A lawsuit filed by the U.S. Securities Exchange Commission (“SEC”) against Ripple Labs, Inc. (“Ripple Labs”), creator of the popular cryptocurrency token known as XRP, represents a turning point for the cryptocurrency and wider blockchain-technology industries in their relationship with regulators. As a significant part of the SEC’s cryptocurrency enforcement campaign, the agency’s case against Ripple could have substantial implications for the SEC’s authority over digital assets in general, with important impacts on U.S. blockchain network operations.
Absent clear legislative measures by Congress, the SEC has stepped into the regulatory void as the blockchain industry has roiled with a series of bankruptcies and controversies in recent months. In November, the prominent cryptocurrency exchange FTX filed for bankruptcy after reports suggested liquidity and solvency questions for the firm. Later in the month, crypto lender BlockFi—for which FTX was a substantial creditor—initiated its own bankruptcy proceedings, citing liquidity concerns stemming from the FTX matter. Amidst such crypto asset market mayhem, the SEC recently warned U.S. companies that they may have disclosure obligations regarding the impacts the crypto market downturn has had or may have had on their business.
In SEC v. Ripple, the parties have now completed briefing on summary judgment in the case, which lies at the convergence of cryptocurrency, blockchain technology, and the scope of the SEC’s regulatory authority—namely, whether digital asset tokens, in a variety of market conditions and circumstances, can be considered “investment contracts” subject to federal securities laws. That dry, legalistic question lies at the heart of the SEC’s authority here: If so, such assets arguably fall under the SEC’s regulatory authority; if not, they do not. With closing briefs due before Christmas 2022, a resolution is expected sometime in the first quarter of 2023.
Without a federal law adequately addressing blockchain regulation, regulators and market participants have had to consult the history books to determine when a crypto asset may be a security. In the landmark case SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court devised a test to determine when an investment contract is present in any contract, scheme, or transaction. Under the “Howey Test,” the following characteristics must be present for an investment contract to be evidenced: (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profits (4) derived from the efforts of others. While subsequent case law has refined the Howey Test and its application, the essence remains the same.
Of course, the Ripple matter is not the SEC’s first attempt at regulating blockchain products, and one recent win for the agency—in SEC v. LBRY—could bolster its arguments on summary judgment. Still, the agency’s grasp on the blockchain industry is far from secure, as Congress continues to weigh legislation that could clarify the government’s approach to these products.
The three sections of this article examine these aspects of the Howey–digital asset issue in turn. In the first section of this article, we briefly discuss the facts and outcome of the SEC’s win against LBRY Inc. and how that ruling implicates the same issue in the SEC’s battle against Ripple. From there, we dive into SEC v. Ripple by outlining each side’s arguments with respect to the Howey test. Finally, we discuss the extent the whole issue could be annulled if Congress passes legislation clarifying the regulatory boundaries surrounding cryptocurrency and blockchain technologies, even after a ruling in Ripple.
SEC v. LBRY Inc.: A Potential Roadmap for the SEC
In November, the Howey–digital asset issue received attention in a now-resolved matter—SEC v. LBRY, Inc.
LBRY, Inc. runs a popular “open-source” and “community-driven” digital content marketplace (the “LBRY Network”) that offers a blockchain-based alternative to platforms such as YouTube, Spotify, and Instagram. Part of the LBRY Network’s advertised appeal as an alternative content-creation platform was that content creators are never at risk for demonetization or de-platforming since the LBRY protocol is decentralized. Central to this scheme was the LBRY Credit or “LBC,” which was created as a means to incentivize network transaction validation (also known as “mining”). The token could be spent on the LBRY Network to publish content, tip content creators, purchase paywalled content, or purchase advertisement boosts.
In March 2021, the SEC brought an enforcement action in New Hampshire federal court alleging that LBRY Inc. had sold LBC to U.S. investors to fund LBRY’s business and build its product—a violation of the same federal securities registration requirements at issue in SEC v. Ripple.
LBRY Inc. had two responses. First, it argued that LBC functions as a digital currency that is an essential component of the LBRY Network, which was already fully developed and launched prior to any offer or sale of LBC. Second, LBRY Inc. asserted that the SEC’s attempt to treat LBC as a security violated its right to due process because the SEC did not give LBRY Inc. fair notice that its LBC offerings were subject to the securities laws. To support its positions, LBRY Inc. indicated that the SEC’s prior enforcement actions focused only on digital assets offered in Initial Coin Offerings, or “ICOs,” and never against a fully developed product like the LBRY Network.
On November 7, 2022, Judge Peter Barbadoro of the U.S. District Court for the District of New Hampshire granted the SEC’s motion for summary judgment against LBRY Inc., holding that the company had offered and sold LBC as a security in violation of the registration provisions of the federal securities laws. The judge further noted that LBRY Inc. was in “no position” to claim that it lacked fair notice of the application of those laws, concluding that LBRY did not offer “any persuasive reading of Howey that would cause a reasonable issuer to conclude that only ICOs are subject to the registration requirement.”
The ruling could have important implications for Ripple because it lends theoretical support to the SEC’s position, although the SEC v. LBRY Inc. ruling is limited to a single district court with fact-specific holdings. Consistent with LBRY Inc.’s arguments, the ruling in that case marked a departure for the SEC, as every prior enforcement action had focused on issuers of digital tokens who had conducted ICOs. Like LBC, the XRP tokens at issue in Ripple were not issued through an ICO.
Similarities also exist in the conduct of the LBRY and Ripple Labs executive teams. In a Reddit post, LBRY Inc. had stated that the company “reserved 10% of all LBRY Credits to fund continued development and provide profit for the founders. Since Credits only gain value as the use of the protocol grows, the company has an incentive to continue developing this open-source project.” Judge Barbadoro’s summary judgment decision noted that because LBRY Inc. retained its own tokens, reasonable purchasers could understand that decision as a signal that “[the purchaser] too would profit from holding LBC as a result of LBRY’s assiduous efforts.” Furthermore, “by intertwining LBRY’s financial fate with the commercial success of LBC, LBRY made it obvious to its investors that it would work diligently to develop the [LBRY] Network so that LBC would increase in value.”
Similarly, the SEC has asserted in its action against Ripple Labs that the company’s co-founder and current chair Christian Larsen and CEO Bradley Garlinghouse—both named defendants in the matter—structured and promoted XRP sales to finance the company’s business and “also effected personal unregistered sales of XRP totaling approximately $600 million.”
While the SEC v. LBRY Inc. ruling is limited to a single district court, the SEC’s victory in Ripple may be a harbinger of a looming regulatory crackdown against the broader cryptocurrency industry that would be given the go-ahead if the SEC wins its case versus Ripple Labs. And the implications for market actors can, of course, be dramatic: In a Twitter thread posted weeks after the summary judgment decision, LBRY wrote, “LBRY Inc. will likely be dead in the near future…the company itself has been killed by legal and SEC debts…[although] the LBRY protocol and blockchain will continue.”
Ripple’s Battle with the SEC
Ripple Labs is a software company that dubs itself the “leading provider of crypto-enabled solutions for businesses,” the strategy for which includes use of its own XRP blockchain and native cryptocurrency token under the same name to facilitate cross-border payments, cryptocurrency liquidity, and the implementation of central bank digital currencies. Ripple first launched its XRP blockchain and native cryptocurrency token in June 2012. At one point, XRP was the third largest cryptocurrency in terms of market capitalization, although since then it has fallen to sixth, at around $17.6 billion as of January 4.
In December 2020, the SEC filed a complaint in the Southern District of New York arguing that Ripple Labs, along with its Chairman and CEO, had violated Sections 5(a) and 5(c) of the Securities Act of 1933 by engaging in the unlawful offer and sale of securities. In September 2022, both sides filed for summary judgment, asking the court to decide whether XRP qualifies as a security and thus needs to be regulated pursuant to the Securities Act.
The SEC’s complaint alleges that, beginning in 2013, Ripple Labs, Larsen, and Garlinghouse raised funds through the sale of XRP in an unregistered securities offering. The agency also alleges that Ripple Labs distributed billions of XRP in exchange for non-cash considerations, like labor and market-making services.
The SEC posits that Ripple Labs’ offering and sale of XRP straightforwardly qualify as an investment contract under the Howey Test. While the SEC deems numerous features of Ripple’s offering significant, the primary features of the agency’s argument are as follows. The SEC argues that the first prong of the Howey Test is met because purchasers obtained XRP through cash and non-cash considerations (and so made an investment of money). The SEC argues that the second prong is met—that the investment is in a common enterprise—because Ripple Labs pooled funds obtained from purchases of XRP to fund and build its operation, which includes financing the development of XRP use cases. As to this factor, the SEC also cites the fact that XRP’s price rises and falls for all investors together equally. In effect, the SEC is attempting to establish the presence of vertical and horizontal commonality, which, in Howey case law, has been a manner to distinguish when a common enterprise is present. Vertical commonality is evinced either strictly by the fortunes of the investor being interwoven with and dependent upon the efforts and success of those seeking the investment or broadly by the success of an investor depending on a promoter’s expertise. Alternatively, horizontal commonality focuses on the relationship between investors in which their funds are pooled into a common enterprise.
In regards to the third and fourth prongs of the Howey Test, wherein investors are led to a reasonable expectation of profits derived from the efforts of others, the SEC contends that Ripple openly touted the token as an investment and took publicly advertised measures to ensure rising demand for XRP. According to the agency, Ripple Labs “gave specific details of the efforts it would undertake to find ‘uses’ for XRP, to attract others to the ‘ecosystem,’ to manage the supply of XRP, to get platforms to list XRP, and to develop uses for the ledger.” Further, the SEC focuses on the fact that XRP lacked a notable use, beyond mere speculative investment, well past its 2013 launch date. Ripple Labs originally announced that XRP would be a “universal digital asset” that would allow banks to transfer money, a promise which never actualized. Yet only five years after XRP’s launch, in 2018, did XRP have a product that permitted its use, Ripple Labs’ own On-Demand Liquidity Product (“ODL”), which targeted “money transmitter” businesses rather than individuals as potential users. Between October 2018 and June 2020, only 15 money transmitters were signed up to use ODL, and ODL transactions never amounted to more than 1.6% of XRP’s quarterly trading volume.
Whereas LBRY Inc. challenged the SEC as to only part of the Howey Test—the matter of whether purchasers were led to a reasonable expectation of profits derived from the efforts of others—the Ripple Defendants challenge the SEC on all four prongs of the Test.
When it comes to the first prong, Ripple Labs, Larsen, and Garlinghouse (“Ripple Defendants”) contend that, in many cases, there was no investment of money because Ripple Labs gave away more than two billion XRP tokens to charities and various grant recipients. Further, the Ripple Defendants argue that the second prong is not met—that there is no common enterprise—because Ripple Labs is not engaged in a profit-seeking business venture of which, according to Howey, must be present for the second prong to be met. The XRP Ledger, the Ripple Defendants point out, is decentralized and thus incapable of being controlled or managed by Ripple Labs. The Ripple Defendants also deny that horizontal and vertical commonality are present along similar lines (in addition to other circumstances), while also maintaining that vertical commonality is insufficient as a criterion for the second prong to be met even if established. The Ripple Defendants’ point regarding the company’s own control or lack thereof over the XRP Ledger dovetails well not only with the second prong but with the third and fourth: The decentralized nature of XRP, Defendants argue, prevents its purchasers from relying on Ripple Labs’ efforts for profit.
However, the Ripple Defendants’ main argument on the third and fourth prongs relies on the fact that Ripple Labs was never under any contractual obligation to promote XRP. In essence, Defendants claim that an investment contract cannot be present if there is no contract at all. Expanding on this point, the Ripple Defendants broadly argue that XRP lacks the “essential ingredients” of an investment contract, as interpreted by the courts since Howey, which the Ripple Defendants argue (1) involve an actual contract, (2) impose post-sale obligations on the promoter, and (3) entitle the purchaser to receive a profit, and that XRP lacks all of these characteristics.
In response, the SEC asserts that Defendants are relying on a “made up” test that ignores federal securities laws:
[T]hese common law contract terms are not required to satisfy Howey’s ‘expectation of profits’ inquiry. This part of the test is about expectations, not about commitments, a point supported by far more than just ‘out-of-circuit cases.’
Could It All Be for Nothing?
In LBRY and the still-pending Ripple case, the SEC is attempting to clarify its authority over blockchain matters. But a federal proposal could eradicate the issue entirely in the near future. In June, Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) introduced the Responsible Financial Innovation Act (“RFIA”) in the Senate, which, among other things, aims to establish a comprehensive regulatory framework for digital assets in order to address the Howey–digital asset issue.
The RFIA introduces a new category of digital assets called “ancillary assets” to the Securities Exchange Act that would encompass “investment contracts.” The new category would be treated as “commodities” under the Commodity Exchange Act (“CEA”), rather than securities, and thus be subject to the regulatory authority of the Commodity Futures Trading Commission, or CFTC. Title III of the RFIA defines an “ancillary asset” as:
an intangible, fungible asset that is offered, sold, or otherwise provided to a person in connection with the purchase and sale of a security through an arrangement or scheme that constitutes an investment contract, as that term is used in section 2(a)(1) of the Securities Act of 1933 (15 U.S.C. 77b(a)(1)).
While unlikely to become law before the congressional session adjourns on January 3, 2023, the RFIA represents a potential yet long-anticipated legislative answer to problems created by regulatory gaps pertaining to the cryptocurrency and broader blockchain technology industries. And the bill—or another like it—could solidify the regulatory landscape in place of the SEC’s ad hoc approach thus far.
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SEC v. Ripple Labs, Inc., et al. 1:20-cv-10832-AT-SN. Plaintiff SEC’s Reply Memorandum of Law in Further Support of its Motion for Summary Judgment. December 2, 2022, available at: https://fingfx.thomsonreuters.com/gfx/legaldocs/myvmoneblvr/SECURITIES%20CRYPTO%20RIPPLE%20sec%20brief.pdf. ↑
SEC v. Ripple Labs, Inc., et al. 1:20-cv-10832-AT-SN. Defendants’ Reply in Support of Motion for Summary Judgment. December 2, 2022, available at: https://fingfx.thomsonreuters.com/gfx/legaldocs/gkvlwgobopb/SECURITIES%20CRYPTO%20RIPPLE%20brief.pdf. See Howey; this claim is a reference to the following (emphasis added): “A common enterprise managed by respondents or third parties with adequate personnel and equipment is therefore essential if the investors are to achieve their paramount aim of a return on their investments. Their respective shares in this enterprise are evidenced by land sales contracts and warranty deeds, which serve as a convenient method of determining the investors’ allocable shares of the profits. The resulting transfer of rights in land is purely incidental. Thus all the elements of a profit-seeking business venture are present here. The investors provide the capital and share in the earnings and profits; the promoters manage, control and operate the enterprise. It follows that the arrangements whereby the investors’ interests are made manifest involve investment contracts, regardless of the legal terminology in which such contracts are clothed.” ↑
SEC v. Ripple, Inc., et al. SEC’s Reply Memorandum in Support of Motion for Summary Judgment, supra note 15. ↑
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§301; Proposed § 41(a)(1)(A). ↑