6 million worth of the token by retail investors and the distribution of $609 million of XRP to pay for services and employee compensation did not, because they did not meet the Howey test for an investment contract.
The Howey test
The Howey test defines investment contracts, which would be considered securities under US federal law, as offerings that represent a monetary investment with an expectation of profit from a common enterprise in which the profit is derived solely from the efforts of the promoter or a third party.
The sale to institutional investors did meet all three prongs of the test, according to the ruling:
- an investment of money
- a common enterprise and
- a reasonable expectation of profit from the entrepreneurial or managerial efforts of others.
“Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts. From Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP,” Judge Torres wrote.
In contrast, public buyers who purchased XRP in blind bid/ask transactions would not have the same expectation, as they did not even know whether their money would go to Ripple or any other seller of XRP.
The order said, “Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, Programmatic Buyers [public buyers who bought XRP through the use of trading algorithms] could not reasonably expect the same.”
Therefore, the judge held, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all.
Although the ruling did not explicitly address secondary sales of tokens, it is difficult to see how the logic applied by the judge would not also cover the resale of tokens on an exchange.
The decision, celebrated as at least a partial success by the crypto industry, is somewhat baffling as it appears to turn the consumer protection aspects of securities regulation on its head.
It effectively grants protection to sophisticated institutional buyers while taking it away from retail investors, which securities laws typically aim to protect.
Moreover, Ripple provided institutional buyers with information disclosure, whereas it sold the tokens anonymously without any disclosure via an exchange to retail investors.
It is also difficult to apply the conclusion, that a token is not an investment contract because retail investors may not know if their money is going to the issuer, to the world of actual securities: stocks.
Buyers of a company’s shares on a stock exchange do not know who is selling to them, but they can be almost certain that it is not the company itself. This does not mean that the stock ceases to be a security, only because the third prong of the Howey test becomes a little less clear cut.
Position rejects broad assertion that tokens are securities
The SEC has taken the position that XRP is a digital asset security and that the Howey test and the concept of the investment contract had fused with the digital asset token. As the XRP tokens were sold initially in an investment contract transaction, all subsequent sales were themselves functionally securities transactions, the SEC claimed.
The judge has rejected this view, noting that buyers on an exchange were not engaging in an investment contract transaction with Ripple and that the XRP digital token is not in and of itself an investment contract transaction or scheme.
The effects of the order
Some effects of the decision were immediate, as several digital asset exchanges announced they would re-list XRP.
The order could further influence how venture capital firms invest in digital asset projects going forward, with a preference for receiving equity over tokens.
In the case itself, the judge ordered the trial to go ahead. The SEC is going to press on with its unregistered securities offering claim against Ripple in connection with the sale to institutional investors.
The SEC said in a statement it is “pleased that the court found that XRP tokens were offered and sold by Ripple as investment contracts in violation of the securities laws.”
Although the agency has not said as much, an appeal against other points of the order appears likely.
So far, the order is just the opinion of a single judge that could be overturned or confirmed on appeal by a Circuit Court. Either way a Circuit Court decision would set much stronger binding precedent. Further appeal could even re-evaluate the definition of securities.
