Should a 77-Year-Old Definition Be Used to Regulate Digital Assets?

December 12, 2023

Insights, Securities Law

SEC Chair Gary Gensler testified before the House Financial Services Committee on Tuesday and was unexpectedly tight-lipped about whether XRP, a digital currency, is a security. In response to Committee Chairman Warren Davidson’s question, Gensler said that the question of whether XRP is a security is currently “in court, and [there are] active discussions and litigation on that matter.”

For the woefully unaware, the Securities and Exchange Commission filed an enforcement action against Ripple Labs, Inc., its CEO, Christian Larsen and its COO, Bradley Garlinghouse, for selling over $1.3 billion dollars’ worth of a digital asset security called “XRP” without registering said sale. The SEC filed its action against XRP in December of 2020, on the last day of former Chair Jay Clayton’s tenure with the SEC.

At issue in the case is whether XRP is a security. If it is, then Ripple’s unregistered offer and sale of XRP violated Sections 5(a) and 5(c) of the Securities Act of 1933 (“Securities Act”).  If, as Ripple claims, XRP is not a security but is instead a digital currency, the SEC lacks authority to question Ripple’s sale of XRP and the case goes away.

In its Complaint, the SEC alleged that XRP was an investment contract under the Supreme Court’s definition in SEC v. W.J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946), and therefore a security subject to the registration requirements of the federal securities laws. This is what makes Mr. Gensler’s refusal to publicly state that XRP is a security so intriguing. But what is the Howey test?

The Howey Test

The definition of a security under the Securities Act includes a wide range of investment vehicles, including “investment contracts.” 15 U.S.C. § 77b(a)(1). The SEC asserts that Ripple’s offering of XRP tokens constitutes an “investment contract” under the seminal test set forth in Howey. Howey, the owner of citrus groves, offered tracts of his land for sale to the public along with service contracts for the maintenance of the groves. The service contracts stipulated that Howey retained the exclusive right to cultivate the land and that purchasers would share in the profits from the sale of the crops. The Court defined an investment contract as “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 third party…” 328 U.S. at 299. In defining “investment contracts,” the Court found that Howey’s service contracts were unregistered and nonexempt securities under the Securities Act of 1933.

The SEC argues that XRP is a security because its only utility since 2013 has been as an investment contract in Ripple, a company that uses it for its payment software. Ripple, argues the SEC, sold XRP tokens to investors, who assumed they were investing in a joint venture, namely Ripple, and that the price of XRP would increase based on the performance of Ripple. In other words, like the citrus groves in Howey, XRP’s value derives from Ripple’s involvement in helping cultivate the XRP payment system. Ripple counters that XRP derives its profit potential from the valuation of the commodity—not from a single group of people at Ripple. In this way, Ripple has likened XRP to Ether, which former SEC Director of Corporate Finance William Hinman stated was not a security.

All of this begs the question, should we be using the Howey Court’s 77-year-old test to decide this issue? While the Howey Court reasoned that Congress defined “security” broadly enough to include orange groves—or, more accurately, service contracts in orange groves—cryptocurrencies may flout the definitions available in 1946. Regardless of the outcome of the SEC’s case against Ripple, perhaps it is time for Congress to establish clearer guidelines for the proper legal classification of digital assets and cryptocurrencies.

Disgorgement

Until clearer guidelines emerge, the SEC will continue to bring these enforcement actions and cryptocurrency issuers will risk being on the wrong end of a court order disgorging all the money they raised through the sale of the unregistered securities. And, unlike fraud charges, where the SEC must plead and prove that a defendant has acted with scienter, meaning the intent to deceive, manipulate, or defraud, Section 5 is a strict liability provision.

The SEC can therefore charge defendants and obtain disgorgement of the proceeds of the alleged unregistered sale and penalties for Section 5 violations when it would not be possible to do so under fraud charges. Since 2017, the SEC has successfully obtained billions of dollars in disgorgement and penalty orders against non-fraudulent issuers and others involved with them seeking capital for their digital asset projects. The SEC justifies these awards by arguing that because cryptocurrency issuers failed to abide by the Securities Act’s registration requirements, investors were deprived of material information they needed to make informed decisions. But the truth is, these claims are just easier for the agency to bring.

While there are safe harbors and exemptions from registration, the Section 5 landscape is thorny. Hiring a lawyer who understands this landscape and the SEC’s enforcement toolkit is critical when facing an investigation or enforcement action brought by the Commission.

By: Alejandro O. Soto

Alejandro Soto is a former senior official with the SEC and leads Fridman Fels & Soto, PLLC’s Securities Litigation and SEC Enforcement Practice Group.