An edited version of this post was published on CoinDesk on Tuesday, December 6th.
The story of the Initial Coin Offering in American law is a play in four acts: Kik Interactive, Telegram, LBRY, and Ripple Labs. With three of the four cases decided, and Ripple Labs and the U.S. Securities and Exchange Commission exchanging dueling replies to motions for summary judgment on Friday, Dec. 2nd, we now enter the dénouement of a ten-year-long story that began with long-forgotten projects like Mastercoin and Counterparty, blasted into public consciousness with projects like Ethereum, and now slowly dies as American crypto developers shun the mother country for greener pastures abroad.
If Ripple should lose, as I expect it will sooner or later, its defeat would be highly symbolic. The company and its associated protocol are among the most longstanding and significant cryptocurrency projects in the world. Back when it got its start in 2012, the term “Initial Coin Offering” didn’t even exist. Neither did enforcement against the then-miniscule crypto industry – the U.S. Securities and Exchange Commission (“SEC”) wouldn’t announce its first settlement for non-registration until November of 2018 with the Airfox and Paragon ICOs. For context, Ripple’s network went into production on January 1st, 2013 – nearly six years earlier.
Apart from the fact that Ripple has sat in the top ten coins by market cap for nearly a decade, the project also represented a unique approach to consensus at a time when approaches to blockchain consensus of any kind were only a few years old, and both cryptocurrency users and institutional blockchain users were engaged in substantial experimentation to get the lay of the land.
Generally speaking, blockchains in the 2013-15 period worked in one of four ways: (1) proof-of-work, (2) proof-of-stake, (3) permissioned, and (4) that weird thing Ripple does.
Ripple utilized a novel consensus mechanism where a list of nodes, the so-called “UNL” or “Unique Node List,” conduct round-robin voting until 80% of them arrive at an agreement as to which transactions should be appended to the end of a chain in a given round, similar to a model more commonly known today as delegated proof-of-stake (except, without the stake). Similar approaches with PBFT round robin voting processes, without the UNL and markedly more decentralized, can be found today with many protocols like Tendermint or Cosmos. The advantages of this approach, it was claimed by Ripple’s proponents, are that the network can process many more transactions at far lower cost. The disadvantages, it is claimed by its detractors, are that it requires a higher degree of trust and is not truly decentralized.
Ripple’s legal troubles are not about the protocol, though – they’re about the tokens. On genesis, Ripple Labs or its predecessor OpenCoin entity minted 100 billion tokens, which were subsequently distributed to the company and early officers and then sold into the wider crypto markets to fund Ripple Labs’ operations.
At the time, there was much spirited debate about whether tokens sold in such a manner constituted securities. On one side were crypto entrepreneurs who claimed that token sales could serve as a lightly regulated governance mechanism and crowdfunding tool. On the other were many lawyers, myself included, who thought that the SEC would eventually get wise and crack down on the practice.
As we now know, the skeptics were right.
The first ICO to go down in a big way was Kik Interactive. Kik was, or rather still is, a lightly-used messaging app which pivoted into crypto at the height of the first great ICO boom in 2017. Kik sold tokens directly to the public without a registration statement in effect. The SEC sued and, sixteen months later, Kik lost on a motion for summary judgement.
Telegram was the Commission’s next scalp. Telegram, as is widely known, is a popular, allegedly encrypted messaging app founded by Russian VK billionaire Pavel Durov. Famously, despite being one of the most popular messaging apps on the planet, Telegram generates no revenue. To remedy this, Telegram issued and sold a staggering $1.7 billion in cryptocurrency tokens in various private fundraising transactions via private placement over the course of 2018.
Telegram differed from Kik Interactive mainly in that Telegram sold tokens first via private placement to high net worth and offshore investors, who would presumably later unload those tokens onto U.S. markets and thus to U.S. retail purchasers. Mere days before the tokens were to be issued, the SEC sued Telegram and obtained an emergency restraining order halting the token conversion. Here, too, the SEC would quickly win on a motion for preliminary injunction. The Telegram token project died immediately.
LBRY (pronounced “Library”) was the next project on the chopping block. LBRY is a reimagining of YouTube with decentralized monetization tools, designed to solve the problem of politically-motivated censorship at companies like Google and Facebook. The token performed a real function in a real application. In my estimation the project was one of the most honest and straight-shooting, if not the most honest, ICO ever conducted in the United States. The sale of that token, however, was deemed to be an offering of investment contracts. As in Kik Interactive and Telegram, LBRY too lost a motion for summary judgment, this time in the District of New Hampshire. LBRY has said that “LBRY Inc. will likely be dead in the near future.”
This brings us to the present day. On December 2nd the SEC and Ripple exchanged duelling motions in what should be the last shots fired, or at least among the last shots fired, between them, before a judge in the Southern District of New York will rule, once again, on the legality of a token project.
Boiling down Ripple’s argument in this case to a single line on Twitter, company counsel Stuart Alderoty resorted to something akin to denial, arguing, among other things, that there is no investment contract because there is no formal contract between Ripple and XRP purchasers, and that the tokens were sold for consumptive use.
The SEC, for its part, refers to “economic reality” not less than 15 times, asking the court to look “beyond boilerplate disclaimers to the economic reality” of the sales and that this economic reality “forecloses any argument that Ripple offered and sold XRP primarily for consumptive use.”
Reviewing the precedents, it’s pretty clear which argument has been more successful in federal courts. In Kik, Judge Hellerstein wrote that “form should be disregarded for substance and the emphasis should be on economic reality” (citing Tcherepenin v. Knight, 389 U.S. 332, 336 (1967)). In Telegram, Judge Castel pointed out “Congress intended the application of [the securities laws] to turn on the economic realities underlying a transaction, and not on the name appended thereto” (citing Glen-Arden v. Constantino, 493 F.2d 1027, 1034 (2d Cir. 1974)). In LBRY, Judge Barbadoro wrote that “the focus of the inquiry is on the objective economic realities of the transaction rather than the form the transaction takes” (citing United Housing Foundation v. Forman, 421 U.S. 837, 848 (1975)).
The SEC concludes its reply brief by stating “the registration regime established by the federal securities laws does not regulate ‘industries.’ It regulates conduct… for the benefit of investors.”
But does it really?
Reconsidering “economic reality”
At this point, the crypto industry has more or less resigned itself to the fact that a garden-variety ICO likely satisfies all of the limbs of the Howey test. I expect the outcome of the Ripple litigation will only confirm that. But unlike 2016, when most of these investigations presumably started, there is another economic reality that needs to be considered: today, it is abundantly clear that crypto is never going away.
For all the case precedent discussing “economic reality,” the more material economic reality for America, as a society, is that there are hundreds of millions of crypto users around the globe, and that number is growing exponentially.
It’s pretty clear that a huge class of investors doesn’t want what the SEC’s selling. In fact, they want its opposite. Millions of digital natives use trustless smart contracts daily for loans and other financial beasties, or grant and purchase assets like fractional royalty cashflows. They do so in an instant, from anywhere in the world, with anyone in the world, on handheld supercomputers smaller than a chocolate bar. Very soon they will do so with the assistance of AI. Such investors will literally have superhuman abilities at their fingertips.
Telling next-generation crypto projects that the only path to compliance is to “come in and register” or drop dead is like trying to take a Model T into space. Crypto’s basic mode of operation is by self-custody and directly peer to peer over the Internet, not via paper forms signed with wet ink and mailed to a transfer agent or broker-dealer. There are no national securities exchanges which support cryptoasset trading. The SEC won’t even approve an ETF. The list goes on.
For the last six years, crypto has accepted the economic realities of a Depression-era regulatory scheme. The only question for America, at this juncture, is whether we want to back off from that regime just a little bit so we can nurture and supervise these new crypto companies right here at home – or persist, and drive them offshore.
The old ways are finished, whether Congress likes it or not.