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Is cryptocurrency considered a security in the eyes of U.S. regulators? A three-year court battle between Ripple Labs, Inc., a blockchain developer and creator of the XRP token, and the Securities and Exchange Commission (SEC) has helped answer that question.
The court’s most recent ruling more narrowly defines the potential scope of regulatory actions that may be taken by the SEC. For years, the SEC has argued that digital assets constitute securities, similar to stocks and bonds traded on Wall Street, and should be subject to the same strict regulations.
The SEC sued Ripple in December 2020, accusing the crypto firm of violating securities laws in one of the first major legal fights involving cryptocurrencies. In the 34-page ruling on July 13, 2023, (20 Civ. 10832), Judge Analisa Torres of the U.S. District Court for the Southern District of New York stated that Ripple Labs did not break securities laws when the cryptocurrency it created, XRP, was sold on public cryptocurrency exchanges. However, Judge Torres did find that Ripple had violated securities law when it sold XRP to institutional investors, like sophisticated hedge funds.
Section 5 of the Securities Act
In large part, the Court’s ruling centered on Section 5 Liability and the Howey Test. Under Section 5 of the Securities Act, it is “unlawful for any person, directly or indirectly, . . . to offer to sell, offer to buy or purchase[,] or sell” a “security” unless a registration statement is in effect or has been filed with the SEC as to the offer and sale of such security to the public. 15 U.S.C. §§ 77e(a), (c), (e). To prove a violation of Section 5, the SEC must show: (1) that no registration statement was filed or in effect as to the transaction, and (2) that the defendant directly or indirectly offered to sell or sold the securities (3) through interstate commerce. See SEC v. Cavanagh, 445 F.3d 105, 111 n.13 (2d Cir. 2006).
Howey Test
In SEC v. W.J. Howey Co., the Supreme Court held that under the Securities Act, an investment contract is “a contract, transaction[,] or scheme whereby a person [(1)] invests his money [(2)] in a common enterprise and [(3)] is led to expect profits solely from the efforts of the promoter or a third party.”
The Howey case involved the application of § 2(1) of the Securities Act of 1933 to an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor.
The court in Howey determined that Section 2(1) of the Act defined the term “security” to include the commonly known documents traded for speculation or investment. This definition also included “securities” of a more variable character, designated by such descriptive terms as “certificate of interest or participation in any profit-sharing agreement,” “investment contract,” and “in general, any interest or instrument commonly known as a security.'”
The legal issue in Howey turned upon a determination of whether, under the circumstances, the land sales contract, the warranty deed, and the service contract together constitute an “investment contract” within the meaning of § 2(1); and the application of operation the registration requirements of § 5(a), unless the security is granted an exemption under § 3(b). Some lower courts had reached a negative answer to this problem by treating the contracts and deeds as separate transactions involving no more than an ordinary real estate sale and an agreement by the seller to manage the property for the buyer.
About Ripple
According to court filings, Ripple launched XRP Ledger in 2012. Ripple was originally named NewCoin, Inc. and incorporated under California law. Ripple’s mission has been to realize an “Internet of Value” by using technology to facilitate the transfer of value across the internet.
Specifically, Ripple “seeks to modernize international payments by developing a global payments network for international currency transfers.” For instance, Ripple developed a software product called RippleNet, which allows customers to clear and settle cross-border financial transactions on mutually agreed-upon terms. One feature of RippleNet is known as “on demand liquidity” (“ODL”). ODL facilitates cross-border transactions by allowing customers to exchange fiat currency (for example, U.S. dollars) for XRP and then the XRP for another fiat currency (for example, Mexican pesos). Ripple also distributed XRP as a form of payment for services (“Other Distributions”). For instance, Ripple distributed XRP to its employees as a form of employee compensation.
Ripple also distributed XRP in conjunction with its Xpring initiative to fund third parties that would develop new applications for XRP and the XRP Ledger. Other developers have built software products that use the XRP Ledger, such as payment-processing applications. Ripple has also funded companies as part of its “Xpring” initiative to incentivize the development of other use “cases” on the XRP Ledger.
In addition to Ripple’s sales and distributions, individuals offered and sold XRP in their individual capacities. The XRP Ledger is based on open-source software; anyone can use the ledger, submit transactions, host a node to contribute to the validation of transactions, propose changes to the source code, or develop applications that run on the ledger. Not all of Ripple’s products and services rely on the XRP Ledger and XRP.
Next Up
Last month, the SEC sued two of the largest crypto exchanges, Coinbase and Binance, alleging they were operating as unregistered exchanges and brokers.
As a result of the Ripple ruling, Paul Grewal, chief legal officer at Coinbase, told CNBC “For exchanges, for tokens that are listed on exchanges, for regular investors, there’s no question that this ruling strikes a blow to the idea that somehow securities are being traded when people go onto exchanges and trade the assets,” he said. Coinbase’s arguments in its legal case against the U.S. Securities and Exchange Commission have been strengthened as a result.
However, there are significant differences in the SEC allegations and arguments against Coinbase and Binance, specifically related to their operation as trading platforms for products that might be considered securities. In the lawsuits against Binance and Coinbase, the SEC has argued that a wide slate of cryptocurrencies constitute securities. Judges in those cases will have to make separate determinations about whether the sale of those digital assets broke the law.
While this case has shed some light on crypto and securities law, there are still several issues and cases in the pipeline that have yet to be determined.
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