SEC v. Ripple: The Regulation of Cryptocurrencies as Securities
Securities and Exchange Commission v. Ripple—a current case regarding the legal status of cryptocurrency—could be taken to the Second Circuit Court of Appeals (if not the Supreme Court) and set a precedent for the amount of jurisdiction that the U.S. Securities and Exchange Commission (SEC) holds over future cryptocurrency transactions. [1] Because this case could designate a new legal “guardian” for cryptocurrency, it has generated significant interest within the cryptocurrency community. [2] However, an evaluation of cryptocurrency against the standards established in the 1946 Supreme Court case Securities and Exchange Commission v. W. J. Howey Co. points to an ambiguous legal future for cryptocurrency. XRP, the cryptocurrency at issue in Ripple, appears more likely to satisfy the Howey test due to the centrality in its distribution and its exhibition of vertical and horizontal commonality. Thus, despite the furor regarding this case, the final decision in Ripple may not constitute a conclusive legal determination for all cryptocurrencies.
Ripple began with a lawsuit that the SEC brought against Ripple Labs Inc. over a violation of the Securities Act of 1933, which alleged that Ripple had conducted an unregistered securities offering. The SEC initiated this action with reference to the precedent from Howey, where the court ruled that the definition of a security is a “flexible rather than a static principle” and can be adapted to regulate those who “seek the use of the money of others on the promise of profit.” [3] This case also established a series of guidelines, known as the Howey test, for the identification and subsequent regulation of securities, leading the SEC to declare Bitcoin and Ethereum as non-securities in previous administrative announcements. [4] However, the SEC is not extending the same leniency to XRP but instead declaring that it can be regulated as a security. In response, Ripple claims that XRP is a medium of exchange that only has to register with the Commodity Futures Trading Commission (CTFC), citing a settlement agreement between itself and the Financial Crimes Enforcement Network of the U.S. Department of the Treasury (FinCEN) in 2015. [5]
To understand the complex arguments in Ripple, it is prudent to begin with the Howey test. This test states that a security is “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” [6] This definition can be divided into four requirements: (1) an investment of money, (2) a common enterprise in which the investments are made, (3) an expectation of profit, and (4) a profit that is derived from the efforts of others. From the public’s end, it is difficult to determine whether XRP fits into these categories due to a lack of access to internal documents.
However, we can use other cryptocurrencies to infer how XRP’s deviance from the currently dominant model may influence the final determination of its legal status. Cryptocurrency certainly passes requirements (1) and (3): almost all current cryptocurrency holders have purchased their share with money and expect to earn profit. A central point of a dispute regarding the determination of status for any cryptocurrency, as SEC chairman Gary Gensler stated in 2021, is requirement (2), as claims of decentralization often do not correspond with the realities of the distribution, or “mining”, of the currency. [7] Often, this process inevitably falls into the trap of centralization, meaning that investors become engaged in a common enterprise as referenced in (2).
The legal definition of a common enterprise can be defined by either vertical or horizontal commonality: the former is defined by mutual dependence of the fortunes between a promoter and investor in which both parties have to make money, while the latter is defined by the pooling of assets from multiple investors where all share the profits and risks of the enterprise. [8] An example of vertical commonality is real estate: the real estate agent’s profits are dependent upon the selling of the property while the owner’s profits are derived from the agent’s efforts. Horizontal commonality, on the other hand, is exemplified by the stock market, which involves the distribution of profit as dividends to a pool of investors. For the general trading of cryptocurrency, exchange mediums receive a flat fee; therefore, there is no mutual dependence on the profits of the investors, meaning trading does not satisfy the requirements for vertical commonality.
However, cryptocurrency also confounds the typical standards for horizontal commonality. Blockchain-based cryptocurrencies are less prone to this accusation of centralization since there is no pooling of funds, but there are certainly shared profits and risks since the investors collectively decide the price of the currency. Further, with certain cryptocurrencies such as XRP, which is administered centrally, companies serve as a platform of centralization. These companies’ inner workings could demonstrate certain manipulations of risks and profits, as the currency and the company are so tightly linked that administrative choices may inevitably generate impacts on the currency itself. Therefore, whether a cryptocurrency exhibits horizontal commonality is highly dependent upon the characteristics of both the currency itself and its administrative details such as algorithms and profit derivation.
The last requirement of the Howey test is that the profits are derived from others. At a first glance, cryptocurrency seems highly dependent upon this “effort of others”: the profit of cryptocurrency does come from being generally traded and functions similarly to the stock market. Additionally, those who use cryptocurrency as a form of exchangeable crypto-assets can assert that cryptocurrency, like any other asset whose price fluctuates as a result of the market being composed of multiple investors, is highly reliant upon the effort of others. However, different forms of profit derivation within the cryptocurrency industry challenge such assertions. One example is autonomous trading, in which investors and traders can input pre-established rules into an algorithm that automatically completes transactions without manual interference. [9] In choosing to trade autonomously, there is no collaboration between any of the trading parties. Profits of the individual investor are a result of the appropriate investment choices of the individual rather than from others. The differing levels of collaboration within the profit-derivation process creates significant ambiguity over the question of whether cryptocurrency satisfies this prong of the Howey test. In summary, it can be hard to determine if cryptocurrency, according to the Howey test, can be regulated as a security.
Going back to our starting point—Ripple v. SEC—one should note that there are essential differences between XRP and coins like Bitcoin and Ethereum (the two most popular forms of cryptocurrency). First, XRP has a centralizing company that pools money from investors, demonstrating potential horizontal commonality. Second, Ripple’s business model differs from trading platforms such as Coinbase since it uses its own patented technology, Ripple Protocol Consensus Algorithm, in which all nodes in a transaction must unanimously agree on its validity before it can be completed, instead of relying on blockchain technology. [10] Finally, unlike Bitcoin, all 100 million XRP tokens have already been mined out and their attraction to investors lies in this exclusivity. [11] This commonality also ties the investors together and functions to make them interdependent on each other’s efforts, resulting in unintended vertical commonality. These characteristics all suggest that XRP, unlike other cryptocurrencies, may satisfy the Howey test standards with regard to constituting a common enterprise. Unsurprisingly, Ripple states a similar position: “Ripple’s value proposition as a company depends upon the promotion of XRP, yet XRP is entirely or essentially pre-functional and purchased by investors in anticipation of profit based on the efforts of Ripple.” [12]
This examination of cryptocurrency’s legal status under the Howey test reveals that there is much clarification needed to properly classify the sector of decentralized finance as investment securities. However, the inseparability of XRP and Ripple, as well as its close conformity to the Howey test, means that Ripple will likely not be representative of the general cryptocurrency scene. Nonetheless, the legal field still regards this case as potentially precedent-setting; it is the SEC’s first attempt at regulating cryptocurrencies and its outcomes will be applicable to almost all non-blockchain crypto-assets (e.g., stablecoins). These kinds of legal complexities, as a consequence of the decentralized nature of cryptocurrency, will become increasingly present in corporate and civil lawsuits as cryptocurrency becomes more ubiquitous and convenient.
Edited by JiHoon Ko
Sources:
[1] Keith Lewis, Ripple case seen as precedent for cryptocurrency regulation, Roll Call (May 4, 2021), online at https://www.rollcall.com/2021/05/04/ripple-case-seen-as-precedent-for-cryptocurrency-regulation/ (visited January 7, 2022).
[2] “Why the SEC v. Ripple case is significant for crypto's future,” Yahoo Finance (September 23, 2021), online at https://news.yahoo.com/why-sec-v-ripple-case-142941012.html (visited January 7, 2022).
[3] SEC v. Howey Co., 328 U.S. 293, 299 (U.S. 1946).
[4] Lewis, “Ripple Case Seen.”
[5] FinCEN Fines Ripple Labs Inc. in First Civil Enforcement Action Against a Virtual Currency Exchanger, Finance Crimes Enforcement Network (May 5, 2015), online at https://www.fincen.gov/sites/default/files/2016-08/20150505.pdf (visited January 7, 2022).
[6] SEC v. Howey Co., 328 U.S. 293, 298-299 (U.S. 1946).
[7] Rakesh Sharma, SEC Chief Reiterates Call for Cryptocurrency Regulation, Investopedia (September 14, 2021), online at https://www.investopedia.com/sec-chief-reiterates-call-for-cryptocurrency-regulation-5201311 (visited January 7, 2022).
[8] Justin Henning, “The Howey Test: Are Crypto-Assets Investment Contracts?,” 27 U. Miami Bus. L. Rev. 51, 61-67 (2018).
[9] Jean Folger, Automated Trading Systems: The Pros and Cons, Investopedia (May 12, 2019), online at https://www.investopedia.com/articles/trading/11/automated-trading-systems.asp (visited January 7, 2022).
[10] Stavros Georgiadis, Ripple Is Pricey But Has a Clear Business Model, Nasdaq (May 4, 2021), online at https://www.nasdaq.com/articles/ripple-is-pricey-but-has-a-clear-business-model-2021-05-04 (visited January 7, 2022).
[11] Id.
[12] In re Ripple Labs Inc. Litig., 18-cv-06753-PJH (N.D. Cal. Nov. 3, 2021).