An earlier version of this post appeared on Zero Hedge.
What, legally speaking, is a cryptocurrency token sold to the public?
Following Thursday’s bombshell split decision by judge Analisa Torres of the Southern District of New York in SEC v. Ripple Labs et al., the answer appears to be that XRP is both an unlawfully sold investment contract when sold to VCs or institutional buyers, but a perfectly lawful, “something else” when sold anonymously via cryptocurrency exchanges, or distributed to employees or by insiders.
The only thing this ruling guarantees for cryptocurrency issuers, then, is continued uncertainty in the cryptocurrency markets – uncertainty which Congress, and only Congress, can step in to correct.
At issue in this case is whether a decade’s worth of token distributions by Ripple Labs are sales of securities by dint of the transactions being “investment contracts” as such term is defined by the “Howey Test” in SEC v W.J. Howey Co., 328 U.S. 293 (1946), as clarified by subsequent precedents. That test says, in brief, that a contract, transaction or scheme involving (1) the investment of money (2) in a common enterprise with (3) a reasonable expectation of profits arising from the entrepreneurial or managerial efforts of others is a juridical critter known as an “investment contract” and is, per the federal Securities Act of 1933, to be regulated in exactly the same manner as a security.
For the purposes of conducting the Howey analysis, the court in Ripple Labs divided Ripple’s sales of tokens into three categories: (1) institutional sales to hedge funds, VCs and the like; (2) programmatic sales to retail directly on digital asset exchanges; and (3) “as a form of payment for services,” such as in restricted token purchase agreements or option contracts, to employees and other service providers.
Ripple loses on “Institutional Sales” of XRP…
On the first category of sales, institutional sales, Ripple lost, and lost big. $700 million + in disgorgement plus interest and penalties if Ripple doesn’t appeal (which it will).
There are few if any informed legal commentators who I have seen arguing that any court should have found otherwise.
…but wins on “Programmatic Sales”…
On the second category of sales, programmatic sales, the Court found in Ripple’s favor, arguing that the third, “expectation of profits” prong of Howey was not met despite finding that the prong was met for institutional sales. The reasoning for this was odd and appears to be based on the choice of venue through which XRP were sold: “Ripple’s Programmatic Sales were blind bid/ask transactions,” the Court wrote, “and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP” and as such “a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.” As a result, the Court opined, “Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple.”
The Court here clearly erred, for one simple reason: the expectation of profit prong doesn’t require an expectation of profit as a result of the efforts of the seller, but rather the efforts of another; per Howey, “the efforts of the promoter or a third party.” As will be obvious to anyone active in the industry, XRP’s principal promoter is and always has been Ripple Labs, whether a purchaser was aware they were purchasing tokens from Ripple Labs or not.
For an example of the SDNY applying this principle correctly, look no further than a 2020 decision granting the SEC’s motion for a preliminary injunction in a massive win against the Telegram messenger app and its blockchain development subsidiary. There, Judge Kevin P. Castel (more recently famous due to his smackdown of a couple of lawyers who wrote pleadings that included ChatGPT hallucinations) linked purchasers’ expectation of profits “upon the essential entrepreneurial and managerial efforts of Telegram[,]”not the entrepreneurial and managerial efforts of intermediaries who were selling Telegram SAFT contracts to all and sundry at the time.
It was “Telegram’s commitment to develop the project,” not the intermediary sellers’ resale efforts, which the Court held constituted the “essential efforts of another” for the purposes of this Howey prong. Because of this, I expect Ripple’s win on this point to be lost on appeal.
So when Ripple sold to sophisticated investors, those investors were protected by securities laws, but when it sold its token to retail, those unsophisticated investors weren't?— kadhim (＾ｰ^)ノ (@kadhim) July 13, 2023
It's pretty much the inverse of our normal understanding of how securities laws function
…and bizarrely also wins on “Other Distributions” of XRP
Finally, and most bizarrely, Ripple won on the basis that “Other Distributions” to e.g. employees did not satisfy the first prong of Howey, the “investment of money” prong. This one is a real head-scratcher because it is abundantly clear from the precedents that an “investment of money” for Howey purposes need not actually include the transfer of funds – what it requires is only that the purchaser “gave up some tangible and definable consideration in return for an interest that had substantially the characteristics of the security.”
Yet, after stating that Ripple’s “Other Distributions” “include distributions to employees as compensation and… to develop new applications for XRP,” relationships which in practically any commercial setting are regarded as possessing the requisite bi-directional movement of contractual consideration necessary to satisfy this prong (employee provides services; employer provides tokens), the Court concluded that the necessary contractual consideration was nonetheless absent and no “tangible or definable consideration” was paid to Ripple. Employees providing services and third parties developing applications for use on a protocol strike me as profoundly tangible and measurable things in relation to which great sums of money and cryptotokens are routinely paid.
That the consideration for this prong can be minor, or even nominal, is not a point which has been seriously disputed for some time, even among the crypto bar. Peter Van Valkenburgh at Coin Center wrote in 2017 that even “free” distributions of tokens via an airdrop which required a user to provide only an e-mail address was sufficient consideration flowing from the investor to the issuer, and going the other way issuers benefited through the receipt of “value by spawning a fledgling public market for their shares, increasing their business, creating publicity, increasing traffic to their websites, and, in two cases, generating possible interest in projected public offerings.” For this reason, this finding strikes me as probably erroneous and vulnerable to challenge on appeal.
The legal status of XRP, then, seems to possess a kind of quantized duality, Schrodinger’s Shitcoin – it’s a security when sold to an institutional investor in a primary sale, but not a security when sold behind the anonymity of a cryptocurrency exchange, or when sold in exchange for services to insiders. This position strikes me as deeply unsatisfactory from the standpoint of regulatory consistency – no other security magically transmogrifies from a security to a non-security depending on to whom it is sold, or after it is sold more than once – as well as being a manifestly incorrect application of the line of precedents relating to the first and third Howey prongs when one considers the entirety of the reasons why an XRP purchaser buys XRP tokens.
Much has also been made of the judge’s opinion that “XRP, as a digital token, is not in and of itself a ‘contract, transaction or scheme’ that embodies the Howey requirements of an investment contract.” Ok, fine. But the term “contract, transaction, or scheme” in Howey is very deliberately open-ended, and there’s nothing in the caselaw which would prevent XRP itself from being designated as embodying the investment contract, much in the same fashion as a bearer security. When the SEC appeals this finding or raises it in other litigation in other federal courts, as is virtually certain to occur, the SEC is going to have plenty of precedent on its side (see e.g. pyramid scheme cases such as 1973’s SEC v. Glenn Turner, where the product constituting an “investment contract” was a bunch of motivational tapes and rights to sell motivational tapes to new investors). A cryptocurrency token which can only do one thing – be re-sold to new investors – seems to fit those half-century-old precedents, if the SEC decides that reclassifying tokens in this way is an issue it needs to discuss.
There are other issues in this case relating to Ripple executives Chris Larsen and Brad Garlinghouse. I leave those issues undiscussed here to focus on the legal problems faced by cryptocurrency issuers and keep under my word count. As for issuers, the U.S. market is thus presented with two broad pathways for further development, much as it had in 2018 after the SEC’s Bill Hinman unwisely invented the “sufficiently decentralized” test for token issuance which launched a thousand ICOs, and was subsequently benchslapped by district courts across the United States.
The first path is that our unfit-for-purpose regulations will not change and a new wave of token issuers will seek to avail themselves of this narrow and in my view likely incorrect ruling to launch new programmatic token schemes – “Programmatic ICOs” or PICOs – aping the Ripple structure, and the SEC will find itself bringing enforcement actions against these schemes in two to three years, to the detriment of the American economy, investors, and innovation more broadly. Startups following this first path should exercise extreme caution – as my colleague Palley puts it, “that order in the Ripple case is a partial summary judgment from a single district court judge. While persuasive, it’s not binding precedent on other courts and will likely be appealed and could be reversed. Don’t yolo into anything based on that decision.”
The second path is that the U.S. Congress realizes that it makes no sense for a thing to be a security in one transaction but not another, and passes laws – as the UK is now doing – to normalize cryptocurrency investment by conferring a well-defined legal status on all token transactions, requiring an aggressive disclosure regime and doing away with the Securities Act of 1933’s requirement that we regulate tokens which are paired with no contractual promises in the same manner as we regulate contractual instruments, as the UK has done.
Ripple’s business of selling tokens should be legal in the United States, within regulatory guardrails. Currently, in my personal opinion, it isn’t. In my view Judge Torres’ ruling that it is, will likely be reversed on appeal.
In the meantime, it is probable that this ruling has changed the risk calculus of crypto developers and investors in the United States, for which the final outcome of an eventual appeal is largely irrelevant, because the business risk of investing in crypto has likely decreased.
Whilst the crypto markets are global and the U.S. has a mere 5% of the world’s population (and thus the effects of any American regulatory scheme will, ultimately, be limited), U.S. investors and entrepreneurs, whether we like it or not, tend to have more money and execution capacity than those elsewhere. Hence regulatory developments in the U.S. tend to have limited but relatively larger effects on the global markets than regulatory developments elsewhere.
Where the mood post-FTX was dark and was only getting progressively darker as the Gensler SEC’s regulation-by-enforcement drive hit a fever pitch with lawsuits against major global exchanges in June, this seems to have turned on a dime now that a federal judge has given a glimmer of hope that the SEC is wrong and those exchanges and issuers are right. This also piles pressure on the SEC and its anti-crypto Democratic handlers in the Congress who, for the first time I can think of, have experienced a defeat in a crypto case and thus have renewed incentive to avoid that outcome from happening again by implementing a statutory scheme for cryptocurrency which regularizes the product and cannot be defeated in court. For these reasons, while the appeals are pending, I expect crypto new product development and marketing to resume and indeed increase.
My hope is that Congress will get its act together and decide that it’s time for cryptocurrency tokens and cryptocurrency exchanges to receive their own purpose-built disclosure and supervisory frameworks which will take cryptocurrency regulation out of the slow and contradictory hands of our courts and the politically motivated hands of the SEC, and dispense with the anachronistic regime of broker-dealers, custodians, and transfer agents with which the SEC presently seeks to hamstring the industry, to allow U.S. crypto business to proceed, with regulatory certainty, in a more laissez-faire manner, such as is permitted in jurisdictions like the United Kingdom.
My expectations of Congress are, however, quite low. I hope to be proven wrong.
Image licensed under the Pixabay license.