The rapid expansion in market capitalization of cryptocurrencies to over $1.7 trillion, the rapid rise of NFTs ($25 billion in 2021, $4 billion in January of 2022) and other digital assets, as well as the dramatic increase in DeFi ($75 billion) staking and liquidity pools ($108 billion as of Dec, 2021), raises two clear questions: how should digital assets such as cryptocurrencies be regulated, and how might this innovative technology add value and benefit to our economy? An SEC enforcement action moving through the Southern District of New York is poised to shape the answers to both questions, due in large part to the aggressive stance toward cryptocurrency represented by the Commission’s legal theory. Legal experts and policymakers had best pay close attention.
In December 2020, the SEC filed a civil enforcement action against Ripple Labs, a cross-border payments company, and its two top executives, alleging that the company’s sales of XRP, the cryptocurrency native to the blockchain ledger Ripple uses, have been unregistered securities sales since they began in 2013. The SEC bases its position on the assertion that XRP’s only utility is as an investment contract between holders and the company, and that all sales of the token – even on the secondary markets – have been and continue to be “one long securities trade” to fund Ripple’s operations, which would require SEC registration. The Commission’s case rests on its reading of the Supreme Court’s 1946 Howey decision, which has provided the guiding precedent for determining if an instrument is a security since then.
The recent White House executive order regarding digital assets merely states that there will be a centralized response, but there are no specifics as to what that response will be. The cryptocurrency asset class has been on the SEC’s radar for years. Despite dozens of enforcement actions, public comments and speeches by officials, and questionable invitations for innovators to seek individual guidance, no cohesive body of guidance has emerged. This has become clearer in the pre-trial phase of the Ripple case, as the company has mounted an affirmative defense that it had not received fair notice by the SEC that its actions were unlawful. To that effect it submitted evidence of the myriad confusing public and private guidance given by the agency about XRP specifically and cryptocurrencies in general.
Ripple contends that it did not create or issue XRP on its decentralized ledger, and its sales were akin to asset liquidations. Before the enforcement action was filed billions of XRP tokens had been traded for more than seven years by holders and users with no connection to Ripple. During that time, the SEC brought a variety of enforcement actions against digital assets other than XRP and senior SEC officials made public statements that could be reasonably interpreted to mean that an asset like XRP would not be considered a security.
The SEC’s case rests on conclusory arguments regarding the nature of XRP with which they seem to believe all reasonable people would agree, despite widespread activity among a variety of sophisticated and experienced market participants for such an extended period of time. This exceedingly broad reading of its own powers means the SEC intends to establish a very wide avenue of attack against any cryptocurrency market participant, going back several years and disregarding whatever its officials and staff may have said in guidance.
Should the SEC get the outcome it desires, market participants will be forced to assume that any token or digital asset could be considered a security and subject to enforcement action regardless of guidance SEC personnel have given them. This means all tokens, regardless of their use case, must be submitted to the SEC’s still undefined (but likely onerous) requirements to avoid costly litigation. A win for the Commission in the Ripple case could signal that the courts will allow the SEC to make up the rules on cryptocurrency as it goes along, and they need not be coherent or consistent. Employees of an issuer could effectively face strict liability for aiding and abetting securities laws violations, despite due process requirements and well-established precedent to the contrary. This could extend the Commission’s powers beyond what the Securities Act arguably provides.
If the Southern District agrees with the SEC that it provided Ripple and market participants adequate fair notice that XRP is a security and all sales of the asset are securities trades – regardless of specific features that fall well outside the elements of the Howey test – this will set a precedent that would allow the Commission to target any token issuer and any market participant at any time for any sale, regardless of when the transaction took place. Such a broad standard could even allow for future enforcement actions against miners of Bitcoin dating back to the first sales of that token in July 2010. The practical effect of the court granting the SEC such broad discretion would be to put an abrupt end to cryptocurrency trading in the United States and send innovators overseas.
Perhaps the SEC launched a broad legal attack on Ripple with the expectation of a quick settlement by the company and its executives. But Ripple appears to be a successful going concern and, like much of the expanding cryptocurrency industry, is flush with cash and eager to fight. Its executives have said publicly they will not accept any settlement that doesn’t provide regulatory clarity to XRP. So, the legal stakes have become high for the entire cryptocurrency space, and for the regulator as well.
If the case goes to trial and Ripple wins on its fair notice defense, the court could establish an important precedent that the Commission failed to provide fair notice to market participants given the confusion it has sown– effectively forcing the Commission to finally create sorely needed comprehensive official guidance for the industry. The fear created by the settlements extracted in its cases against Kik Interactive and Telegram would be put to rest, and Coinbase may be emboldened to proceed with offering its cryptocurrency-backed lending product, ignoring the SEC’s chilling Wells notice issued earlier this year.
For all these reasons, and with trillions of dollars in value at stake (not to mention the future of NFTs, DeFi, Blockchain-based Metaverses, and Web3 applications and architectures), all eyes had best be fixed on the Ripple case in coming weeks and months. It is likely to have an enormous impact on the markets and on the future of this innovative technology that cannot be ignored.
Daniel Conway, who co-authored this article, is a professor at the University of Arkansas’s Walton School of Business and the co-director of its Blockchain Center for Excellence.
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