Crypto law experts suggest the SEC is likely to lose the key case and discredit the Howey test

As the cryptocurrency trial of the century draws to a close in a Manhattan federal court, signs are mounting that the US Securities and Exchange Commission (SEC) is facing a crushing defeat against San Francisco-based blockchain innovator Ripple Labs. The ruling could drastically limit the SEC’s authority to regulate crypto in the United States. If it ends up like this, it will have been a self-inflicted disaster from the start.

The SEC filed its bombshell lawsuit against Ripple and its two top executives in December 2020, the last day in office of ex-chairman Jay Clayton. The Republican joined the two Democratic commissioners in arguing that the cryptocurrency XRP is an unregistered security because its only use since 2013 has been as an investment contract in a company that uses it for its payment software.

The breadth of the allegations was sweeping as the lawsuit’s legal theory exceeded. Almost two years later, the SEC is facing a painful bill because Ripple decided to fight back, as did tens of thousands of retail users of XRP who have no connection to Ripple other than being co-victims of the government’s behavior.

The SEC realized early in the trial that it had lost its way in a maze of its own making. The amazing defense team for Ripple went for the throat, calling out the bizarre SEC premise that XRP had been an unregistered investment contract in Ripple since 2013, and that even selling billions of XRP tokens on the secondary market for seven years were also securities . Ripple didn’t have to look too hard to document how the SEC had repeatedly balked at market participants for years on whether XRP was a security. Yet it now claimed that Ripple and everyone else in the market should have known anyway.

Ripple also focused on a market-moving speech in 2018 by Clayton’s Director of Corporation Finance, William Hinman, who laid out a vision of how XRP’s main rival in the crypto markets – Ethereum’s original cryptocurrency ether – was not a security because the ledger had “decentralized” over time . The internal SEC emails and drafts behind that speech became central to Ripple’s rebuttal, and the SEC spent 18 months fighting six separate bench orders to hand them over, making it increasingly clear that their real behind-the-scenes confusion over tokens would would be humiliating if it ever became public.

Ripple finally obtained the Hinman speech documents last month, CEO (and co-defendant) Brad Garlinghouse tweeted that the SEC “wants you to believe it cares about disclosure, transparency and clarity. Don’t believe them. When the truth finally comes out, the shame in their behavior here shock you.”

Now that the parties have reached the end of an exhaustive discovery phase with dueling motions for summary judgment, Ripple fired off a solid set of arguments while the SEC’s proposal was just a heated version of the original complaint. Some legal observers noted that the agency failed to prove its case. Its own expert said that XRP’s market value was not tied to Ripple’s performance, and that it found no way after two years to demonstrate how tens of thousands of retail users and traders of XRP knew the token was an investment in a company most of them had never heard of.

This is where things really went south for the government. Retail XRP holders launched themselves into the cause by the tens of thousands. Led by Rhode Island attorney John Deaton, they first tried to intervene against the SEC by asking the judge to make them defendants along with Ripple. The SEC responded with a ferocious effort to vilify Deaton personally and portray his clients as unworthy antics.

Instead of turning her nose up at the XRP holders without comment, Judge Analisa Torres rejected their motion to intervene, saying she had spent time digging into legal precedent to see if it was even possible for a party to make himself a defendant in a case, and came up empty. But she offered them the chance to file amicus briefs instead, sending a blunt signal to the SEC that real investors were going to have her ear when its assumptions about their motivations would be considered. In retrospect, with all that has happened since, anyone with a political instinct close to Gensler should have convinced him to take the plunge then and there.

Deaton’s putative class of XRP holders has swelled to more than 75,000, among whom more than 3,000 have provided affidavits to Ripple’s defense team saying they had never heard of the company they allegedly invested in before the SEC filed the suit. Those statements were entered into evidence with Ripple’s motion for summary judgment, which was a brutal takedown of a federal agency in violation of its own mission to protect retail investors, appealing to authority granted in 1946 Howey decision by the Supreme Court to claim that anonymous lines of computer code are investment contracts in a company.

Behind Deaton were other XRP users unrelated to Ripple who have filed amicus briefs, as well as the two most prominent crypto industry associations, the Digital Chamber of Commerce and the Blockchain Association. The SEC has had no allies, not even its own expert witnesses who ended up providing ammunition to the defense. Attorney Jeremy Hogan, who has followed the case on his popular YouTube channel, says the SEC can only prevail with its summary judgment if Judge Torres “forgets his first year of law school.”

Prominent legal experts such as Curt Levey of the Federalist Society and Professor JW Verret of George Mason University’s Scalia School of Law agree that Ripple is on track to win this case. Worse for the SEC Verret predicts that if the SEC appeals to the Supreme Court, it is likely not only to lose, but to set a sweeping precedent that would limit or completely eliminate the application of Howey on cryptocurrencies, which defy the 1946 definitions.

So why is Gensler still letting his enforcement department drive this bus off a cliff? They are legal cases, but Gensler is ultimately a political figure. Politicians, Deaton said recently in an interview, are about somehow turning a loss into a victory and moving on. Ripple’s general counsel, Stuart Alderoty, has made it clear that they will settle “in minutes” and pay a fine if the SEC makes it clear that today’s XRP is not a security. Having used his political capital, Gensler should take the deal.