On July 13, 2023, the United States District Court for the Southern District of New York issued the landmark decision Securities Exchange Commission (SEC) vs. Ripple Labs, Inc., Bradley Garlinghouse and Christian A. Larsen (the Ripple Decision or Decision). The Decision holds that the digital token XRP is not a security and rejects the SEC’s position that a crypto asset, if initially distributed by way of an investment contract to which securities law applies, should retain that securities law character in all subsequent transactions. The Decision is not binding precedent in Canada or other courts in the United States, and is expected to be appealed. Due to the interest the Decision has attracted, we have considered its implications for the regulation of crypto assets in Canada.
As to whether secondary market trading in XRP tokens could constitute trading in securities, the Court states: “Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction or scheme.” This contrasts with the widely quoted assertion of current SEC Chair Gary Gensler that the “vast majority” of tokens in the crypto market are securities, which is the theory driving the SEC’s recent complaint against Coinbase and other U.S.-based crypto asset exchanges and issuers.
We consider the Decision’s relevance to Canadian crypto asset market participants in the following contexts:
- Dealer CTPs. Crypto asset trading platforms (CTPs) that are registered as dealers under Canadian securities law (Dealer CTPs) are prohibited from offering crypto assets that are, in and of themselves, securities. Whether a security is involved is based on an analysis conducted by the Dealer CTP, which must take into account the determinations of a court “in the foreign jurisdiction with which the Crypto Asset has the most significant connection.” Dealer CTPs may elect to use the Ripple Decision to determine, for the purpose of their platform, that XRP is not a security. The Decision may also be applied by Dealer CTPs engaged in regulatory analysis of other crypto assets proposed to be offered on their platforms.
- Classification of Crypto Assets as Securities. The Canadian Securities Administrators (CSA) were among the first regulators in the world to impose capital markets regulation on crypto asset market intermediaries. To do so, the CSA asserted that the contractual relationship between a custodial CTP and its clients is itself a security or derivative known as a “Crypto Contract”, even if the underlying crypto asset is not a security.Subjecting crypto assets to securities regulation in Canada has undoubtedly had an impact, in particular by addressing certain counterparty risks associated with CTP activities. In principle, such regulation of CTPs is desirable. It promotes market integrity and provides investors with valuable information about crypto assets. However, the Ripple Decision identifies key differences between crypto assets and securities, and illustrates why ongoing regulation should be sensitive to both the investment and non-investment (sometimes called “consumptive”) uses for crypto assets. For example, the CSA’s regulatory approach to stablecoins should recognize that such crypto assets are generally used as a payment instrument or store of value, and not as an investment.
- Resale Restrictions. Canadians who acquire crypto assets in early stage transactions (e.g. venture investors, founders, employees and service providers) have been hampered by the potential application in subsequent sales of broad resale restrictions in Canada which deem the first trade in securities issued under a prospectus exemption to be a distribution. The Ripple Decision potentially gives Canadian holders a basis for arguing that secondary market sales of crypto assets received in exempt securities transactions should not be regulated as distributions of securities. On the other hand, any sales of such tokens on Dealer CTPs would be constrained by the CSA’s Crypto Contract construct and could therefore engage Canadian securities laws, including the CTP’s duty to review the creation and governance of the crypto asset and the background of its developers, and to disclose relevant risks to its clients.
- Future Canadian Regulation. We expect that the CSA will continue to develop its regulatory framework for CTPs and related initiatives focused on crypto asset investor protection and market integrity concerns they have expressed repeatedly in relation to the crypto asset market. Still, the Ripple Decision illustrates how the current and sometimes rigid securities regulatory framework does not map perfectly onto crypto assets, and should not necessarily be applied as an all-encompassing regulatory solution for Canada
Ripple Decision: Institutional Sales vs. Programmatic Sales
To provide necessary context for our Canadian analysis, set out below are key factors which led the Court in the Ripple Decision to conclude, based on an examination of “the totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP,” that “Institutional Sales” of XRP to sophisticated purchasers pursuant to written contracts were investment contracts and therefore securities, while “Programmatic Sales” of XRP on crypto asset exchanges were not investment contracts, and therefore not securities:
- Ripple Labs marketed and sold XRP as an investment directly to Institutional Buyers, while Programmatic Sales were blind bid/ask transactions.
- Institutional Sales were made pursuant to negotiated contracts, including lock-up provisions, resale restrictions, indemnification clauses and other conditions typical of an investment, while there was no contractual relationship between Ripple Labs and Programmatic Buyers.
- Proceeds of Institutional Sales were paid by Institutional Buyers directly to Ripple Labs, pooled into bank accounts and used to finance operations. Conversely, Programmatic Buyers “could not have known if their payments of money went to Ripple, or to any other seller of XRP”, “many Programmatic Buyers were entirely unaware of Ripple’s existence” and the “vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all.”
- Ripple Labs provided Institutional Buyers with promotional materials that “touted XRP as an investment tied to the company’s success” and explained that, “Ripple’s business model is predicated on a belief that the demand of XRP will increase…if the Ripple protocol becomes widely adopted.” The Court did not consider Ripple’s targeting of speculators in its public social media campaigns to be analogous, citing precedent that “a speculative motive on the part of the purchaser or seller does not evidence the existence of an investment contract.” Since “Ripple did not know who was buying the XRP,” Programmatic Buyers were not given promises or offers similar to those given to Institutional Buyers.
Judge Analisa Torres also found that distributions of XRP by Ripple Labs to employees and project grant recipients were not securities because there was no “investment of money” by the recipient, and made several other findings that are beyond the scope of this article.
The Decision rejects the SEC’s allegation that Institutional Sales were “distributions of XRP into public markets through conduits, [with] some…buying XRP as brokers, while others simply resold it as part of their trading strategies.” Despite contractual terms between certain Institutional Buyers and Ripple Labs expressly stating that the Institutional Buyer was purchasing XRP “solely to resell or otherwise distribute” XRP, the Court rejected the SEC’s argument that Ripple sold investment contracts to the public and used the Institutional Buyers as underwriters.
The Court also held that Programmatic Sales did not establish an expectation of profits from the efforts of Ripple Labs. Judge Torres conceded that, “many 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).” The Ripple Decision has caused excitement in the crypto asset industry because it provides a basis for challenging the SEC’s position that existing U.S. securities laws give it sufficient jurisdiction and tools to act as the primary regulator for crypto asset markets.
Judge Torres’ unflinching application of the Howey Test is being criticized by some because it extends the protections of securities laws to sophisticated Institutional Buyers but does not extend the same protections to retail purchasers. This criticism misses an important point: the Decision does not oppose the need for sensible regulation of the crypto asset market; it simply defines the limits of the “investment contract” concept in the secondary market. By strictly applying the legal principles of “Howey and its progeny,” the Decision illustrates that regulation of the secondary market for crypto assets in the United States will undoubtedly require Congressional action. Several legislative proposals are under discussion and momentum appears to be growing for new, fit-for-purpose regulation for the crypto asset industry.
Dealer CTPs and the Know-Your-Product Obligation
In March 2021, the CSA asserted jurisdiction over “Platforms that facilitate the buying and selling of crypto assets, including crypto assets that are commodities, because the user’s contractual right to the crypto asset may itself constitute a derivative [or a security]’ known as a Crypto Contract. Since that time, eleven CTPs have been registered as securities dealers in Canada, and ten more have given undertakings to become registered as securities dealers by no later than March 2024. See our article, Retail Investment Limits under the Canadian Crypto Asset Trading Platform (CTP) Regulatory Regime for a description of the CSA’s emerging regulatory regime for Dealer CTPs (the Dealer CTP Framework).
The Dealer CTP Framework imposes “know your product” (KYP) obligations on Dealer CTPs, requiring them to analyze the investment appropriateness of each crypto asset offered on the platform having regard to, among other things, “legal and regulatory risks associated with the crypto asset, including any pending, potential or prior civil, regulatory, criminal or enforcement action relating to the issuance, distribution, or use of the crypto asset.” The KYP obligation seeks to protect Canadian retail investors from investing in unacceptably risky crypto assets. It also absolves the CSA from responsibility for reviewing specific crypto assets offered by Dealer CTPs, by imposing the burden squarely and completely on Dealer CTPs.
A Dealer CTP is prohibited from trading a crypto asset with Canadian clients if it determines that the crypto asset is a security or derivative, based on: (i) the Dealer CTP’s own analysis (including by obtaining legal advice, if necessary); (ii) the determination of a court, regulator or securities regulatory authority in Canada or the foreign jurisdiction with which the crypto asset has the most significant connection; or (iii) if the Dealer CTP is made aware or is informed that the crypto asset is “viewed by a regulator or securities regulatory authority to be a security and/or derivative.”
The foregoing prohibition prompted many Dealer CTPs to de-list XRP from their platforms during the course of the CSA’s review of their registration applications. Beginning in mid-2021, at least five Canadian CTPs de-listed XRP. Notably, several prominent U.S.-based platforms also de-listed XRP in the United States but continued to offer it in Canada. As the Court proceeding evolved and Ripple Labs began to amass small victories against the SEC, some Canadian CTPs quietly re-listed XRP starting in the fall of 2022. Last week, within hours of the release of the Ripple Decision, XRP was made available by all Dealer CTPs in Canada.
The Ripple Decision may also provide guidance to Dealer CTPs when applying their KYP obligations to other crypto assets. The Decision suggests Dealer CTPs “examine the totality of circumstances surrounding proposed transactions” in crypto assets when considering whether the crypto asset is being sold as a security or derivative. Having regard to the distinction between Institutional Sales and Programmatic Sales made in the Ripple Decision, it would be reasonable for Dealer CTPs to consider whether clients have any expectation that their money paid for a crypto asset will be “invested in” managerial efforts to increase the value of that crypto asset.
Dealer CTPs should note that the Ripple Decision suggests that the level of “decentralization” of a blockchain network or application is not relevant to the reasonable expectations of secondary market purchasers. The Court did not find it necessary to determine whether the XRP Ledger was “sufficiently decentralized” to assess the “reasonable expectations” of secondary market purchasers, as posited by Commissioner William Hinman in his 2018 “When Howey Met Gary (Plastic)” speech. The Court did not mention the number of nodes of the XRP computer network that Ripple Labs operated (or did not operate), the number of XRP tokens that Ripple Labs controlled (or did not control) or, more generally, how instrumental the ongoing efforts of Ripple Labs would be for the XRP ecosystem to succeed, all factors which have been understood to reflect the extent to which a blockchain project may be “centralized” and cause crypto assets native to that project to be securities. The Decision takes some pressure off of the strained “decentralization” analysis, which is highly variable and difficult to apply in practice.
Classification of Crypto Assets as Securities
In March 2021, CSA Staff established the Crypto Contract concept as a means for asserting jurisdiction over CTPs, some of which were exposing retail investors to significant counterparty risk. The CSA’s initiative has had a significant impact, as many offshore CTPs which had been offering high risk derivatives and leverage to retail investors exited Canada, while onshore CTPs submitted to the Dealer CTP Framework, which imposes strict investor protection requirements on CTPs.
Still, the CSA approach has significant limitations. The Crypto Contract construct can be perceived as a somewhat contrived application of investment contract principles and is not uniformly understood or applied across the CSA. Different CSA jurisdictions have different views regarding whether Crypto Contracts should be regulated as securities or derivatives, and if a security, whether it is an investment contract, evidence of indebtedness, or fits under another limb of the definition of security which may exist in some CSA jurisdictions but not others. In addition, Canada’s regulatory framework has been fashioned from multiple reactive CSA Staff Notices and bespoke exemption orders negotiated by each CTP instead of comprehensive rules resulting from broad public consultation.
When broadening the Dealer CTP Framework to accommodate new innovations, the CSA has considered it necessary to assert that each new crypto asset-based product proposed to be offered by Dealer CTPs is a security or derivative, and therefore ought to be regulated in a manner similar to the regulation of securities or derivatives. Examples of this approach include the terms and conditions for CTPs proposing to offer staking as a service, and more recently, the CSA’s position that stablecoins are securities and subject to a separate regulatory approval requirement when offered by a Dealer CTP. Initially, the CSA’s approach to stablecoins was so strict that it would have been virtually impossible for even the most heavily regulated stablecoin in the world to meet the CSA’s standards. The CSA is now working with Dealer CTPs to reach a more reasonable interim approach to stablecoin regulation, while other regulatory frameworks for digital payment instruments are under development.
As illustrated by the Ripple Decision, the securities regulatory framework does not map perfectly onto crypto assets. The continued designation of every crypto asset innovation as a security may be too rigid to allow the product innovation needed to keep CTPs viable, yet regulated as securities dealers. In addition, businesses that offer crypto asset services outside of Crypto Contracts face ongoing uncertainty regarding the extent to which their activities may engage securities laws.
Under Canadian securities law, the first trade in securities acquired by a Canadian holder pursuant to a prospectus exemption is deemed to be a distribution, and therefore such securities cannot be resold unless they are qualified by a prospectus (e.g. the issuer has become a “reporting issuer” in Canada) or an exemption from the prospectus requirement is available. The objective of this “closed system” for securities in Canada is “to prevent the free trading of securities where there is no disclosure record account about the issuer”. Conversely, in the United States, securities acquired in unregistered, private sales generally become freely tradeable after a twelve month hold period, subject to certain exceptions.
Canadian resale restrictions amplify some regulatory risks associated with holding crypto assets in Canada, even in circumstances where such crypto assets are acquired in securities transactions that are exempt from the prospectus requirement. For example, venture capital investors may acquire tokens or token rights in investment contract transactions with early-stage blockchain projects. Likewise, Canadian-based employees of, and service providers to, blockchain projects may receive tokens or token rights as compensation, and Canadian software developers may receive token grants as inducements to develop software for a particular blockchain network or protocol. In such cases, prospectus exemptions would typically be available for the initial distribution of tokens or token rights under an investment contract or other securities transaction.
For so long as crypto assets acquired under a prospectus exemption are considered securities in Canada, and unless the issuer has become a public company in Canada or has obtained discretionary exemptive relief, the holder can only resell the securities in another prospectus-exempt transaction. While exemptions for trades in securities on markets outside of Canada are available, they are conditional on the issuer having limited connections to Canada. The Ripple Decision gives a basis for Canadian holders who acquire tokens in early-stage transactions or as compensation to argue that such tokens are not, in and of themselves, securities, and therefore resale restrictions should not apply.
To the extent that such holders seek liquidity for their tokens using a Dealer CTP, the trade would be conducted in a Crypto Contract and would therefore engage securities laws. The Dealer CTP’s KYP assessment would include a review of the creation, governance, usage and design of the Crypto Asset and the background of the developers. In addition, the Dealer CTP would disclose material risks associated with the crypto asset to its clients. Finally, the Dealer CTP Framework prohibits a Dealer CTP from engaging in trades that are designed to facilitate a distribution of crypto assets by the developers of the crypto assets, its issuers or affiliates or associates of such persons.
Future Canadian Regulation
In June 2023, after conducting consultations with Canada’s blockchain industry, the House of Commons Standing Committee on Industry and Technology published the report Blockchain Technology: Cryptocurrencies and Beyond (the HoC Report). The HoC Report recommends the government recognize the long-term potential of blockchain as an emerging industry and establish a national blockchain strategy that clarifies policy direction and regulatory approach, and demonstrates support for the industry. Among the 16 specific recommendations in the report are protections for the right to self-custody, promotion of access to banking and insurance for crypto asset businesses, support for custodians and miners, and “a distinct regulatory approach to stablecoins that reflects the difference between these products and other cryptocurrencies, and accounts for the unique regulatory challenges they present.”
The consumptive use cases for crypto assets engage myriad Canadian regulatory regimes, including banking and payments, privacy, gaming, insurance and taxation. Consequently, it is desirable for other regulators and various levels of government to be engaged in the regulation of crypto assets. Of course, the CSA have already carved out a critical role in regulating crypto and in any national blockchain strategy that Canada may pursue, having regard to its mandates of investor protection and market integrity. We expect that the CSA will continue to develop the Dealer CTP Framework and related regulatory initiatives for crypto assets. When doing so, the Ripple Decision can serve as a reminder that Canada’s regulatory framework for crypto assets should consider the differences between crypto assets and securities in a way that exhibits flexibility and fosters innovation in our capital markets.