Last week, a US District Court found that the sale of Ripple’s XRP token on exchanges is not an investment contract, while the institutional sale of XRP did violate securities laws.
The decision undoubtedly sets a strong precedent that crypto assets are not securities or investment contracts per se, and that each case should be analyzed according to its particularities, but it does not imply that all crypto assets are not securities.
We believe that while this decision is an undeniable milestone in the legal treatment of crypto assets, it is still too early to assume that the ruling provides regulatory clarity over the characterization of most digital assets by US judges and regulators.
For crypto investors, the decision serves as an important step in the incremental progress being made to provide more regulatory clarity.
Last week, the US District Court of the Southern District of New York made an important decision regarding the years-long lawsuit by the US Securities and Exchange Commission (SEC) against Ripple Labs Inc. and two of its executives. In the lawsuit, originally filed on December 22, 2020, the SEC charged Ripple Labs and its CEO and former CEO with conducting the offering of $1.3 billion in unregistered securities through public sales of XRP, the native token of the Ripple blockchain. The US District Court found that the sale of XRP on exchanges is not an investment contract, while the institutional sale of XRP did violate US securities laws. The ruling is being referred to as a big defeat for the SEC, and a step toward tokens not being considered securities. SEC Chair Gary Gensler said this week that he and his agency find certain aspects of the ruling disappointing, particularly when it comes to the impact for retail investors.
We believe that while this decision is an undeniable milestone in the legal treatment of crypto assets, it is still too early to assume that the ruling provides real regulatory clarity over the characterization of most digital assets by US judges and regulators.
The Howey Test
Last week’s decision was based on the benchmark test in the US to define whether an investment contract is a security or not—the “Howey Test.” The Howey Test refers to the iconic case SEC v. W. J. Howey Co., which reached the Supreme Court in 1946. Howey Company sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey. Company staff would tend to the groves and sell the fruit on behalf of the owners. Both parties shared in the revenue. However, Howey failed to register the transactions and the SEC intervened, stating that the leaseback arrangements qualified as investment contracts. To further embase the ruling, the Supreme Court noted that there were four characteristics to the case in hand that caused the leaseback agreements to be deemed as securities, namely,
An investment of money,
In a common enterprise,
With the expectation of profit,
To be derived from the efforts of others.
These four characteristics would later become the criteria used by case law to define an investment contract. In the case of Ripple, the Court analyzed the four separate claims made by the SEC in order to assess whether or not the sales of XRP met the Howey criteria to be considered investment contracts, and, therefore an unregistered public offering of securities:
The sale of XRP directly from Ripple to institutional investors,
The sale of XRP by Ripple through crypto exchanges,
The sale of XRP by Ripple’s executives through crypto exchanges, and
The exchange of XRP for services provided by Ripple’s employees and contractors.
The judge’s decision
The District Judge, Analisa Torres, understood that, out of the four claims made by the SEC, only the first one (sale of XRP directly from Ripple to institutional investors) was actually an investment contract, because: (1) there was an undisputed investment of money by institutional buyers; (2) Ripple pooled the proceeds of theses sales into a network of bank accounts, creating a common enterprise; and (3) these “reasonable investors would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts.” Therefore, the Court ruled that the so-called institutional sales constituted an unregistered offer and sale of investment contracts in violation of the Securities Act of 1933.
On the other hand, according to Judge Torres, the second and third claims, related to the sale of XRP via crypto exchanges by both Ripple and its two executives, respectively, must not be characterized as investment contracts for Howey Test purposes. This is because the bid/ask process in a conventional order book exchange prevents traders from knowing from whom or to whom they are buying/selling assets. Therefore, there is no way for them to know whether they are actually investing in Ripple or just buying it in a secondary market transaction. According to the Court, since the buyers did not know whether or not the investment of money made by them would actually be used by Ripple to fund its operations, there is not a reasonable expectation of profit derived from the efforts of others. In other words, the economic reality of the transaction failed prongs 3 and 4 of the Howey Test.
Finally, when analyzing the SEC’s fourth claim (exchange of XRP for services provided by Ripple’s employees and contractors), the ruling states that it fails to satisfy Howey’s first prong, namely an investment of money, and thus it cannot be characterized as an investment contract or a security.
What does this mean for the future of crypto asset investing?
The decision undoubtedly sets a strong precedent that crypto assets are not, per se, securities or investment contracts. The simple fact that the court analyzed each of the circumstances under which the tokens were sold in order to decide whether those sales represented or not investment contracts pursuant to the Securities Act of 1933 is an important milestone. Moreover, Judge Torres’ ruling goes further and expressly states 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. Rather, the Court examines the totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP.”
However, there is one fair question that should be asked: Does last week’s decision imply that all crypto assets are not securities? The short answer is “no.”
While the decision sets the precedent to argue that, depending on the way a token is sold or promoted, it shall not be deemed an investment contract and its sale is not a public offering of securities, it is noteworthy that, when analyzing claims 2, 3, and 4 made by the SEC (sales of XRP through exchanges and XRP being used as compensation), the Court did not run a complete Howey Test.
Since crypto exchange sales failed to meet the “expectation of profit derived from the efforts of others” criteria, due to the bid/ask process, the Court did not analyze the other two Howey criteria (investment of money and common enterprise). Prong 1, for instance, if analyzed, could have gone either way, considering that investors may use either cash or other digital assets (such as bitcoin or ether) to purchase XRP via crypto exchanges. The same is true for Prong 2, depending on what the Court would have understood that is the “common enterprise.” Does it need to be Ripple’s effort or the “XRP community” would benefit from the investments made that would ultimately increase their overall market value?
Claim 4 (XRP being used as compensation) is no different. The ruling states that the economic reality of the facts fails to meet Prong 1 of the Howey Test, since there was no investment of money, and vaguely mentions Prongs 2, 3, and 4 (common enterprise, with the expectation of profit derived from the efforts of others), stating that “there is no evidence that Ripple funded its projects by transferring XRP to third parties and then having them sell the XRP.” However, under different circumstances, or when analyzed by a different court, the conclusions might differ.
It is clear from this decision that each crypto asset (and its respective sales) will have to be analyzed on its own, and depending on whether or not each particular case passes or fails the Howey Test, the tokens can be considered a security or not. We believe last week’s ruling is not a silver bullet for determining what is or isn’t a security within the crypto ecosystem. Regardless, we see it is as an important step in the direction of more incremental regulatory clarity, which will ultimately benefit crypto investors, and is an undeniable milestone in the legal treatment of crypto assets in the US.
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