Ripple Labs Ruling Upsets US Crypto Token Regulation
Following Thursday’s controversial split decision by Southern District of New York (SDNY) Judge Analisa Torres in the SEC v. Ripple Labs et al. The answer seems to be that XRP is both an illegally sold investment contract when sold to VCs or institutional buyers, but a perfectly legitimate “something else” when sold anonymously through cryptocurrency exchanges or distributed to employees or by insiders.
The only thing this ruling guarantees cryptocurrency issuers is the ongoing uncertainty in the cryptocurrency markets — uncertainty that Congress, and only Congress, can correct.
Preston Byrne, an occasional AskFX columnist, is a corporate partner in Brown Rudnick’s digital commerce group.
In this case, the question is whether Ripple Labs’ decade worth of token distributions are sales of securities since the transactions are “investment contracts”, as that term is used in the “Howey test” is defined in SEC v. WJ Howey Co. ., 328 US 293 (1946, as clarified by later precedents.
This test, in brief, states that a contract, transaction or plan (1) the Investing money (2) in a common enterprise involving (3) A reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others is a legal criterion known as an “investment contract” and is, under the Federal Securities Act of 1933.
For the purposes of Howey’s analysis, the court at Ripple Labs divided Ripple’s token sales into three categories: (1) institutional sales to hedge funds, VCs, and the like ; (2) programmatic sales to retail direct to digital asset exchanges; and (3) “as payment for services,” such as in restricted token purchase agreements or option agreements, to employees and other service providers.
Ripple Loses on “Institutional Sales” of XRP…
Ripple lost on the first category, institutional sales. There are few, if any, informed legal commentators I’ve seen who have argued that a court should have decided otherwise.
…but it wins in programmatic sales…
In the second category of sales, programmatic sales, the court ruled in Ripple’s favor, arguing that Howey’s third, “profit expectation” was not met. “Ripple’s programmatic sales were blind bid/ask transactions,” the court wrote, “and the programmatic buyers had no way of knowing whether their cash payments went to Ripple or another XRP seller.” The same shoes as a secondary market buyer who didn’t know who or what he was paying his money to.”
As a result, the court opined, “Programmatic buyers bought XRP with an expectation of profit, but they did not infer that expectation from Ripple’s efforts (unlike other factors , such as general market trends for cryptocurrencies) – especially since this was not the case.” of the programmatic buyers were aware that they were buying XRP from Ripple.”
Is that correct?
The court is clearly wrong here, for one simple reason: the expectation of profit does not require the expectation of profit as a result of the seller’s efforts, but rather someone else’s efforts; according to Howey, “the efforts of the promoter or a third party”. As is obvious to anyone working in the industry, Ripple Labs was and is the main promoter of XRP, regardless of whether a buyer knew they were buying tokens from Ripple Labs or not.
It was “Telegram’s commitment to develop the project” and not the resale efforts of the intermediaries, which the court held constituted the “substantial efforts of someone else” within the meaning of that Howey quote. For that reason, I expect Ripple’s victory on this point to be overturned on appeal.
…and strangely enough, Ripple also wins on “Other Distributions” from the Prong of the Money. This is a real conundrum, as the precedents make it abundantly clear that a “money investment” in Howey’s sense does not necessarily involve a transfer of funds – it only requires that the buyer “have given up something tangible and definable”. Consideration for a share that essentially had the characteristics of the security.”
However, after finding that Ripple’s “other distributions” “distributions to employees as remuneration and … to develop new applications for the court concluded that the required contractual consideration was still missing and no “tangible or determinable consideration” was paid to Ripple.
Employees providing services and third parties developing applications for use on a protocol strike me as a business advocate as deeply tangible and measurable things given the large sums of money and crypto tokens routinely paid to them.
For this reason I consider this finding to be probably erroneous and open to challenge on appeal.
Schrödinger’s Shitcoin
So the legal status of XRP seems to have some sort of quantized duality, Schrödinger’s Shitcoin, if you will. It is a security when sold in a primary sale to an institutional investor, but not a security when sold behind the anonymity of a cryptocurrency exchange or when sold in exchange for insider services.
This position seems to me extremely unsatisfactory from the point of view of regulatory coherence. No other security magically transforms from a security to a non-security after being sold more than once. It is also an obvious misapplication of the precedents regarding Howey’s first and third points (see above) when considering the totality of reasons why an XRP buyer buys XRP tokens.
Ripple and crypto industry win partial victory in SEC court battle over unwisely invented the “sufficiently decentralized” test for token issuance that launched thousands of ICOs (and subsequently by district courts across the United States was rejected).
The first way: Assuming that inappropriate regulations don’t change and new token issuers take advantage of this tight (and probably wrong regulation) to introduce new programmatic token schemes, the SEC will initiate enforcement actions against them in two to three years to the detriment of the American economy, investors and innovation in general.
Startups pursuing this first avenue should exercise extreme caution – as my colleague Stephen Palley puts it: “This finding in the Ripple case is a partial summary judgment by a single district judge.” While compelling, it is a matter of concern to others courts does not set binding precedent and is likely to be challenged and may be reversed. Don’t get involved in anything based on that decision.”
The second way is for the US Congress to recognize that it doesn’t make sense that one thing is a security in one transaction but is a security in another not, and is legislating – as the UK is now doing – to normalize cryptocurrency investments. It will give all token transactions a well-defined legal status that requires an aggressive disclosure regime, and eliminate the Securities Act of 1933’s requirement that we regulate tokens without contractual promises in the same way as contractual instruments.
Conclusions
Ripple’s business of selling tokens should be legal in the United States within regulatory limits. Currently this is not the case.
In my view, Judge Torres’ decision in the affirmative will likely be overturned on appeal. I hope Congress pulls itself together and decides it’s time cryptocurrency tokens and cryptocurrency exchanges got their own purpose-built disclosure and oversight frameworks that take cryptocurrency regulation out of the slow and conflicting hands of our courts and the politically motivated hands of the SEC, to allow the US crypto business to adopt a more laissez-faire approach, as permitted in jurisdictions such as the UK.
However, my expectations of the congress are quite low. I hope that I will be taught better on this point.
