In a landmark crypto-currency litigation case pending before the US District Court in the Southern District of New York, the Securities and Exchange Commission (“SEC”) brought an action against Ripple Labs, Inc. and its officers (“Ripple”). The crux of the SEC’s complaint is that Ripple sold unregistered securities – XRP – a virtual currency designed and engineered to be a “native currency” of the XRP Ledger, which purports to settle transactions in “3 to 5 seconds” according to Ripple1. There are approximately 100 billion XRP in circulation with Ripple owning 50.2% and 49.8 billion held by outside investors.
Most recently, the SEC and Ripple filed Motions for Summary Judgment as to the determination of whether XRP is a security that falls within the ambit of the registration and disclosure requirements of the 1933 Securities Act. The core arguments center around the seminal test espoused in SEC v. W.J. Howey Co. (a case that is remarkably over 75 years old) as to whether XRP is a security, or not. The Howey test is comprised of three (3) elements: “an investment of money in a common enterprise with profits to come solely from the efforts of others2.”
For its part, Ripple has argued that XRP is not a security subject to registration or disclosure. More specifically, that “…XRP gives the recipient no stake in any business enterprise and certainly no stake in Ripple.”; “There was no exchange of money for a significant portion of the XRP distributed by Ripple; and where money was exchanged, it was not an ‘investment of money’ under Howey”; That there was no common enterprise and no evidence that XRP purchasers “reasonably expected profits” from Ripple3.
The SEC contends that Ripple violated Section 5 of the 1933 Act by “offering and selling over $2 billion worth of XRP to the public and used those proceeds to fund Ripple’s business” without appropriate registration4. And consequently, that XRP constitutes a security under the Howey test as:
- Ripple made money through XRP sales;
- That XRP investors expected to profit from buying XRP; &
- “Ripple publicly tied the potential for profit to its promised entrepreneurial and managerial efforts” (essentially relying on the XRP ledger and ecosphere to promote demand and enhance value)5.
The SEC also reiterated its previous guidance in the DAO Report6 which analyzed the offer and sale of certain “DAO Tokens” and concluded that they were offered and sold as investment contracts predicated on Howey and latter cases.
In short, the SEC’s position has been that “those who sell digital assets to publicly raise capital must ensure their actions comply with the federal securities laws7.” The next question becomes what about exemptions from the securities laws? What about when digital assets are used as collateral for traditional deals? What Howey, DAO Tokens and now Ripple have taught us is that each digital asset must be analyzed on its own with a facts and circumstances analysis. Also, depending on the context, a digital asset could also be treated as a commodity under the auspices of the Commodities Exchange Act and CFTC regulations. This would warrant a similar analysis as well.
While we await the Court’s ruling on the cross-motions for Summary Judgment, the Howey test remains instructive many years later and should be utilized when analyzing whether or not a digital asset constitutes a “security” within the ambit of the federal securities laws.