On July 13th, 2023, the cryptocurrency community celebrated Ripple’s partial victory in their legal dispute with the U.S. Securities and Exchange Commission (SEC) regarding the sale of Ripple’s XRP tokens.
The reason was, the U.S. District Court of the Southern District of New York issued its findings in a partial grant order for a motion of summary judgment, that the sale of Ripple’s XRP tokens on exchanges and through algorithms was not deemed as investment contracts, while institutional sale of the tokens did violate federal securities laws.
So, you might be wondering why this news was so widely celebrated, and why Ripple was sued by the SEC in the first place.
There are multiple answers to these questions, but we can confidently state that it all comes down to whether or not cryptocurrencies are securities.
So, what are securities?
The Howey Test
The journey to answer the question made its way up to the United States Supreme Court through SEC v. W.J. Howey Co (1946), where the test that defines securities, the Howey Test was created.
It all started with a citrus grove where W.J. Howey sold investors parcels of land with a service contract to lease back the land to Howey’s company to manage the cultivation and harvesting of oranges on their behalf. Investors did not have to tend to the groves themselves, instead, relied on Howey’s company’s expertise and labor to generate profits.
The SEC contended that the sale of the land parcels and service contracts amounted to an unregistered offering of securities. However, Howey disputed this claim, stating that they were simply engaged in the sale of real estate and, as such, should not be subject to securities regulations.
The Supreme Court ultimately sided with the SEC, stating that the combined sale of the land and service contracts constituted an investment contract, thereby qualifying as a security.
The Howey Test consists of three elements:
- Investment of Money: the transaction must involve an investment of money.
- Common Enterprise: the investment must be part of a common enterprise, wherein the investors’ fortunes become intertwined with the efforts of the promoter or a third party.
- The expectation of Profits from the Efforts of Others: the investors’ anticipation of profits must primarily result from the endeavors of a third party, like the promoter or enterprise management. In essence, the investors depend on the expertise or actions of others to yield returns.
If a transaction or investment scheme checks all three aspects of the Howey Test, it is likely to be classified as an investment contract and consequently deemed a security that needs to be regulated by the SEC.
Howey Test for Cryptocurrencies
In 2019, referencing the Howey Test, the SEC published its “Framework for ‘Investment Contract’ Analysis of Digital Assets” which outlines what the SEC takes into account when evaluating whether a digital asset (including cryptocurrencies) qualifies as an investment contract and, consequently, a security.
Some of these factors include:
- Is there an investment of money?
- Are there expectations of generating profits?
- Is the investment part of a common enterprise?
- Do the profits come from the efforts of others?
We can see how the underlying criterion is taken from the Howey Test, and it was revealed on July 31st, 2023 that before the SEC sued Coinbase for allegedly listing unregistered securities, the SEC told Coinbase CEO Brian Armstrong to delist every asset except Bitcoin.
“They came back to us, and they said . . . we believe every asset other than bitcoin is a security,” Armstrong said. “And, we said, well how are you coming to that conclusion, because that’s not our interpretation of the law. And they said, we’re not going to explain it to you, you need to delist every asset other than Bitcoin.”
As we can see with Ripple and Coinbase, when a cryptocurrency is deemed a security in the United States it has significant implications for both the issuing entity and investors:
- Regulatory Compliance: If a cryptocurrency is deemed a security, the issuing entity must comply with applicable securities regulations, including registration with the SEC and adherence to disclosure requirements. Failure to comply with these regulations can lead to legal consequences for the issuer.
- Investor Protection: If a cryptocurrency is considered a security, investors are entitled to certain legal protections provided by securities laws, such as the right to accurate and complete information about the investment and the issuer’s activities.
- Securities Exchange Act of 1934: If a cryptocurrency is classified as a security, it could potentially be subject to the Securities Exchange Act of 1934, which covers securities trading, exchanges, and other related activities.
The SEC is strong in their stance that the majority of digital assets are considered securities, and issuers need to undergo extensive registration procedures before making them accessible to the public. Also, exchanges would be required to register as broker-dealers before listing such assets.
On the opposite end, the cryptocurrency industry argues that applying laws created in an analog era to an asset class born in the digital era creates ambiguity and challenges.
This is why the cryptocurrency industry and SEC are going head-to-head with each other over this definition.
In Conclusion
We need to remember that regulations and legal interpretations regarding cryptocurrencies are constantly changing due to new laws, court rulings, regulatory guidelines, and more.
Nonetheless, Ripple’s recent partial victory is certainly moving the conversation forward. While, Coinbase’s revelation regarding the SEC’s recommendation to delist all cryptocurrencies except Bitcoin, lets us know how sensitive this topic is for regulators and the overall cryptocurrency industry.
It is an extraordinary time. We are experiencing the birth of a paradigm-shifting technology and how its creation and applications affect not only the technology sector but financial regulation as a whole. I believe these are necessary growing pains that will help cryptocurrencies and other blockchain use cases to be more anti-fragile and widely adopted in the future.
So what do you think? Are there any cryptocurrencies that you believe are not cryptocurrencies?
Let me know your thoughts. Thanks!
