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On Friday the Blockchain Association filed an amicus brief in the SEC v. Ripple lawsuit. The Association’s lawyers joined other friends of the court petitioners like John Deaton in arguing that “downstream purchasers” of cryptocurrency coins and tokens are not necessarily investing in securities or involved in an investment contract.
…even if an initial token issuance qualified as an investment contract… the SEC seems to believe that that token remains a “security” through further, downstream transactions, no matter what rights the initial purchaser kept for themselves… why the downstream user purchases that token… or how that token is used.
BRIEF OF AMICUS CURIAE THE BLOCKCHAIN ASSOCIATION, theblockchainassociation.org, 10/28/22
So interestingly, these petitioners are not arguing against SEC allegations that Ripple initially sold XRP (XRP-USD) as an unregistered security. Rather, they argue there is an obvious limit to the application of current securities regulations to digital assets and a limit to using the Howey test on coins and tokens because by their nature they do not easily fit the now outmoded regulatory regime instituted in 1946.
The Blockchain Association explained the specific problem simply but somewhat unorthodoxly in the following excerpt from the brief:
…SEC Chair Gary Gensler has recently stated that the “vast majority” of tokens are – not were, but are – securities.
BRIEF OF AMICUS CURIAE [emphasis is original] (link above)
The brief forwarded a number of points making this “were” versus “are” contrast. And the article below weighs a few of the included ideas and how the Court’s decision may support XRP and the broader crypto sector though regulatory clarity. A finding that XRP is not currently a security would likely have broad positive ramifications on the current crypto legislation process, general institutional adoption and pricing of the similarly situated large-cap altcoins.
Tokens Function Beyond Being Investment Contracts
Many holders look to gain from the appreciation of their coins and rely on the efforts of those issuing the coin to further these profits. But there is now substantial, meaningful and quickly growing evidence cryptocurrencies function well beyond just a means of speculation. Examples of some uses are complied below and appear as quoted in the Blockchain Association’s amicus brief.
- Some people use tokens as a currency or a payment method.
- Some tokens are used in a particular implementation in a blockchain-based infrastructure.
- Some tokens allow users to participate in community governance…
- Other tokens allow users to collectively own some asset like a domain name.
- Some tokens represent digital embodiments of art, music, videos, or other media, and can convey intellectual property rights…
As a matter of fact and practicality, continuing to treat digital assets as securities each time they are transferred would impair their ability to function in the ways listed above. Because of this fact, the Blockchain Association brief suggested the following:
The Association respectfully submits that even if this Court holds that the original issuance of XRP was a security, the Court should refrain from deciding that secondary sales are investment contracts, or that XRP itself is, today, a security.
BRIEF OF AMICUS CURIAE (link above)
Howey Test Problems
In the case of SEC v. Howey, the Supreme Court stated “an investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
However beyond first blush, this Howey test becomes somewhat problematic when applied to cryptos:
1. With crypto projects there is often no investment of money to receive initial tokens. For instance, projects gain participants to their platform though giveaways of tokens for using the system or tokens are partially distributed freely or to charity.
The Supreme Court’s language in Howey should be taken literally: an investment contract requires an actual investment of tangible consideration. Intangibles cannot suffice, because such concepts could include literally anything.
BRIEF OF AMICUS CURIAE (link above)
2. As discussed in the first section, many token holders do not expect profits and increasingly use or consume their coins or tokens. And the brief cites and comments on United Housing Foundation v. Forman from 1975:
By contrast, when a purchaser is motivated by a desire to use or consume the item purchased … the securities laws do not apply… [Forman]
Accordingly, even if the Court finds that some participants purchased XRP with an expectation of profit, the Association respectfully requests that the Court is careful to not conclude that by necessity, all purchasers in the market for XRP had some expectation of profit.
BRIEF OF AMICUS CURIAE (link above)
When looking at the Howey test, a lot of prior arguments by crypto proponents had focused on the decentralized nature of crypto platforms and their development. These arguments rightly pointed to the often harder to identify “promoter” or “third party” required in the test. And the arguments above add to these issues for the SEC position, especially by weakening the expectation of profits prong of the test relative to downstream purchasers of the assets.
Fair Notice Defense
Due process includes a fair notice that an act is criminal prior to the offense. And the SEC has compellingly argued that a crypto sector participant of “ordinary intelligence” is aware the selling of digital assets to raise capital implicates federal security laws. The Commission has pointed to the longstanding Howey test along with enforcement actions and public statements as providing the necessary guidance and notice. Importantly, a security exists if there is an investment of money, in a common enterprise, where profits are expected, from the efforts of the enterprise’s promoter.
However, as detailed by the Blockchain Association, beyond the seemingly straightforward Howey test, in application the SEC regulations are less clear. And some SEC Commissioners have agreed that confusion persists. The link just below to the SEC statement concerning Coinschedule is a short must read on this topic for those following the crypto regulation process.
There is a decided lack of clarity for market participants around the application of the securities laws to digital assets and their trading, as is evidenced by the requests each of us receives for clarity and the consistent outreach to the Commission staff for no-action and other relief.
In the Matter of Coinschedule, sec.gov, 7/14/21
SEC Commissioners have also weighed in on the “were” versus “are” debate, though not in a dispositive, fair notice manner. The following quote about Ethereum (ETH-USD) is from the now famous Hinman speech (note the funny title).
And putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions.
Digital Asset Transactions: When Howey Met Gary (Plastic), sec.gov, 6/14/2018
Further, the Blockchain Association argues that the SEC can’t just ask platforms to simply register as securities. This is because the “security” moniker opens a Pandora’s box related to “buying, selling, brokering, dealing, custodying, trading, and exchanging” where existing regulations are not geared toward how crypto sector participants actually use their coins and tokens. In the quote below, the Blockchain Association argues that fair notice requires regulations that are “sensible in the context of a software token”.
This Court should lay down a marker: before the SEC brings enforcement actions against blockchain industry participants for failing to abide by securities laws and regulations, those laws and regulations must be clear, understandable, and sensible in the context of a software token that has a fundamentally different technological nature than a traditional security.
BRIEF OF AMICUS CURIAE (link above)
Watershed Moment For XRP and Crypto Sector
A Forbes article titled “Crypto Law Experts Suggest SEC Likely To Lose Key Case And Discredit Howey Test” demonstrates that lawyers outside the crypto industry tend to agree with the points made in the Blockchain Association’s amicus brief. And if accepted by the Court, the arguments above provide a regulatory cutout from the securities definition for XRP, similarly situated coins and tokens and the digital asset marketplaces that trade them.
One outcome could be that Ripple, which has directly stated a willingness to settle, pays a relatively large fine; but Ripple would require an agreement or ruling that XRP is not a security. This outcome would likely allow XRP to be relisted on digital asset marketplaces like Coinbase (COIN). For this reason, a constructive resolution of the lawsuit may not be a sell the news type event, as new demand channels could come online shortly after the resolution.
So now a main question is the timing. Purportedly final briefs are due by the end of the year. However it does appear the SEC may again adopt delaying tactics and has indicated a need for more time and more “pages” to respond to the friend of the court briefs beings proffered. Note that this week Coinbase also officially proposed an amicus brief which it has prepared and provided to the Court. As an aside, the outcome of the case has direct bearing on Coinbase’s business and their larger proposal for a new regulatory regime specifically designed for digital assets.
In any case, the years long battle is coming to a close. Both sides have filed and responded to briefs asking for summary judgment in their favor. Considering the timing opinions from the media and Ripple representatives, the lawsuit resolution likely comes in the first quarter of next year. This makes the coming months a prime accumulation period for XRP from a fundamental standpoint. I am giving an initial buy rating on XRP based on the litigation upside.
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