A. Introduction
On Thursday July 13, 2023, a federal district court in the 2nd Circuit issued a ruling on cross motions for summary judgment in the ongoing litigation between Ripple and the SEC. If upheld on appeal, the digital asset industry may have just received some much needed clarity.
B. Background
After reading through the summary judgment opinion, and if the opinion holds up on appeal, we believe this case may substantially shift our doctrinal understanding of how the securities laws apply to investment contracts. But first, some quick background.
If you are selling something and you want to know whether it is a security, in the United States you look at the federal securities laws or FSLs. There are basically 4 statutes. Each of those statutes has a definitions section, essentially a glossary. There, you look up the word “security” and read its definition. The definition is essentially a list of financial products that are regularly bought in sold in the investment industry. Essentially, if the thing you are selling is not listed there, then you are good to go, you are not selling a security and the FSLs don’t apply.
The definition of security is a list of financial products whose status as a security are pretty self-evident, a share of stock, an option on stock, corporate bonds, and many other things that would be commonly understood to be securities if an average person spent a year watching CNBC or Bloomberg. But when you read the list, you will eventually land on a term that is not self-evident, investment contract. After eliminating all other self-evident possibilities that the thing you are selling is a security, you have one last check to figure out if you are selling a security, and that is to determine if you are selling an investment contract.
Because an investment contract is not self-evident, the Supreme Court setup a test to help with this analysis. When addressing citrus groves in a case called Howey, the Supreme Court said you look at the facts and circumstances of what was sold and ask 3 questions: (1) Was there an investment of money? (2) Was the investment in a common enterprise? And (3) Did the investor reasonably expect profits to come primarily from the efforts of others? If all 3 of these elements are satisfied, then you sold an investment contract, i.e., you sold a security.
After Howey, lots of cases, some at the Supreme Court and others in lower courts, applied this test to new and unique fact patterns to help solidify the investment contract test. Some of these cases address “underlying” or “referenced” assets that are clearly not securities, like bank certificates of deposit. Two of these subsequent cases are Marine Bank and Gary Plastics. In Marine Bank, the facts and circumstances surrounding the sale of the certificates of deposit let to the conclusion that the CDs were not securities. Under Gary Plastics, the facts and circumstances “wrapped” the bank CDs in benefits and burdens that caused those sales of bank CDs to be the sales of securities. Notably, same underlying asset, different conclusion in respect of the FSLs.
Clearly, Marine Bank and Gary Plastics stand for the proposition that an asset like a bank certificate deposit is not by itself an investment contract and hence a security. Even Howey establishes this fact with citrus groves. Thus, to a certain degree, we already knew that it is not necessarily what you are transacting that is an investment contract, i.e., certificates of deposit or citrus groves, but how you are structuring benefits and burdens around the underlying asset that will cause a transaction of that reference asset to be an investment contract.
But now we have more clarity on this point. The recent court opinion on Ripple and XRP casts a new question in respect of investment contracts, does the analysis focus on the thing or the scheme of sale? If the former, then initial sales and resales of the thing are securities transactions but if the latter, the facts and circumstances of every transaction, the initial sale and the resales need to be analyzed under the Howey Test. The court’s opinion concludes the latter.
C. Howey Is One Transaction At A Time
Turning back to digital assets, many careful securities attorneys around 2017-2018 concluded that the SEC believes all tokens, other than BTC and maybe ETH, to be an investment contract and thus a security. The security status question focused on the underlying asset, the token, not the scheme of sale. The working thesis was that the SEC believed the token was a security, and almost like stock, would remain a security because the token only had value because of the ongoing efforts of the creator of the token. Further, the token would remain an investment contract until decentralization was sufficient enough that other market factors out weighed the issuer’s efforts; this was the Hinman Ether thesis. In the Ripple opinion, the court rejected this theory. Instead of a static status determination at the time of issuance, the court implicitly held that the investment contract analysis is not a one time blanket status determination of the token, but is an analysis that must be conducted transaction by transaction.
According to this opinion, immediately after one transaction that is clearly an investment contract, an immediately subsequent sale of the same underlying asset can be structured in a completely different way that makes the transaction no longer a sale of a security. Here, the token itself is a mere object that is fungible and the demand for the limited supply of that token will drive the price. But the token, without more, is not a security under this opinion. Yet, when the token is sold in a manner that satisfies all of the prongs of Howey, then the transaction of that token is now a securities transaction. Whereas another sale of the token under a different scheme is not a securities transaction. Thus, the court adopted a transaction by transaction investment contract analysis and rejected a static status determination that stays in place from the primary sale until sufficient decentralization breaks the “efforts of others” prong of Howey.
This is a big shift because until this opinion, our Howey framework was that the token itself received the status of being an investment contract (i.e., a security). Instead, this opinion seems to hold that under Howey the scheme of the token sale receives the status as an investment contract. If the securities status is tied to the “thing” then the status carries forward in time. But if the securities status is tied to the “scheme,” then the status merely exists for a single point in time and the Howey test must be applied anew for each subsequent transaction. If this opinion is sustained on appeal, then this is a big doctrinal shift in how the Howey test has been applied. As noted above, we’ll describe this shift as a move from a static status determination to a transaction by transaction determination.
D. Is the Transactional Approach Novel?
Seems like it. There is nothing more powerful than an idea whose time has come.
Blockchain technology represents an innovation that solved the digital world’s problem of scarcity and title transfer. Go back to the days of Napster and music mp3 file sharing. If Alice wanted to sell her mp3 of Unchained Melody by the Righteous Brothers to Bob, there was no good way to ensure title transfer and enforce scarcity in the digital world. In the analog world, Alice owns a vinyl record of the single, Unchained Melody. Bob gives Alice $3 and Alice gives Bob the vinyl. Scarcity is enforced because another copy of the vinyl was not created and title transfer was enforced because Alice can no longer play the vinyl because Bob owns title and possesses the vinyl to the exclusion of Alice. In the digital world, the equivalent of these steps could not occur because copies of mp3’s are easy and cheap to make, Alice gives Bob a copy of her Unchained Melody mp3, keeps a copy for herself, Alice and Bob can both listen to the mp3, scarcity is not enforced, and title transfer is likewise not enforced. But substitute Napster with blockchain and substitute mp3 with token, and now the digital world’s problem of how to enforce scarcity and title transfer is solved.
Historically, many of the investment contract cases had relatively complicated fact patterns where purchasers were acquiring a bundle of rights and sometimes with respect to an underlying reference asset like a bank CD, whiskey, or citrus groves. In those cases, the fungibility and tradability of the investment contract or the or underlying reference asset did not exist. Whereas blockchain technology creates a circumstance where a deep and active market for fungible and non-fungible tokens of anonymous buyers and sellers can form quickly and across the globe. The technology also allows for price discovery to quickly occur and be driven by many factors other than the efforts of the issuer of the token. In contrast, we are not aware of prior cases addressing fact patterns of deep and robust secondary markets for investment contracts. Therefore, technological innovation has resulted in the courts having the opportunity to figure out that the Howey test is truly a test that must be conducted on a transaction by transaction basis.
E. Hope for Secondary Markets
Returning to the Ripple opinion, the court also held that the programmatic sales of tokens were not investment contract transactions. Several factors were considered by the court. The buyers and sellers were matched on a blinded basis and the buyers did not know that Ripple, i.e., the issuer, was on the other side of those transactions. Additionally, the court noted that, “[s]ince 2017, Ripple’s Programmatic Sales represented less than 1% of the global XRP trading volume.” Taken together, the court’s opinion seems to stand for the proposition that if buyers and sellers are blindly matched in a deep market (i.e., many units of tokens outstanding) with high trading volume, and the tokens are mere units of account with very little to no additional rights attached to them, those token transactions will not be investment contract transactions, even if the seller is the issuer of the token.
Accordingly, the court concluded that under these facts the buyers in the programmatic transactions did not have any expectation that profits were to be derived primarily from the efforts of Ripple or another small group of people. Instead, buyers in the programmatic transactions were reasonably assumed to believe that other market forces were primary drivers of profit. If that is true for the programmatic transactions where the issuer was the seller into a broad and deep market, though on a blinded basis, it would seem to follow that secondary transactions on exchanges where the buyers and sellers are both blindly matched and not affiliates of the token issuer, are not investment contract transactions. And because the tokens by themselves are not securities, there is no other basis to consider those transactions to be securities transactions.
That being said, the court explicitly declined to address the facts of a secondary market in footnote 16. But as we point out, the same logic would likely hold for many secondary markets where buyers and sellers don’t know each other and are simply trading tokens as they would trade any other valuables. Therefore, if many secondary transactions on crypto exchanges are: (a) blinded, (b) broad and deep markets, (c) 1% or less related to affiliates, and (d) mere units of account with few if any additional rights, the SEC’s cases against many exchanges alleging those exchanges are unregistered securities exchanges should fall apart. Indeed, the stock price of Coinbase closed 24.5% higher after this opinion was issued.
F. Why Was All of This So Hard to Figure Out?
The SEC focused its analysis too narrowly on tokens as things. Under this asset-based or token-based approach, the SEC used Howey to turn the tokens into securities, and therefore, just like a share of stock, all subsequent transactions will have to be securities transactions. Here, the court is saying, hold on a minute, investment contracts are schemes not things.
Certainly tokens have presented some novel facts. Technological innovation created an asset designed to be highly fungible and highly negotiable (i.e., tradable) while by itself conferring no rights to the net assets of a business, no fiduciary protections, no profit sharing payments, no dividends, no interest, nor any rights in bankruptcy. And to the world’s surprise, despite the absence of these indicia of securities, many types of tokens, aided by the accessibility of the internet, rapidly found millions of willing buyers and sellers in both primary and secondary markets. The SEC correctly noticed that the primary transactions smell fishy and should be regulated like securities, but when you are a hammer, everything is a nail, and the SEC wanted jurisdiction over all secondary sales without ever recognizing that original intent of the Securities Act, to regulate and register transactions not things. In this way, Howey is a securities transaction test, not an asset-based test.
In the SEC’s defense, in many cases tokens were sold in a manner that strongly resembled raising start up capital. These are primary offerings that fit squarely in the wheelhouse of securities regulation. So of course the SEC was quite interested in regulating these transactions. The point the court is making here is that the SEC went too far when it moved from trying to regulate the primary offering of investment contracts to also regulating all secondary transactions.
In our view, once the SEC determined the primary transaction was a securities transaction, the SEC borrowed too liberally from the rationale underlying regulating secondary transactions of stock. This muddles the analysis because stock is always a security, that is an immutable quality of stock’s very nature. But an investment contract exists because of the peculiar facts and circumstances surrounding a transaction. In other words, the status of a token being an investment contract is itself ephemeral, whereas stock’s status as a security is immutable.
Going further, the sale of a single share of stock, whether in a primary transaction or secondary transaction, is always a securities transaction because stock is listed in the Securities Act as a thing that is always a security whether or not it satisfies the Howey test. True, investment contracts are also listed as securities in this definition, but by developing a facts and circumstances test for determining an investment contract, the supreme court determined that investment contracts stand apart from the list of self-evident securities. Therefore, the offer and sale of an investment contract is not a self-evident securities transaction like the secondary sale of shares by the founders of a startup company.
Together with Howey and its progeny, this opinion implies that even if you alter, modify, or rearrange the sales scheme to offer a share of stock, there is no way to structure the sale to avoid being a securities transaction because a share of stock is always a security no matter how the offering is structured. But for investment contracts, the facts of every transaction matter to determine whether a security is at issue.
If investment contracts were self-evident, there would be no need for a test. Because there is a need for a test, it follows that the facts of every transaction, not just the initial (or primary) transaction, need to be analyzed to determine whether the offer or sale of a security has taken place. In other words, the SEC went too far by regulating the thing not the scheme.
G. Don’t Forget About Mom and Pop.
Even though this recent Ripple opinion is some potential good news for the crypto industry, the U.S. capital market is one of the best in the world because of the “trust dividend” that gets paid out for taking investor protection seriously. The U.S. capital market will be dealt a substantial blow if any court opinion allows for bad actors to erode that trust.
Over simplifying, the FSLs say that raising operating capital for your business puts most investors in an informationally disadvantaged position with potential financial consequences that are significant. As a result, businesses must be compelled to meet a very high standard of disclosure to raise operating capital from the average person. But if a business only raises operating capital from investors that possess certain indicia of competence or ability to bear financial risk, then go nuts, just don’t commit fraud.
Below are some critiques of the Ripple opinion with our additional thoughts:
-The Ripple opinion flips the script and now in crypto, businesses can do what they want with retail investors, but sophisticated investors get investor protections.
-The Ripple opinion is encouraging crypto businesses to take advantage of the least sophisticated investors.
-The Ripple opinion suggests that crypto businesses can freely sell tokens to retail investors as long as those retail investors are uninformed and the businesses are secretive about it.
-The Ripple opinion says that only if crypto businesses sell tokens openly to sophisticated investors will they get in trouble.
-Mark Zuckerberg just can’t just dump his shares of Meta on the market magically turn his stock sales into mere commodity sales by hiding his identity. And if Zuckerberg can’t do that, why should an executive of a crypto business be able avoid the securities laws so long as she sells her tokens anonymously?
Let’s address some of these critiques.
In the secondary market, retail investors really are not buying the same arrangement as institutional investors in primary transactions. First and importantly, the Ripple opinion does nothing to change the fact that retail investors will largely be prohibited from primary transactions where the crypto business is fully disclosed. Instead, all of the smooth talking promotional conversations by the crypto business executives will be directed at institutional investors and their team of lawyers. Institutional investors in primary transactions will stroke big six- or seven-figure checks, their lawyers will negotiate contracts to protect those checks, the crypto businesses will talk about their dreams for growth with those institutional investors to maximize the size of the check stroked, and the institutional investors will quite reasonably expect those dreams to come true and every one to get rich. This is very much a securities transaction.
Ya, but the Ripple opinion suggests that crypto businesses can freely sell tokens to retail investors as long as those retail investors are uninformed and the businesses are secretive about it.
Hold… on… a… minute… amigo. That is not what the Ripple opinion says.
Direct token sales from the crypto business to retail investors have some criteria they must meet in order to not be investment contract transactions: (a) buyers and sellers are matched blindly; (b) the market for the token is deep and broad; (c) blindly matched issuer sales are 1% or less of daily volume; and (d) the tokens are little more than units of account. Because the token itself is not a security, if token transactions on exchanges satisfy at least these 4 criteria, those transactions will not be investment contract transactions. Arguing that the Ripple opinion suggests that crypto businesses can freely sell tokens to retail investors as long as those retail investors are uninformed and the businesses are secretive about it is wrong and a bit hyperbolic.
Additionally, when a token represents little more than a mere unit of account and confers no rights to the net assets of a business, no fiduciary protections, no profit sharing payments, no dividends, no interest, nor any rights in bankruptcy, what purpose do the disclosure rules of the FSLs serve? If the market conditions of, (a) blinded matches, (b) broad and deep markets, (c) 1% or less related to affiliates, and (d) mere units of account, are satisfied, then token transactions appear to be outside the scope of the FSLs as they are currently written.
Further, consider the practical implication of requiring high trading volume by many market participants around the globe and keeping direct sales to 1% or less of daily volume. Meeting these two elements will take some time. We do not expect that when a crypto business is following the FSLs and raising start up capital in a primary transaction with institutional investors, that business will be able to satisfy these elements. At that subsequent date, when all 4 of the elements can be satisfied, the nature of the token transaction has changed, the Howey test breaks down, and perhaps Rule 180.1 under the Commodity Exchange Act is sufficient retail protection.
Contrast this analysis with stock. At no point, given the passage of time, can the nature of a transaction cause stock to no longer be a security. Congress listed stock in the statutory definition and stock does not need to satisfy the Howey test. This is why comparing Mark Zuckerberg anonymously selling Meta stock to crypto business insiders anonymously selling tokens is comparing apples to citrus.
Finally, keep in mind that the Ripple opinion only applies to investment contracts. The protections afforded retail investors with respect to every other security listed in the definition of security remain in full force and effect.
H. Potential Regulatory Landscape
Going forward, we are likely to see regulatory landscape shape up in the following way:
1. Primary sales will be regulated by the SEC as securities transactions. Regulatory enforcement and private rights of action under the Securities Act and Exchange Act should be available to police bad actors.
2. Great effort will be made to structure secondary sales, especially on exchanges, to be between anonymous buyers and sellers consistent with the Ripple opinion in order to avoid those subsequent sales to be transactions of investment contracts.
3. In many cases, exchanges will be regulated as state and federal money transmitters not forced to be national securities exchanges. Some states, like New York, will establish new tailored regimes that are inspired by state MTL regimes but tailored to digital assets that function as stores of value and mediums of exchange.
4. The tokens and their spot markets will be regulated as commodities and commodity markets. The anti-fraud provisions of the Commodity Exchange Act and its rules will be enforced by the CFTC against bad actors trying to fraudulently manipulate the spot markets.
Note that this opinion addressed several issues, but this post is narrower in scope and focuses on the question of whether primary and secondary transactions of tokens are securities transactions. The word “scheme” here is used in its more British sense of describing a process rather then its pejorative sense. Tokens here refer to those bitcoin-like tokens that are mere units of account for a given blockchain. Finally, certainly it could be true that the SEC has always known that Howey is a test that is applied on a transaction by transaction basis, but we are not aware of this interpretation by any SEC statement, case law, or informal discussions with our network of securities attorneys.
Post Date: July 17, 2023