The US Securities and Exchange Commission has shown continued commitment to regulating digital assets through enforcement actions.
While the SEC’s actions and public statements consistently take the position that the application of securities laws to digital assets is clear, the agency’s “regulation by enforcement”1 the approach has led to many calling for cooperation with industry and regulations, which will provide far greater security.
In this context, recent developments in the SEC v. Ripple Labs case show that the question of whether a particular digital asset should be considered a security remains consistent and contentious.
On September 17, both the SEC and Ripple Labs Inc., with its executive chairman and CEO, filed motions for summary judgment in the SEC’s US District Court for the Southern District of New York in a lawsuit alleging that Ripple Labs sold billions of units of a virtual currency, XRP, which the SEC believes should be considered a digital security.2
According to the SEC’s complaint, the sale of XRP constituted an unregistered sale of securities in violation of the registration and disclosure requirements of federal securities laws.3
Ripple is a private financial technology company founded in 2012 with a particular focus on facilitating cross-border payments. Their products generally rely on the open-source blockchain created by Ripple, called the XRP Ledger, and the associated XRP-native virtual currency.
When the XRP Ledger was created in 2012, a fixed supply of 100 billion units of XRP was created, of which 20% was retained by the founders and the remaining 80% was given to Ripple.4Over the years, the defendants have sold and distributed some XRP currency, transactions that are being challenged by the SEC as unregistered securities sales.5
SEC’s position
The question of whether XRP is a security and therefore subject to the requirements of the federal securities laws is an important issue for the digital asset industry, which has repeatedly requested clear guidance from the SEC on the application of securities laws to these new assets and technologies.6
SEC Chairman Gary Gensler has been aggressive in claiming jurisdiction over digital assets,7 while publicly questioning the digital asset industry’s demands for greater guidance, claiming the agency has “spoken with a pretty clear voice.”8
In its case against Ripple, the SEC argues that XRP should be considered a digital security because it qualifies as an investment contract under the traditional securities test set forth in the US Supreme Court’s 1946 decision in SEC v. Howey Co.: “an instrument in which a person invests money in a joint venture and reasonably expects profits or returns from the entrepreneurial or managerial efforts of others.”9
Specifically, the SEC argues that “economic reality” indicates that “a purchase of XRP is an investment in a joint venture with other XRP holders and with Ripple.”10 The SEC also points to several public representations in which Ripple “publicly linked the potential for profit to its promised entrepreneurial and leadership efforts.”11
The complaint’s arguments are consistent with the position the SEC has taken in other recent enforcement actions involving cryptocurrency assets, including the July 21 insider trading charge against a former Coinbase Global Inc. chief exchange officer, SEC v. Wahi.12
In both Ripple and Wahi, the SEC relied on its broad interpretation of the term “investment contract” under Howey to assert authority over transactions involving digital assets. Its Ripple arguments are also consistent with recent public statements in which the SEC has stated that the securities laws, and which digital assets those laws govern, are sufficiently clear that further guidance is unnecessary.1. 3
In particular, Gensler’s view is that “nothing about the crypto market is inconsistent with securities laws,” concluding that “most crypto tokens are investment contracts under the Howey test,” and thus subject to securities laws and SEC jurisdiction.14
He warned companies that act as intermediaries in digital asset transactions that they should “come in, talk to us and register.”15
Ripple’s response
Ripple pushed back in its own summary judgment, arguing that distributions of XRP lack the “essential ingredients” to be considered investment contracts under the Howey test.16
First, Ripple noted that in many of the transactions covered by the complaint, there was no actual contract between a promoter and an investor — such as donations and giveaways.17
Second, Ripple argued that when contracts were present, they did not establish any post-sale obligations for Ripple or rights for the buyer of XRP to share in the profits from the company’s efforts.18
Third, Ripple pointed to the absence of a “joint enterprise” in which those who buy XRP invest,” arguing that the “XRP ecosystem,” which consists of multiple third parties that interact with the XRP Ledger or its own XRP currency, cannot be characterized .as a joint venture under Howey.19
Essentially, Ripple argues that sales of XRP only represent sales of assets, not securities, and that the SEC’s theory represents an “open assertion of jurisdiction over any transfer of an asset (for consideration or not) that the SEC believes may benefit from registration- and the disclosure requirements in the Securities Act.”20
As such, Ripple argues that the SEC’s position, at least if taken literally and applied consistently, would convert sales of ordinary assets — such as gold and soybeans — into securities transactions.21
Look forward to
These concerns about the potential consequences of the SEC’s aggressive reading of the securities laws have also been expressed by other regulators, particularly by one of the SEC’s primary competing regulators in the digital asset space – the Commodity Futures Trading Commission.
In a public statement published the same day the Wahi indictment and complaint were filed, CFTC Commissioner Caroline Pham noted that the SEC’s decision to pursue the former Coinbase CEO’s actions as securities fraud “may have broad implications beyond this single case, and underscores how critical and it is urgent that regulators work together” and “[engage] the public to develop appropriate policies with expert input.”22
These calls for cooperation were joined by SEC Commissioner Hester Peirce,23 which has suggested that the SEC “needs[s] to commit to working with … companies to create sensible, timely and achievable regulatory pathways.”24
Gensler has at least implicitly decided to take a different path, given that these demands for greater cooperation and regulatory certainty have not resulted in a more nuanced regulatory approach to date.
We may also gain some insight into the SEC’s internal deliberations on this topic, given that the SEC was recently ordered to disclose emails written by a former SEC director in the Division of Corporation Finance as part of an ongoing dispute over the scope of the Ripple discovery case.25
Despite the SEC’s continued aggressive positioning in asserting its authority over digital assets, the Ripple defendants raise significant questions about the wisdom of applying a 1946 Orange Grove case to a class of assets developed only in the last 10 years, particularly as the term “digital assets” encompasses a wide range of assets with varying characteristics and properties.
While the SEC has historically favored flexibility in at least some contexts in the application of the securities laws—for example, in the insider trading context—the regulation of digital assets appears to be a place where security will help all parties inform decisions and move an innovative industry forward on a more orderly way.26
While it won’t replace a robust regulatory framework, perhaps a decision on Ripple’s summary judgment will shed some light on how digital assets will be treated going forward. However, that will not end the debate over whether the SEC’s approach to digital asset regulation is appropriate.
Footnotes
1. Statement of Commissioner Caroline D. Pham on SEC v. Wahi, CFTC (July 21, 2022).
2. Complaint at 1-2, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
3. Id.
4. Defendants’ Court Agreement in Support of Their Motion for Summary Judgment at 1, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
5. Complaint at 1-2, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
6. Coinbase, Petition for Rule Making—Digital Asset Securities Regulation, (July 21, 2022).
7. Chairman Gary Gensler, Kennedy and Crypto, SEC (September 8, 2022).
8. Id.
9. Complaint at 6-7, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
10. Plaintiff’s Memorandum of Law in Support of its Motion for Summary Judgment at 2, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
11. Id.
12. SEC Charges Former Coinbase Manager, Two Others in Crypto Asset Insider Action, SEC (July 21, 2022).
13. Chairman Gary Gensler, Kennedy and Crypto, SEC (September 8, 2022).
14. Id.
15. Id.
16. Defendants’ Memorandum of Law in Support of Their Motion for Summary Judgment at 1-2, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
17. Id. at 2
18. Id.
19. Id. 3 ‘o clock.
20. Id.
21. Id.
22. Statement of Commissioner Caroline D. Pham on SEC v. Wahi, CFTC (July 21, 2022).
23. Caroline D. Pham and Hester M. Peirce, Making Progress on Decentralized Regulation — It’s Time to Talk About Crypto Together, The Hill (May 26, 2022).
24. Commissioner Hester M. Peirce, Statement of Settlement with BlockFi Lending LLC, SEC (Feb. 14, 2022).
25. Order Overruling SEC’s Objections, Sept. 29, 2022, SEC v. Ripple Labs, 20-cv-10832 (SDNY Dec. 22, 2020).
26. Coinbase, Petition for Rule Making—Digital Asset Securities Regulation, (July 21, 2022).
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