SEC Crypto lawsuits enter dangerous legal territory

The US Supreme Court issued the landmark ruling SEC V. Howey decision in 1946, with a specific definition of what constitutes a security. These judges could not have guessed how complex digital commerce over encrypted lines of computer code would fit in nearly a century later.

The Securities and Exchange Commission under Chairman Gary Gensler has its own idea of ​​how cryptocurrencies should be regulated today, but bears little resemblance to that decision — and it’s straying into dangerous legal territory in court.

The Howey case involved orange groves sold by a resort in Florida to tourists in a scheme where the investors earned passive income from the resort’s management and commercialization of the oranges. The so-called Howey test states that a transaction is a security if it is an investment of money, in a joint enterprise, with a reasonable expectation of profit from the efforts of others. All three prongs of the test must be met.

Hundreds of federal cases that followed found unregistered securities in the packaging and sale of whiskey, condos, chinchillas, oil and gas, and beavers. A scheme to sell any asset, including cryptocurrencies, can easily fit this test. All modern securities law is built on it.

Ripple and XRP

But this is not what the SEC has argued for two years in the largest unregistered securities enforcement action to date against a crypto company. The case was brought against US software company Ripple Labs, which sells a digital payment solution for banks, and includes cryptocurrency XRP as a bridge asset to settle cross-border payments in seconds for almost no cost.

Since 2013, the company has also sold billions of XRP tokens it holds to various crypto exchanges that resold them on the secondary markets to millions of retail holders.

Over the past decade, the XRP ledger grew as a decentralized permissionless distributed ledger with a variety of uses by other companies and individuals. The XRP token eventually rose to have the third highest market cap of any cryptocurrency in the world.

I’m an XRP holder and trial attorney, so I read the SEC’s complaint as soon as I heard about it. I expected to see the SEC point to an arrangement with specific early sales of Ripple of XRP, which met Howey test. That would make sense. But I was shocked to read that the SEC argued that all sales of XRP have always been and always will be securities, because the “very nature” of the digital asset is to be a security and nothing else. The token itself is the “embodiment” of an investment contract in Ripple, they claim, even in the secondary markets without the involvement of the company, including mine.

This goes beyond anything the Securities Act of 1933 and over 250 federal appellate and Supreme Court decisions on securities laws have ever imagined. The SEC’s argument corresponds to the oranges in Howey be the “embodiment” of the scheme of selling the groves. If so, how does a corner grocer register an orange with the SEC?

All US exchanges immediately suspended XRP trading for fear of SEC retaliation, locking the tokens to innocent retail holders as their value dropped by $15 billion. The damage done to these holders that the SEC claimed to defend was staggering.

I organized a class of over 75,000 retail XRP holders and obtained amicus curiae status in the case. Our reasons are quite logical. The vast majority confirm that they had never heard of Ripple Labs when they acquired the token for their own purposes.

Those lines of computer code they obtained could not be an investment contract or a joint venture with a company they had never heard of, and nothing in the law – before or after Howey– Supports that idea.

Judge Analisa Torres of the Southern District of New York is taking her time with a decision in the Ripple case because she needs to understand the stakes, especially on appeal. The questions to be decided go to the basis of modern securities law, and which assets can and cannot be included in it. Torres also knows that the current US Supreme Court has struck down regulators who exceed the powers Congress specifically gave them.

Similar Suits Follow

Other crypto companies from Coinbase to LBRY began facing similar SEC lawsuits. Gensler’s public statements on crypto became sharper. The larger goals became clear. He inherited the Ripple case from his predecessor, but he has made its legal theory the centerpiece of an expansion of regulatory power in court, not through regulation or legislation. It has drawn the ire of the Congress.

I am all for clear rules and regulations to protect people. But the SEC is taking advantage of legal uncertainty about crypto to radically redefine what constitutes an investment contract and a joint venture in the United States. The legal and financial consequences could be enormous, and it will only hurt people.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author information

John Deaton is an American attorney serving as amicus counsel for retail digital asset holders in a number of high-profile federal SEC enforcement cases on crypto, notably SEC v. Ripple (SDNY) and SEC v. LBRY (DNH).

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