However, we are currently enjoying a flurry of recent guidance. In April of this year, the SEC published the “Framework for Investment Contract Analysis of Digital Assets,” drawing heavily on a June 14, 2018 speech by William Hinman (the director of the corporation finance division of the SEC) on digital asset transactions.
The discourse surrounding the securities laws and the treatment of digital assets continues to draw debate among market participants, regulators and legal practitioners. One of the most high-profile targets in this ongoing debate is XRP, a digital asset issued by Ripple Labs Inc.
Despite voluminous public examination, regulators have not reached a consensus on the appropriate treatment for this widely traded digital asset. Amid vociferous debate and clamoring from market participants for clear, concise and practical guidance from the United States Securities and Exchange Commission (SEC), the commission’s approach to the digital asset space to date has been notably sparse and cautious.
This suggests some hope that the SEC’s reluctance to embrace and promulgate digital asset guidance may be waning. This historical reluctance is made all the more apparent when compared with the vigor with which the Commodity Futures Trading Commission (CTFC) and the Financial Crimes Enforcement Network (FinCEN) have waded into the digital asset discussion, publishing numerous guides, interpretive letters and proposed rules.
Nevertheless, a pending class action lawsuit against Ripple has the potential to offer a glimmer of regulatory clarity with respect to the fundamental question that continues to disorder the digital asset ecosystem: When is a digital asset a security?
Security criteria: The Howey test
The Ripple lawsuit is slowly winding its way through the federal court system. Owing largely to procedural jostling, the plaintiffs in the case submitted an amended complaint on Aug. 5, to which Ripple responded on Sept. 19 with a motion to dismiss. Among other things, the plaintiffs allege that Ripple has raised hundreds of millions of dollars through the sale of XRP – an asset that the plaintiffs allege is an unregistered security – to retail investors in violation of the registration provisions of federal and state securities laws.
In addition to claiming that XRP constitutes a security under California law, the plaintiffs in the Ripple case argue that XRP is a security under the SEC’s long-standing “investment contract” analysis promulgated under 1946 case of the SEC v. W.J. Howey Co., 328 U.S. 293 – i.e., the Howey test).
Whether any asset (including a digital asset) constitutes an investment contract – and thus a security under the Howey test – is determined by the satisfaction of the following four elements: 1) an investment of money, 2) in a common enterprise, 3) with a reasonable expectation of profits, 4) to be derived from the efforts of others.
The plaintiffs, in asserting their case, borrow heavily from the aforementioned SEC framework, quoting from it extensively.
The SEC framework, mentioned above, suggests, perhaps rather evidently, that “the first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in an exchange for value.” The plaintiffs echo this sentiment and claim that XRP clearly satisfies the first prong of the Howey test.
With respect to the second prong of the Howey test, the plaintiffs argue that purchasers of XRP have clearly invested in a “common enterprise,” acknowledging Ripple’s own concession that it “sells XRP to fund its operations and promote the network.” (Editor’s note: The original website that included this quote was taken down sometime after the lawsuit referenced it, meaning it is only accessible as an archive here).
The plaintiffs argue that the price of XRP is clearly dependent – at least, on some level – on the development, adoption and efficacy of XRP Ledger. Did the plaintiffs purchase XRP with a reasonable expectation of profit? The plaintiffs argue, yes.
The SEC framework provides a litany of characteristics that indicate a reasonable expectation of profits. XRP, according to the plaintiffs, ticks many of these boxes: XRP is available for trading on secondary markets, XRP is offered broadly to potential purchasers rather than targeted users, the issuer (i.e., Ripple) expends funds from proceeds or operations to enhance the functionality or value of the network of the digital asset, and so on.
Lastly, drawing again from the SEC framework, the plaintiffs argue that any such profits are clearly derived from the efforts of others – i.e., Ripple itself. The plaintiffs argue that purchasers reasonably expected Ripple and its employees to provide significant managerial efforts, develop and improve the XRP ledger, develop the network, and work to expand secondary trading of XRP.
New turn in the Ripple case
Ripple’s Sept. 19 response seeks to dismiss the complaint largely on procedural grounds, arguing in part that the plaintiffs’ claims are barred by Section 12(a)(1) of the Securities Act of 1933, which imposes a three-year limitation on claims involving the sale of unregistered securities.
While Ripple only briefly touched on its argument that XRP is not an investment contract and therefore not a security, it does make a point to criticize the plaintiffs’ heavy reliance on the SEC framework – highlighting the fact that the framework explicitly states that it is “not a rule, regulation, or statement of the Commission” and is not binding on the commission or otherwise.
While this latest turn in the Ripple case casts doubt on when and if it will ever reach trial, its outcome could have profound effects, not only for Ripple and other entities that have facilitated – and continue to facilitate – the secondary market trading of XRP, but also for other issuers of similarly situated digital assets.
In short, if the plaintiffs are able to overcome Ripple’s motion to dismiss and the case were to result in a finding that XRP is a security, it would effectively prohibit secondary trading of XRP, radically alter the legal framework within which many trading venues currently operate, and ultimately imperil Ripple’s economic viability.
Regulatory and practical implications
Historically, Ripple has not treated XRP as a security. It was not offered to the general public pursuant to the registration provisions of the Securities Act. While exemptions from the registration provisions of the Securities Act exist (such as Regulation A), XRP was not offered pursuant to any such exemption and would therefore constitute an illegal securities offering.
In addition, many of the most popular digital asset trading venues that facilitate secondary trading in XRP are not currently registered with the SEC as broker-dealers and therefore do not possess the regulatory authority to offer secondary trading in digital asset securities. Based on this fact, as well as the fact that XRP would constitute an illegal unregistered security, these venues would be forced to immediately delist XRP.
However, the ramifications to existing trading venues would extend far beyond an obligation to delist XRP – by having sold XRP and facilitated secondary market trading in the past, these venues will have violated Section 15(a)(1).
This provision of the Securities Act makes it unlawful for any broker or dealer to effect any transaction in – or to induce or attempt to induce the purchase or sale of – any security unless such entity is registered with the SEC.
Ripple, as well as other entities supporting the secondary market trading of XRP, may also find itself subject to civil and criminal penalties pursuant to Section 20(e), which provides the SEC the authority to assess penalties against entities that are seen to aid or abet an unregistered broker-dealer.
While the foregoing regulatory consequences are no doubt significant, they are by no means exhaustive. Section 29(b) provides the ability, as an option of the investor, to void any transaction made in violation of any provision of the Exchange Act (including Section 15(a)(1)) and further provides each such investor or purchaser a right of rescission.
State “blue sky” laws also acknowledge and provide for such rights. The practical implication of a violation of Section 29(b) is that purchasers of XRP will have the right to redeem the amounts they have paid for XRP from Ripple as well as potentially from the various venues through which they have bought XRP.
Given the active trading market that exists for XRP – as well as additional complicating factors, such as the fact that many venues allow customers to buy and sell digital assets using other digital assets (i.e., not fiat currency) – verifying, coordinating and satisfying rescission requests would constitute a monumental, if not impossible, undertaking.
In fact, history shows us that the financial and administrative complexities of rescission can have deleterious effects on issuers. For example, Neogenix Oncology Inc. was an otherwise successful biotechnology company that was forced into bankruptcy after it was discovered that it had used unregistered broker-dealers during its early capital-raising activities, implicating Section 29(b) of the Exchange Act. The substantial rescission liability, as well as the accompanying administrative complexities of quantifying its total exposure, ultimately impeded additional capital raising and led to its filing for Chapter 11 bankruptcy.
Fueled in part by the SEC’s recent framework, the plaintiffs in the Ripple case have made a compelling argument that XRP is a security. As evidenced by the aforementioned collection of legal and practical implications, such a determination could spell the beginning of the end for Ripple and ensnare a number of market participants in a legal and regulatory quagmire. In fact, the commission’s recently filed action against ICOBox – a provider of initial coin offering marketing services, which the commission alleges sold and marketed unregistered digital asset securities and acted as an unregistered broker-dealer, among other things – may provide a preview, albeit on a smaller scale, of the regulatory and economic fallout from such a determination.
Should the Ripple case proceed to trial, we imagine that the practical, economic and market implications of such a determination will weigh heavily on the court. While the Ripple case may yet succumb to procedural extirpation, it serves to highlight the regulatory uncertainty that continues to afflict various aspects of the digital asset market and the need for continued, thoughtful, more specific and expanded commission guidance.