Original Author: William
Original Source: Axia8 Ventures
SEC filed a lawsuit against Ripple in 2020, and after many years, a federal court ruling has added some fun to the bear market in the cryptocurrency circle. Let's take a look at what this ruling says.
Securities Law Section 5 and Howey Test
The U.S. Securities Act of 1933 Section 5 stipulates that any public sale of securities not registered with the SEC is illegal.
To prove whether there is a violation of Section 5, the SEC needs to prove to the court that Ripple (1) traded without registration, (2) directly or indirectly sold securities, and (3) engaged in interstate transactions.
Ripple's defense is that the sale of XRP is not an investment contract (a type of security) and therefore does not need to be registered.
How does the U.S. define securities?
The Securities Act of 1933 lists the types of securities. "Securities" generally refers to any notes, stocks, treasury stocks, futures contracts, securities futures, bonds, debentures, investment contracts, etc. However, it leaves a loophole for various new financial instruments through "investment contracts," and the Howey Test is a standard used to determine whether a transaction is an investment contract. If a transaction meets the Howey Test's criteria for an investment contract, it is considered a security and should be subject to securities laws and SEC regulation.
In SEC v. W.J. Howey Co., the Supreme Court held that under the Securities Act, an investment contract is “a contract, transaction or scheme whereby a person [(1)] invests his money [(2)] in a common enterprise and [(3)] is led to expect profits solely from the efforts of the promoter or a third party.
In summary, the Howey Test sets forth 4 criteria for determining whether a transaction constitutes an investment contract:
Investment of money
In a common enterprise
Expectation of profits
Profits derived solely from the efforts of others
Ruling of this case
In analyzing whether a contract, transaction, or plan constitutes an investment contract, the principle of "substance over form" should be adopted, focusing on economic substance and the overall situation. As of the end of 2020, Ripple had sold XRP in three ways:
Sold approximately $7.289 billion of XRP to institutional investors;
Programmatic sales of approximately $7.576 billion of XRP through trading platforms (Ripple does not know who the buyers are, and the buyers do not know who is selling XRP to them);
Other types of distributions, such as payment for wages, external services, etc., which accounted for approximately $6.09 billion in XRP sales.
The court found that based on the first point, Ripple's sale of XRP to institutional investors met the criteria of the Howey Test for an investment contract, and thus is considered a security.
However, the strange point of this ruling is that the court found that based on the second point, the programmatic sale of XRP to retail investors through cryptocurrency trading platforms does not meet the criteria of the Howey Test and should not be considered a security. The reasons are as follows:
Institutional investors can reasonably expect Ripple to use the investment funds to improve the XRP ecosystem, thereby potentially increasing the price of XRP, but retail investors on the exchange do not have this expectation;
For both parties in the exchange on the trading platform, the transactions are anonymous, and retail buyers do not know who is selling them XRP, whether it is sold to Ripple, and therefore does not meet the standard of a common enterprise as per the Howey Test;
Retail buyers purchasing XRP on the trading platform are more for speculative purposes and cannot be considered as an investment in Ripple, nor can they expect to profit from the efforts of Ripple.
At the same time, the court also found that the "other types of distributions" mentioned in the third point did not meet the criteria of the Howey Test for an investment contract, as the recipients did not invest money.
Analysis
From the background and development of the Howey case, the determination of investment contracts is generally aimed at financial instruments issued in the primary market, which often involves innovative financial instruments brought about by technological development and usually does not have a mature public trading venue. Therefore, the question of whether XRP, which is openly traded on cryptocurrency trading platforms, constitutes an investment contract has not been extensively discussed by the courts before.
Unlike stocks traded in the secondary market, stocks are inherently securities. Stocks and investment contracts are parallel, and stocks do not need to undergo Howey Test scrutiny; they are naturally securities.
So, can XRP, which is openly traded on cryptocurrency trading platforms, be directly considered as stocks? Stocks typically have the following characteristics:
Right to receive dividends
Liquidity
Can be pledged or mortgaged
Holders have voting rights
Potential for appreciation
In reality, issuers of digital assets can design token economics to circumvent certain characteristics of stocks, making it very difficult for digital assets to be directly considered as stocks.
From this perspective, the court's separation of the primary market and secondary market trading of XRP in this ruling seems to have some merit.
However, in terms of the impact of the ruling, allowing digital assets to evade securities regulation by selling them to retail investors through cryptocurrency trading platforms without any disclosure of information and market promotion would undoubtedly turn the cryptocurrency market into a paradise for speculation and fraud, which is not conducive to the long-term development of the entire cryptocurrency market.
Therefore, the subsequent development of this case is worth close attention, and it is not ruled out that the Supreme Court may consider this as a new legal issue and intervene in this case.
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