Among the many cryptocurrencies vying for mainstream adoption by banks, the XRP token backing the Ripple payment protocol led the competition, until recently. Unlike many other cryptocurrencies, XRP is not intended to function primarily as a currency, although it can and does trade like any other cryptocurrency. Instead, it is the medium of exchange underlying the Ripple network, which is intended to facilitate currency exchange in any form and replace the aging systems currently used by banks for settlement. The Ripple network boasts extremely low commissions on currency exchanges, fast transactions, and the ability to transact in any type of currency.
In December, the SEC filed an action against Ripple Labs and two of its executives, at least temporarily quashing Ripple’s ambitions. The suit alleges that the company and two top executives raised money through the distribution and sale of XRP, which the SEC claims is a security. Ripple replies that XRP is not a security and that the SEC has no authority to regulate it as one.
A security is an abstraction that represents ownership of, rights to ownership of, or a priority creditor relationship with a corporation. A security is fungible and holds some kind of monetary value. The characteristics of cryptocurrencies are not, in general, neatly amenable to categorization by the classic definitions of equities and debts.
The Ripple case, if it is adjudicated, might answer a looming question for the cryptocurrency space: where is the line between a currency and a security?
Whether cryptocurrencies are a security or not is a question with financial implications easily reaching billions of dollars. If a cryptocurrency is a security, it is subject to extensive regulatory treatment by the SEC and other federal government agencies, with significant costs to consumers, investors, and the maintainers.
Nor will the answer be stated simply. The sometimes misleadingly labeled zoo of cryptocurrencies, now approaching some 1.5 trillion dollars in value, comprises thousands of entities. Each currency, many of which would perhaps be better termed as “technologies” or “assets,” has unique characteristics and processes. A blanket characterization will not be possible. Any regulatory regime will need to consider each technology on a case-by-case basis.
So far, no court has spoken on this issue with regards to XRP specifically. However, there are a constellation of non-binding opinions from various members of the executive branch that give some insight into issues courts might consider. For example, in 2019, SEC Chairman Jay Clayton stated in an interview that Bitcoin is not a security: “Cryptocurrencies are replacements for sovereign currencies…[they] replace the yen, the dollar, the euro with bitcoin. That type of currency is not a security.” In 2018, William Hinman, the Director of the SEC’s Division of Corporation Finance, in a speech spoke similarly on Ethereum, “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.” The SEC has stated unambiguously that Initial Coin Offerings (ICOs) are subject to classification as securities. If and when the issue of XRP comes before a court, the court will likely apply the Supreme Court’s test developed in its 1946 SEC v. Howey Co. decision to determine whether or not XRP is a security. In Howey, the defendant was selling leaseback agreements for citrus groves to investors without registering the sales contracts with the SEC. The SEC filed suit to enjoin Howey from continuing to transact without submitting to SEC regulatory oversight. The Court ruled that the contracts were securities and that Howey was liable under the Securities Act of 1933. In doing so, the Justice Murphy developed what has come to be known as the Howey Test.
Under the Howey Test, a transaction is a security if it is an “investment contract.” A transaction is an investment contract if it satisfies all four of the following conditions: (1) it constitutes an investment of money; (2) there is an expectation of profits from the investment; (3) the investment of money is in a common enterprise; and (4) any profit comes about as a result of the efforts of others.
In their complaint, the SEC spends little time making a systematic argument from Howey, instead emphasizing that the Court intended the test to be timeless and “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” In other words, the SEC takes it as self-evident that XRP is a security and argues that Ripple itself was aware of the danger of this classification. They cite evidence from internal memorandum indicating that the executives knew of and recklessly disregarded the possibility that registration was mandated.
In their reply, Ripple pushes back on this legal conclusion. First, they argue that XRP is “categorically [different] from the various instruments and business arrangements that Congress authorized the SEC to regulate,” distinguishing XRP from ICOs and other promises of future payments that have been classified as securities. Next, responding to the guidance from Howey that the Test be intended to identify securities based on substance and not form, Ripple expounds on the ways in which Ripple’s distributions and sales of XRP differed from comparable transactions involving securities. Finally, Ripple responds tersely and directly to the SEC’s own perfunctory Howey assessment by respectfully referring the court to the case.
Most recently, the SEC filed an amended complaint, further expounding upon its Howey arguments and the parties held a pre-trial conference at which they agreed that a settlement was unlikely. However, as the Presidential administration has changed, a new SEC chair awaits nomination. Gary Gensler, an MIT professor and cryptocurrency expert, might have different priorities for the SEC. He has, however, indicated in the past that he believes XRP might be a security. The Ripple case, if it is adjudicated, might answer a looming question for the cryptocurrency space: where is the line between a currency and a security? An expanded scope of regulatory oversight by the SEC means greater regulatory and reporting costs for companies developing these types of assets. Moreover, US-based cryptocurrency exchanges are not licensed to sell securities. On the other hand, XRP and other cryptocurrencies that are similarly categorized as securities would be eligible for trading on traditional stock exchanges, a potential boon. Finally, this decision will only be binding inside the United States. The success of XRP and Ripple internationally is technically and legally independent of the decisions of US courts. Whatever its outcome, the resolution of this lawsuit will have a lasting impact on the regulatory structure surrounding cryptocurrencies.