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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 (SDNY) 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, institutional sales, Ripple lost. There are few if any informed legal commentators who I have seen arguing that any court should have found otherwise.
…but it 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. “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.”
Is this right?
The Court here is clearly mistaken, 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 why SDNY is mistaken, look no further than its 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 overturned on appeal.
…and bizarrely Ripple 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 a commercial lawyer, as profoundly tangible and measurable things, given the great sums of money and crypto-tokens routinely paid to them.
For this reason, this finding strikes me as probably erroneous and vulnerable to challenge on appeal.
Schrodinger’s Shitcoin
The legal status of XRP, then, seems to possess a kind of quantized duality, Schrodinger’s Shitcoin, if you will.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 after it is sold more than once. It is also a manifestly incorrect application of the line of precedents relating to the first and third Howey prongs (see above) when one considers the entirety of the reasons why an XRP purchaser buys XRP tokens.
Issuers is the U.S. market are thus presented with two broad pathways for further development, much like in 2017 when the SEC’s Bill Hinman unwisely invented the “sufficiently decentralized” test for token issuance which launched a thousand ICOs (and was subsequently bench-slapped by District Courts across the United States).
The first path, assuming unfit-for-purpose regulations don’t change and new token issuers take advantage of this narrow (and likely incorrect ruling) to launch new programmatic token schemes, 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 Stephen 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 U.K. is now doing – to normalize cryptocurrency investment. It will confer a well-defined legal status on all token transactions, requiring an aggressive disclosure regime and do away with the Securities Act of 1933’s requirement that we regulate tokens with no contractual promises in the same manner as we regulate contractual instruments.
Conclusions
Ripple’s business of selling tokens should be legal in the United States, within regulatory guardrails. Currently, it isn’t.
In my view Judge Torres’ ruling holding that it is, will likely be reversed on appeal. 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, to allow U.S. crypto business to proceed 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 on that point.