SEC v. Ripple: Redefining the Regulation of Crypto Assets

In December 2020, the Securities and Exchange Commission (“SEC”) filed a complaint in the United States District Court for the Southern District of New York against Ripple Labs, Inc. (“Ripple”), one of the crypto asset industry’s most prominent companies. (Securities and Exchange Commission, Complaint). The complaint alleged Ripple’s XRP token was an investment contract, and therefore a security which required registration under Section 5 of the Securities Act of 1933 (“Securities Act”). (Securities and Exchange Commission, Complaint; Jeff Roberts, Decrypt). Regardless of the victor, this litigation will set precedent regarding digital asset regulation in the future. Further, the SEC action will provide the industry with a much-needed regulatory framework by firmly cementing how the term “investment contract” applies to digital assets. (David Jolly, Bloomberg Law; see Securities and Exchange Commission, Motion for Summary Judgment; see Ripple Labs, Inc., Motion for Summary Judgment). In the interim, other industry participants will need to do their best to comply with the SEC’s unclear regulatory regime. (See Mary Fowler, Derek Flint, & Brett Johnson, Snell & Wilmer).

            In its 71-page complaint, the SEC argued that XRP meets the definition of an investment contract under the “Howey” test. (Securities and Exchange Commission, Complaint). To qualify as an investment contract under this test, the asset must satisfy four elements: (1) an investment of money (2) into a common enterprise (3) with an expectation of profits (4) that comes predominantly through the entrepreneurial or managerial efforts of others. (Securities and Exchange Commission). In the complaint, the SEC primarily focused on the final two elements. (Securities and Exchange Commission, Complaint). The SEC alleged Ripple created an expectation of profits because Ripple openly acknowledged that the “principal reason for anyone to buy XRP was to speculate on it as an investment.” Id. Indeed, the complaint referred to an internal email where a Ripple executive listed speculation as XRP’s primary use. Id. Moreover, those who purchased the XRP asset openly acknowledged that XRP’s success was “heavily dependent on the success of Ripple.” Id.The SEC’s complaint and its most recent motion for summary judgment are highly fact specific and attempt to highlight how Ripple’s actions make XRP an investment contract. Id.

            On the other hand, in its motion for summary judgment filed on September 17, 2022, Ripple attempts to explore the meaning behind the term “investment contract.” (Ripple Labs, Inc., Motion for Summary Judgment). Ripple splits its Motion for Summary Judgment into two parts. Part two argues how XRP does not fit the definition of an “investment contract” under the Howey test; but part one challenges the definition of an investment contract itself. Id. Rather than apply the Howey test, Ripple argues that courts should interpret the term “investment contract” according to state securities, or “blue sky,” laws and jurisprudence that existed prior to the introduction of the Securities Act in 1933. Id.Ripple takes this approach because the Securities Act’s drafters looked to state securities law cases for guidance in developing the term.   Id. Moreover, Ripple points out that every pre-Securities Act “blue sky” case that involved investment contracts required an actual contract. Id. Therefore, before there can be an investment contract, there must first be a contract, which would require an “undertaking of post-sale obligations by the promoter to the investor,” or in other words, consideration (Id.; see Edeh Chukwuemeka, BScholarly). If there is no consideration in the form of a post-sale obligation,, there can be no contract, and thus no investment contract. (Ripple Labs, Inc., Motion for Summary Judgment; see Edeh Chukwuemeka, BScholarly). Ripple has no post-sale obligation to purchasers of XRP. Id. Along with the “blue sky” jurisprudence supporting this proposed definition, the SEC itself, in its briefing to the Supreme Court in SEC v. S.J. Howey Co., proposed requiring some form of post-sale obligation to form an investment contract. Id. Under this interpretation, Ripple argues that there is no way XRP can constitute an investment contract. Id.

            The stakes in this litigation are high on both sides. (Id.;  Ryan Browne, CNBC). The SEC, if victorious, would force both XRP and other digital assets like it to register as securities with the SEC or apply for an exemption. Id. This consequence could be disastrous for the industry because many participate in it because of its less regulated nature. (Ryan Browne, CNBC; Emma Newbery, The Ascent). Indeed, Ripple’s CEO threatens to leave the US, and take Ripple with him, if the SEC prevails in this litigation. (Benjamin Pimentel, Protocol). This departure could start a chain reaction in the US as many other companies may follow its example. (Ben Strack, Blockworks; see Osato Avan-Nomayo, CoinTelegraph). On the other hand, Ripple’s latest argument could completely redefine the meaning of an investment contract and ensure no digital asset could be classified as a security without a separate contractual arrangement. (Ripple Labs, Inc., Motion for Summary Judgment). Because most crypto assets do not have any such contractual arrangement, they would not be subject to registration under this new definition. (See, e.g., XRP Whitepaper).

            While the litigation has the potential to provide some clarity regarding the SEC’s ambiguous regulatory framework, players in the industry currently must do their best to comply with the limited tools available. One of the most powerful tools industry participants have is the no-action letter. (Financial Crimes Enforcement Network). An individual or entity who is not certain whether a product, service or action would violate securities laws—or more specifically, constitute an investment contract—may request a no-action letter from the SEC. (Investor.gov). To request this letter, the individual or entity must describe in detail exactly what that individual or entity will be doing and discuss the laws, rules, facts, and circumstances involved. Id. SEC staff will analyze this letter and determine if, based on the exact description provided, the SEC would recommend an enforcement action. Id. This letter is powerful because it provides clear feedback regarding potential securities laws violations. Id. However, requesting a no-action letter is a time-consuming and expensive process and agencies can only review a certain number of them. (See Marc-Alain Galeazzi & Malka Levitin, Morrison Foerster).  Moreover, each no-action letter only applies to the specific circumstances discussed therein and would be useless if the party requesting it deviated in any way from what it represented to the SEC. (Securities and Exchange Commission).

            Another way to stay abreast of the relevant rules and regulations is to simply stay informed regarding the most recent industry developments. For example, the SEC’s website has a wide variety of useful insights. (See, e.g., Securities and Exchange Commission). Nevertheless, complying with SEC regulations is difficult because, according to Commissioner Hester Peirce, the SEC has “dropped the ball” when it comes to regulating the industry. (MacKenzie Sigalos, CNBC). Even the Chamber of Digital Commerce notes in its amicus brief for SEC v. Ripple how people inside the crypto industry often merely guess because the regulatory framework is so unclear and ask the courts and the legislature for clear regulatory guidance. (See David McNickel, Brave New Coin; Chamber of Digital Commerce, Cision). Without some SEC guidance, it will remain very difficult for industry participants to comply with SEC regulations. (See id.; see MacKenzie Sigalos, CNBC).