Our Thanks to Justin Slaughter of Paradigm for joining us on this week's episode of Let's Talk Markets!
Last week, we promised you that we’d take a good hard look at the recent decision from US District Judge Analisa Torres on the case of SEC vs. Ripple.
So, we started looking into it and the truth is, it's a bit perplexing. So we’re just gonna bail. The rest of this article is a ranking of the best Keanu Reeves movies in order of their greatest influence on humanity.
If Bill and Ted’s Excellent Adventure isn’t tops on your list, what are you even doing with your life?
Ok. You twisted our arm. We’ll also talk about the Ripple decision.
But be warned—this court decision is a bit confusing, perhaps because there are so many contradictory interpretations floating around out there. We’ll try to decipher a bit of it here.
We hope the result is just a few breadcrumbs for those of us wondering where the rocky road to crypto regulation (and/or legislation) will ultimately lead.
Everything Is Different, But the Same
So at the heart of the SEC’s legal campaign against crypto writ large—is a key question: are cryptocurrencies securities?
But the question at the heart of the Ripple case is actually something slightly different. The question here really concerns whether or not Ripple’s XRP token qualifies as an “investment contract.”
As we’ll discuss hereafter, this is the threshold that the SEC must clear in order to prove that the XRP token falls under securities law.
That threshold was established in a 1946 Supreme Court ruling concerning an investment in orange groves, and is now commonly known as the Howey Test. The Howey Test, which we’ll explore with just a bit more depth hereafter, is meant to tell us whether a given financial arrangement–for example, the sale of crypto tokens–qualifies as an investment contract.
So did Ripple’s marketing of XRP qualify as an investment contract?
The Torres opinion clearly states that the answer is yes…and also no.
Here’s what Torres basically says…
XRP is the world's first blockchain-based Transformer. An unwatchable Michael Bay movie is already in production.
In the meantime, we’re left to grapple with a very basic question—how does a security become not a security?
Here’s how Judge Torres explained it…
Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, Programmatic Buyers could not reasonably expect the same. Indeed, Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP….
Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract…
It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple
In short, Ripple made it explicitly clear to institutional investors that they were buying directly from the issuer, who had intent to reinvest this capital in the growth of Ripple. Under these terms, Ripple has an obligation to institutional investors to follow through on that stated intent. Therefore, the sale of XRP tokens to institutional investors falls under the purview of securities law
By contrast, because Ripple did not make explicitly clear to retail investors on the secondary market that they were buying XRP tokens directly from an issuer with intent to reinvest in Ripple’s growth, Ripple had no obligation to individual investors. Therefore, the sale of XRP to individual investors does not fall under the purview of securities law.
Hmmmm.
Still feels weird, right?
Fortunately, we have a telephone booth time machine, so we can get some historical perspective on the matter. Let’s go all the way back to 1933.
I Believe Our Adventure Through Time Has Taken a Most Serious Turn
That’s when Congress passed the Securities Act, which gave the SEC authority to govern newly issued securities. Jumping ahead one year, Congress passed the Securities Exchange Act of 1934, which subsequently gave the SEC authority to govern securities sold on the secondary market.
Ok. Everything seems in order here. Let’s jump to 1946. That’s when the Supreme Court weighed in on a now famous case concerning an investment in orange groves. As Ann Lipton explains on the Business Law Prof Blog,
Section 2 of the Securities Act defines a “security” to mean multiple kinds of instruments (stock, notes, voting trust certificates), and then has a catch-all provision that an “investment contract” is a security. But “investment contract” is not a recognized type of instrument and so needed a definition. In 1946, the Supreme Court decided SEC v. Howey Co., 328 U.S. 293 (1946), which laid out the so-called Howey test for whether a new instrument is an investment contract. There must be an investment of money, in a common enterprise (which usually means pooling of investor resources), with the expectation of profit by the investor, derived from the efforts of others (usually, a centralized management team).
It’s important to note that, in spite of the wording here, precedent shows that no formal “contract” must be drafted, that any number of financial arrangements, however traditional or out of the ordinary, may qualify as contracts.
Lipton points out that the vagueness of the so-called Howey Test is intentional, and that it was designed to leave interpretive space so that the Commission could ultimately exercise its regulatory oversight over all manner of unforeseen financial arrangements.
One of the central points of contention in this entire debate is whether or not the Howey test leaves sufficient space to account for something like virtual currency. The SEC believes it does. Much of the crypto industry disagrees.
Former practicing appellate lawyer and clerk to the DC Circuit and the Supreme Courts, Sina Kian offers an extremely thoughtful analysis on Twitter. While affirming the correctness of the Torres decision, Kian argues that “Contrary to the SEC's suggestions, the *legal* questions presented by crypto are novel, bc cryptocurrencies are often not a share of a company, so to be covered by securities laws they must constitute some other form of ‘investment contract.’”
This necessarily invokes the Howey Test.
It may be argued that the Howey Test simply isn’t equipped to answer our questions about crypto regulation in a satisfying way. This may well be the reason that so many observers find this decision confusing.
If you’re waiting for a better instrument, that would require a new SCOTUS precedent or an act of Congress.
It’s not out of the question that the current proceedings even lead toward one or both of these outcomes
But until then…
All We are Is Dust in the Wind, Dude.
…we, the retail investors, that is. Because as Kian explains, Ripple owed us nothing.
Kian points out that “the main question, from a legal perspective, is whether the selling counterparty intends--or holds itself out as--having obligations with regards to the buying person's ‘investment.’”
This–and not the existence of some written formal agreement–is the qualifying condition for being categorized as an “investment contract.”
The Torres decision finds that the sale of XRP on the secondary market did not meet the conditions of the Howey test because Ripple expressed no obligation to individual investors that it would expend effort to increase the value of this investment.
As Matt Levine sarcastically suggests in an article for Bloomberg, perhaps retail investors are simply sentimental about owning encrypted alphanumeric sequences of coding.
I know that I personally treasure the promo code for every Starbucks gift card I've ever received.
But the Torres decision suggests that whether individual investors expected to profit or not is completely immaterial. The actual issue is whether or not Ripple itself had an obligation based on its arrangement with retail buyers to pursue profits on their behalf.
Kian’s analysis points out–and the Torres decision ultimately reflects–that no, Ripple had no such obligation. As Kian points out, the very nature of cryptocurrency suggests that every principal individual involved in Ripple could have walked away from the enterprise with no further obligation to the programmatic retail buyers who snapped up XRP tokens at their own, anonymous volition.
So, from a legal point of view, and using the Howey Test, Kian explains that the Torres decision gets it right.
But it still begs a central philosophical question. Who’s actually looking out for the retail investors here. The Torres decision says that institutional investors—those who actually knew what they were investing in–enjoy certain regulatory protections. Simultaneously, those who, by the court's own assessment—did not know what they were investing in–enjoy no such protections.
It’s like, hey Tiger Woods—here's a 10 stroke handicap. The rest of us will be driving with homemade putters.
This Should Be Most Triumphant
Putting aside investor protections for just a moment, there’s a pretty good chance you noticed a spike in your crypto wallet last week. The day that the District Court rendered its decision, Bitcoin reached its high point for the year to date, topping $31,400.
Clearly, the medium-range outcome of the decision is a thawing of our recent crypto winter. And if you hold the view that the SEC truly aspires to put an end to crypto altogether in the US.—as Matt Levine suggests—this is also a long-term victory for crypto. But hold off on the barbecue blockchain party for just a moment.
It's not actually clear what this means for other crypto exchanges like Coinbase. After all, the decision doesn’t say that all cryptocurrencies aren’t securities.
Not only does the decision hedge both lines—identifying the XRP tokens as investment contracts when sold to institutional investors but not so when sold to individual investors—but it supplies a rationale for the latter condition that actually gives the SEC (or somebody) plenty of room for future enforcement.
To reiterate a point, the reason, according to the District Court, that Ripple tokens should not be viewed as securities when sold to individual investors, is because individual investors—especially during the period prior to 2020—did not necessarily have access to the same sales pitch as the institutional investors did (although even here it’s pretty clear that such material was out there and accessible).
As Bloomberg reports, the decision on XRP tokens fell short of the Howey Test because, according to Torres, “secondary-market buyers were never promised anything by Ripple itself.”
Ok…
For just a moment, let's put aside the fact that secondary market buyers of exchange-traded securities often purchase those securities without having reviewed company filings or even any information from the companies themselves.
If the real reason that the XRP tokens sold on secondary markets were not securities was because Ripple had no obligation to retail investors, this could perhaps pave the way for the SEC to codify some such obligation.
The inevitability may be that crypto tokens will eventually be treated as securities in all contexts. But clearly, the Torres decision leaves room for both sides to claim victory and absorb defeat.
Things are More Moderner Than Before
So it’s hard to say for certain what this means for the regulatory future of crypto. The preliminary decision from Torres is obviously a can of worms that will be opened in a fuller trial soon enough. This will shed further light on the path ahead for both Ripple and the crypto exchanges that will ultimately be the subject of SEC oversight…or not.
Many predict that this whole mess is bumbling its way into the waiting arms of a Congress that has thrown a lot of rhetorical bombs, but has so far avoided actually legislating a regulatory status for cryptocurrencies.
Congressional action is probably the right answer. As we’ve noted, and as Kian seems to suggest, the Howey test is probably not the best way to understand what crypto is or isn’t. Its novel features–most especially its capacity for community stewardship rather than oversight from a traditional executive board–make it a different animal altogether.
More than likely, new legislation is needed if we are to facilitate the kind of regulatory oversight that protects everyday investors from this animal.
Still, it’s not very clear that bipartisan compromise is possible. The head of the House Financial Services Committee Patrick McHenry would push for regulation through the far more industry-friendly Commodity Futures Trading Commission (CFTC), while Members on the other side support the more robust protections sought by the SEC.
We can’t say for certain where this will lead regarding the regulatory status of all future cryptocurrencies. But then, as the great philosopher So-crates Johnson once said, "Like sands of the hourglass, so are the days of our lives.”
So we’ll wait and see, and we'll continue to try to offer insight as these events unfold.
But we should say, we don’t have a dog in this fight. It’s entirely about what's best for the investor. Even if legally correct, we still think the Ripple decision falls unfortunately short of that threshold.
We believe consistency, clarity and transparency are always best for investors. We hope that the coming months bring far more of all three.
In the meantime, be excellent to each other.
Dave Lauer is a co-founder and CEO of Urvin Finance, where he leads the team in building Urvin Terminal. Prior to founding Urvin Finance, Dave spent over a decade advocating for financial market reform after quitting his job as a high-frequency-trader.