The decision last month by the US District Court for the Southern District of New York in the SEC v. Ripple Labs case was seen by many as a victory for token issuers and exchanges. However, the actual impact of the decision on the future of cryptocurrencies in the US is not so clear.
This decision is indeed a positive development for the industry, meaning that the SEC's jurisdiction over digital assets depends on the nature of the offering or sale of those assets, and not on the underlying qualities of the assets. But other favorable aspects of the decision for Ripple seem apt to be overturned on appeal. Ironically, this may strengthen the position of the SEC in the future.
Unusual decision
The SEC's claims against Ripple depend on whether Ripple's distribution of the XRP cryptocurrency was a "security" for the purposes of the Securities Act. Specifically, the issue was whether these deals met the three-way criteria for creating an "investment agreement" set by the Supreme Court in SEC v. W.J. Howey Co. over seven decades ago.
According to the Howey test, securities are securities that involve (1) an investment of money (2) a joint venture (3) an expectation of profit from the efforts of others. If these transactions were securities, Ripple would have to make several public disclosures (which it did not accept) along with other compliance obligations.
The court concluded that some contract sales of large blocks of XRP by institutional buyers met Howey’s criterion (the court called the sales “institutional sales”), but Ripple’s anonymous sales to cryptocurrency exchanges (so-called “programmed sales”) did not. Ripple also did not transfer XRP to vendors or employees in exchange for services (referred to as “other distributions”). Thus, the SEC won its claims on institutional sales, but not on other forms of distribution of XRP. Related SEC claims against Ripple founder, former CEO and current chairman Christian Larson and former CEO and current CEO Bradley Gerlinghaus will continue in connection with the institutional sale of Ripple. Larson and Girlinghaus deny any wrongdoing.
The most surprising feature of the decision is that the court applied the "expectation" element of "expectation to profit from the efforts of others" differently to different groups of buyers.
Courts generally focus their analysis of this part of the Howey test on whether the person expects to have public information about the role of the person offering the investment (commonly referred to as the "promoter") in the future success of the investment. The continuous efforts of promoters are the key to profit. Instead, the Court has focused on factual information available to different groups of buyers. The court concluded that because the institutional buyers knew they were buying XRP from Ripple and were presented with marketing materials from Ripple, they expected Ripple's efforts to impact the value of XRP. In contrast, the court concluded that the software buyers' alleged relative ignorance of Ripple's role in the development, marketing, and distribution of XRP meant that these buyers could not reasonably have expected Ripple's activities to impact XRP.
As regards the other distributions, the court concluded that these transfers did not have the necessary "cash contributions" to meet Howey's criterion. The decision is contrary to the SEC's longstanding position that almost any interest held by an issuer has value and can be considered an investment.
What does this mean for the industry?
The crypto industry has long advocated a more transactional approach to Howie. By delimiting groups of XRP buyers, Ripple’s solution provides one of them.
The industry's goal in this regard, among other things, is to exclude secondary market transactions from the jurisdiction of the SEC. This question exists for many market intermediaries, especially cryptocurrency exchanges, whose subjection to SEC jurisdiction depends on whether they are engaged in securities trading, brokerage, clearing, or exchange management.
This is where Ripple’s solution once again benefits the industry. By ruling that knowledge of a promoter's private life is the key to profiting from the efforts of others, the courts are coming close to preventing such secondary market transactions and even (in the case of programmatic sales) anonymous direct sales. Sold by promoters like Ripple.
Likewise, if the court's official interpretation of the money investment aspect of Howie appears to open the door to greater use of digital assets for employee pay, developer grants, and promotional gifts (such as airdrops, a popular and controversial cryptocurrency distribution device). ). -sign).
How can an appeal make things worse?
Before the crypto industry erupts too much for champagne, it should be noted that Ripple's decision is not retroactive and is not necessarily the last word on the matter. The Securities and Exchange Commission is expected to exercise its right of appeal.
In addition to its novelty, the court's focus on some XRP buyers' access to information about Ripple leads to a perverse result. Selling XRP to more experienced financiers, who, due to the private nature of the transaction, were aware of most of the information about how Ripple's activities could affect the value of XRP, is a matter of financier protection security and established restrictions. Offering and selling XRP to retail financiers who deal with Ripple through exchanges and otherwise in anonymous transactions does not constitute a guarantee under the securities laws and does not require disclosure or similar protections to financiers. Those with more information already deserve more, and those with less information are excluded.
The court's decision on "other arguments" looks just as shaky. In addition to the precedent emphasizing that the "sale" of securities does not necessarily involve the transfer of tangible assets, this interpretation seems to open loopholes in the way for various non-traditional types of financing. In fact, it is difficult to even agree with the established concept of “equality at work”.
If the Court of Appeals for the Second Circuit overturns one or both of the industry-friendly elements of the Ripple decision, the SEC will finally be armed with the case law that Howey applies to cryptocurrencies — an important weapon in the fight against cryptocurrencies. Exchanges between Coinbase and Binance if their listed tokens are securities.
Long term effects and benefits
Even if important parts of Ripple’s decision are overturned on appeal, one aspect of the case will benefit the cryptocurrency industry in the long run. The court was almost right in focusing Howe's analysis on the deals in question rather than the underlying assets. Courts have sometimes overlooked this subtle distinction in the past, perhaps because other parts of the Securities Act's definition of "security" refer to financial instruments such as stocks and bonds. But Howie deals with investment contracts, so his test focuses on the actions and expectations of the parties, based on the facts and circumstances associated with the relevant transaction.
While court-established differences between groups of buyers in access to information are unlikely to persist after appeal as important for the purposes of the Howey test, other differences between buyers may one day become relevant. Of course, courts can distinguish between groups of buyers over time. As decentralized token projects evolve, it is safe to assume that the expected impact of promoter efforts on profitability will change. This effort may be profitable for the original group of buyers, but not for later groups when control of the project is fully decentralized. Similarly, the purpose of buying a cryptocurrency may change as such projects mature. A savvy early buyer may be attracted by financial returns (return on investment), while a late buyer's primary goal may be to use a particular network or protocol (utility token).
If future courts take into account these differences between the buyers, the defendants may bring various details of the transaction to the attention of the Ripple Court.
Peter Fox and Peter Skulis are partners with Schoolies, Peters, Russotti & Fox LLP. Damien Scott is an associate at Schoolies, Peters, Russotti & Fox LLP.
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