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This article examines the ongoing regulatory challenges posed by the Securities and Exchange Commission (SEC) to leading crypto platforms, including Kraken, Coinbase, and Ripple Labs, highlighting the complexities of digital asset regulation. It analyses the SEC’s application of established securities laws, such as the Howey Test, to digital assets and juxtaposes it with the Commodity Futures Trading Commission’s (CFTC) classification of virtual currencies as commodities. The piece raises critical questions about the future landscape of crypto regulation and explores the possibility of developing a regulatory framework that simultaneously encourages innovation and ensures investor protection.
In the United States, the regulatory framework for digital assets is yet to be fully established at the federal level, lacking specific legislation dedicated to this emerging asset class. As a result, regulatory bodies are left to interpret and enforce existing financial and securities laws to oversee the digital asset sector. The Securities and Exchange Commission (SEC) has notably taken an active stance, asserting its jurisdiction over digital assets that possess qualities of securities and over service providers in the crypto industry, such as exchanges. Since 2014, the SEC has brought over 130 legal actions against crypto businesses.
Before discussing the article’s core, it’s essential to provide some preliminary context concerning the SEC’s legal actions against prominent crypto exchanges and platforms, namely Kraken, Coinbase, and Ripple Labs.
- SEC v. Kraken: The case against Kraken remains under judicial consideration following the SEC’s initiation of legal proceedings through a complaint. In response, Kraken has filed a motion to dismiss the case. This preliminary action is pivotal as it challenges the court’s basis for hearing the case and establishes the groundwork for subsequent legal debates concerning digital asset classification and regulatory oversight.
- SEC v. Coinbase, Inc., et al.: Unlike the ongoing case with Kraken, there has been a notable development in the SEC’s legal action against Coinbase. The court rejected Coinbase’s motion to dismiss, permitting the SEC’s complaint to advance. This ruling suggests that, in the court’s view, the SEC’s allegations against Coinbase hold enough merit to justify a more detailed investigation and legal scrutiny.
- SEC v. Ripple Labs, Inc., et al.: A significant development in the crypto sector was observed in the Ripple Labs case (20-cv-10832, S.D.N.Y.), which made a critical distinction regarding the sale of digital assets based on the type of investor. The court determined that XRP tokens sold to institutional investors might be classified as securities, whereas those sold to non-institutional investors could not be. This ruling brings a refined perspective to classifying digital assets under securities laws, highlighting the buyer’s nature and the sale conditions as crucial factors in determining their regulatory treatment.
WHO GAVE THE SEC ALL THE POWER?
The government of the United States established the foundational structure for overseeing the securities markets by enacting two critical pieces of legislation: the Securities Act of 1933 (hereinafter — Securities Act) and the Securities Exchange Act of 1934 (hereinafter — Exchange Act). The Supreme Court has recently reemphasised that “the Securities Act and the Exchange Act “form the backbone of American securities laws” (Slack Tech., LLC v. Pirani, 598 U.S. 2023).
The Securities Act of 1933 is foundational in the US financial markets by instituting a comprehensive disclosure regime. This mandate ensures that significant financial information is made available through securities registration, enhancing transparency and fairness in public offerings. Specifically, Section 5 of the Act delineates the prerequisites for securities registration with the SEC, a critical step before securities are offered or sold to the public. Furthermore, Section 7 details the requisite information for inclusion in the registration statement, ensuring that investors receive a thorough overview of the security and its issuer. This framework empowers investors with the information necessary to make informed decisions, reinforcing the integrity of the financial markets (Securities Act of 1933, §§5, 7).
The Securities Exchange Act of 1934 takes the baton from its predecessor to further safeguard investors and the integrity of the financial markets. It ushers in a regime overseeing securities transactions in the secondary market, where shares are traded post-IPO. Central to this Act is the establishment of the SEC, armed with expansive powers to oversee the securities industry. This oversight extends to the regulation, registration, and supervision of key players in the market landscape, including brokerage firms, transfer agents, clearing agencies, and self-regulatory organisations within the securities sector. With a keen eye on market transparency, ethical conduct, and investor protection, the Exchange Act’s comprehensive objectives are to deter fraud and prevent manipulative practices that could jeopardise market integrity and erode investor trust. Specifically, Section 10(b) empowers the SEC to craft rules to curtail fraudulent activities in the securities markets. Meanwhile, Section 21 delineates the SEC’s enforcement capabilities, from conducting investigations to mandating company reports, ensuring that the wheels of justice and regulation turn smoothly to maintain a fair and transparent investment environment (Securities Exchange Act of 1934, §§10(b), 21).
A significant provision of the Exchange Act is dedicated to creating the SEC, and as the court stated in SEC v. Alpine Sec. Corp: “[the Exchange Act] delegate[d] to [the SEC] broad authority to regulate … securities.” SEC v. Alpine Sec. Corp., 354 F. Supp. 3d 396, 418 (S.D.N.Y. 2018).
The SEC’s jurisdiction over securities is firmly established and clear-cut. However, the landscape becomes more complex when we consider digital assets. Before exploring the intricacies of the Howey test and what constitutes security, it’s essential to understand the unique characteristics of digital assets. At this juncture, it’s pertinent to introduce another key player in the US regulatory landscape — the Commodity Futures Trading Commission (CFTC). With authority over a wide array of goods, including, but not limited to, agricultural products, natural resources, and financial instruments, the CFTC has recently expanded its reach to include virtual currencies, deeming them commodities. This classification brings a portion of the digital asset world under the CFTC’s regulatory umbrella alongside the SEC’s oversight.
In March 2018, the New York federal court’s decision in CFTC v. McDonnell, 287 F. Supp. 3d 213 (2018) established a precedent for the Commodity Futures Trading Commission’s (CFTC) authority to regulate virtual currencies as commodities. This ruling was a first in federal judicial backing of the CFTC’s jurisdiction over virtual currencies, thereby marking a significant step in the regulatory oversight of the digital asset space. Despite lacking a formal definition of virtual currencies in its regulations, the CFTC has adopted a comprehensive “virtual currency” description in its March 2020 Final Interpretive Guidance for Retail Commodity Transactions Involving Certain Digital Assets. Virtual currencies are recognised as digital representations of value that can be exchanged and may take various forms, including tokens or coins, often distributed via digital contracts.
The CFTC’s jurisdiction encompasses the regulation of virtual currency trading across derivatives, futures, and spot markets. This aligns with the broader legal definition of commodities, which includes currencies as goods with uniform value globally, serving as mediums of exchange or stores of value. Under the Commodity Exchange Act, particularly Section 9(1), the CFTC is empowered to combat manipulative and deceptive practices in commodity trading, extending its regulatory purview to include futures and spot markets against fraud.
The CFTC clarified its position on digital assets in a complaint against Changpeng Zhao (CZ), the former CEO of Binance, stating:
“A digital asset is anything that can be stored and transmitted electronically and has associated ownership or use rights. Digital assets include virtual currencies that are digital representations of value that function as mediums of exchange, units of account, and/or stores of value. Certain digital assets, including BTC, ETH, LTC, and at least two fiat-backed stablecoins, Tether (“USDT”) and the Binance USD (“BUSD”), as well as other virtual currencies as alleged herein, are “commodities,” as defined under Section 1a(9) of the Commodities Exchange Act, 7 U.S.C. § 1a(9).”
Additionally, the SEC representatives repeatedly stated that they do not consider Ether or Bitcoin securities. However, in light of the recent probe into the Ethereum Foundation, the SEC may change its position concerning Ether not being a security.
Given the information and regulatory positions outlined above, one can infer that digital assets, by their intrinsic characteristics, are primarily classified as commodities akin to traditional assets such as gold, silver, or oil. Despite this categorisation, the SEC’s regulatory interest in digital assets, despite their classification as commodities by the CFTC, stems from how these assets are offered and sold to investors. District Judge Analisa Torres articulated this principle in the landmark Ripple case:
“Even if XRP exhibits certain characteristics of a commodity or a currency, it may nonetheless be offered or sold as an investment contract”.
Further, in the Ripple case, District Judge Analisa Torres stated that “XRP, as a digital token, is not in and of itself a “contract, transaction, or scheme” that embodies the Howey requirements of an investment contract”.
At this stage, it’s reasonable to acknowledge that a digital asset doesn’t inherently classify as a security; such classification depends on its sale method. Therefore, the SEC only exercises authority when the sale of digital assets falls under the definition of an investment contract. The question remains, however: Did Kraken, Coinbase, and Ripple Labs engage in the sale of digital assets in a manner that constitutes an investment contract?
INVESTMENT OR INVESTMENT CONTRACT: WILL CRYPTO COMPANIES CHANGE 78-YEAR-OLD HOWEY TEST?
At the core of identifying whether an asset qualifies as a security within the United States legal framework is the application of the Howey Test. Howey test requires “an investment of money in a common enterprise with an expectation of profit derived from the efforts of others”. Originating from the landmark Supreme Court decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Howey Test has since become a foundational element in securities law, guiding regulatory actions and legal interpretations worldwide.
The case that led to the formulation of the Howey Test revolved around a Florida corporation that sold interests in a citrus grove to its guests and claimed it was selling real estate. However, the transaction also included a service contract to cultivate and harvest the oranges. While the purchasers could have arranged to service the grove themselves, they relied on the efforts of Howey-in-the-Hills Service, Inc., which promised the investors a share of the profits. This arrangement was scrutinised by the SEC, which argued that it constituted an investment contract, hence a security under the Securities Act of 1933, thus requiring proper registration and disclosure. The Supreme Court ruled in favour of the SEC. It stated that “Form [is] disregarded for substance and the emphasis [is] placed upon economic reality”, setting a precedent for evaluating what constitutes an investment contract and, by extension, security. Therefore, under the Howey test, as ruled in Tcherepnin v. Knight, 389 US 332 (1967), the court has to analyse “the economic reality and totality of circumstances surrounding the offers and sales of the underlying asset”.
Elements of the Howey test
1. The investment of money
According to the SEC’s Framework for “Investment Contract” Analysis of Digital Assets, the first criterion of the Howey test is usually met “in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration”.
In its motion to dismiss, Kraken presents a nuanced argument regarding the “investment of money” prong of the Howey Test. Citing SEC v. Rubera 350 F.3d 1084 (9th Cir. 2003) and Inline Utilities, LLC v. Schreiber, 2020 WL 4464463 (S.D. Cal. Aug. 4, 2020), Kraken argues that for an investment of money to satisfy the Howey criterion, there must be a commitment of assets to the enterprise in question. They emphasise that when buyers are “several steps removed from an investment in any actual contract or enterprise,” this criterion is not met. Specifically, Kraken points out that their customers, who sent assets to an anonymous third party rather than directly to the issuer, were not investing in an enterprise per se.
In the case involving Ripple and its sale of XRP to institutional buyers, this criterion was examined by District Judge Analisa Torres. The institutional buyers exchanged fiat currency or other forms of money for XRP, constituting an investment of money. Both parties acknowledged this transaction, with no dispute from the defendants that Ripple received money through its Institutional Sales of XRP. The critical legal question was whether these Institutional Buyers had “provided the capital,” in the words of the Howey decision, or “put up their money”, as elaborated in cases like Glen-Arden Commodities, Inc. v. Costantino 493 F.2d 1027 (2d Cir. 1974) and SEC v. Telegram 448 F. Supp. 3d 352 (S.D.N.Y. 2020). The absence of any dispute over the payment of money for XRP led the court to conclude that the “investment of money” element of the Howey Test was indeed satisfied. The same was concluded with regard to the non-institutional buyers.
It is crucial to note that in the Ripple case, the dispute centres on XRP, a token directly issued by Ripple Labs. Institutional and non-institutional buyers invested money by purchasing XRP with fiat currency or other forms of money. This direct transaction between the buyers and the issuer, Ripple, clearly constituted an “investment of money” under the first criterion of the Howey Test. Conversely, the Kraken case presents a different scenario. Here, the dispute involves tokens not issued by Kraken itself but by other entities. Kraken acted merely as an intermediary, facilitating the sale of these tokens.
In the Coinbase case, we can see a different scenario. In its complaint, the SEC alleges that Coinbase’s staking programme is an investment contract because it involves participants investing money via staking-eligible crypto assets. This action, the SEC argues, places investors’ assets at risk due to potential slashing penalties and operational failures, aligning with the risk of financial loss central to the “investment of money” criterion. In contrast, Coinbase contends that the staking services do not inherently involve an investment of money, pointing to Gary Plastic Packaging Corp. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 756 F.2d 230 (2d Cir. 1985), to argue that its staking programme “create[s] no risk” of loss. The court, however, sided with the SEC, finding that the transfer of crypto assets for staking does indeed constitute an investment of money, acknowledging the inherent risks involved. Thus, the SEC primarily argues that the staking programme, i.e., the method by which digital assets are offered to investors, constitutes an investment contract, not the digital assets themselves.
2. Common Enterprise
The second prong of the Howey Test examines the existence of a common enterprise. Two types of commonality — horizontal and vertical — can demonstrate this aspect.
Horizontal commonality is established when the investors’ funds are pooled, and the fortunes of each investor are directly tied to the fortunes of other investors, as well as to the overall success of the enterprise (Revak v. SEC Realty Corp., 18 F.3d 81 (2d Cir. 1994)).
In the Ripple case, the court found horizontal commonality, noting that Ripple pooled proceeds from its institutional sales into a network of bank accounts controlled by Ripple and used these funds to finance its operations without segregating and separately managing investor funds. Similarly, in the Coinbase case, the court implicitly accepted the SEC’s argument that pooling crypto assets for staking creates a joint enterprise.
Another example is the SEC v. Terraform Labs. Pte. Ltd., 23-cv-1346 (JSR) (S.D.N.Y. Jul. 31, 2023), where the court found allegations of horizontal commonality through the pooling of proceeds from coin sales to develop the tokens’ broader ecosystem, indicating that improvements would benefit the token value collectively.
Vertical commonality focuses on the linkage between the fortunes of the investors and the success of the issuers’ enterprise. To establish strict vertical commonality, there must be a one-to-one relationship between the investors and the issuers, with a mutual dependence on the investment’s profits and losses. This was articulated in Brodt v. Bache Co., Inc., 595 F.2d 459 (9th Cir. 1979), emphasising the need for an interdependence of profits and losses between investors and issuers.
However, in the case of Kraken, their argument against the existence of a common enterprise centres on the absence of direct pooling of Kraken customer funds by issuers and the lack of a direct relationship or correlation between the success of the issuers’ enterprise and the profits or losses of the buyers on Kraken. Kraken’s motion to dismiss emphasised that the SEC’s allegations did not satisfactorily demonstrate that funds traded on Kraken were directly pooled by issuers. Moreover, Kraken highlighted the absence of a one-to-one relationship between any issuer and purchaser necessary for establishing vertical commonality.
3. Expectations of profits derived from the efforts of others
The evaluation of whether a digital asset transaction meets the Howey test’s third prong heavily relies on assessing whether purchasers have a reasonable expectation of profits derived from the efforts of others. This expectation can manifest in various forms, including through distributions, appreciation in asset value, or selling the asset at a gain in a secondary market. The critical factor is the significant role of a promoter, sponsor, or another third party in driving the asset’s value through their managerial efforts, leading investors to anticipate profits from such endeavours (Framework for “Investment Contract” Analysis of Digital Assets).
The definition of profit in this context encompasses any form of income or return, including dividends, other periodic payments, or the increase in the investment’s value (SEC v. Edwards, 540 U.S. 389 (2004)). Notably, the expectation of profit is one of many motivations behind the purchase; digital assets might be acquired for both consumptive and speculative purposes (Warfield v. Alaniz, 569 F.3d 1015, 1021 (9th Cir. 2009)). The evaluation focuses objectively on the offers made to investors rather than the subjective motivations of each participant.
In the Ripple case, the court concluded that institutional buyers would expect profits from Ripple’s efforts based on various factors. These included Ripple’s marketing strategies, which highlighted XRP’s potential as an investment tied to Ripple’s success, and contractual arrangements like lockup provisions that further signalled an investment rather than consumptive intent. Ripple’s efforts to enhance the XRP Ledger and promote the adoption of the Ripple protocol were seen as direct actions aimed at increasing XRP’s value, aligning with the investors’ profit expectations.
Contrastingly, the situation differed for non-institutional buyers purchasing XRP through digital asset exchanges. These buyers engaged in transactions without knowing that their purchases directly contributed to Ripple’s capital. Given the blind nature of these bid/ask transactions and the fact that Ripple’s Programmatic Sales constituted a minimal fraction of global XRP trading volume, the court found it could not establish the third Howey prong for these buyers. Their investment did not directly hinge on Ripple’s efforts, as was the case with institutional buyers.
Moreover, targeting speculators or understanding that people speculated on XRP did not suffice to meet the Howey test’s criteria. The mere presence of a speculative motive, without a clear link to the profits derived from the efforts of a specific third party, falls short of constituting an investment contract under securities law. (Sinva, Inc. v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 48 F.R.D. 385 (S.D.N.Y. 1969)).
Kraken’s motion to dismiss centres on the argument that their customers cannot have a “reasonable expectation of profits” based on the efforts of issuers due to the absence of any contractual relationship or undertaking with the issuers or their businesses. This distinction is crucial in the context of the “efforts of others” prong of the Howey test, which distinguishes between investing in a business (which could satisfy the Howey criterion) and merely purchasing the output of a business (which does not).
The motion references the case of the SEC. v. Belmont Reid Co., Inc., 794 F.2d 1388 (9th Cir. 1986) to illustrate this point. In the SEC v. Belmont Reid case, investors purchased gold directly from a developer before its extraction, with the developer planning to use the capital raised for extraction. The SEC argued this constituted an investment contract due to the reliance on the developer’s efforts for success. However, the court determined that the investors’ expected profits were derived from the anticipated increase in the world gold price, not from the developer’s efforts to extract gold, thereby not meeting the “efforts of others” criterion of the Howey test.
Kraken asserts that its platform facilitates customer-to-customer digital asset transactions, not direct purchases from issuers, leaving buyers without a stake in the issuer’s business, income, or profits. This model, Kraken argues, resembles market speculation rather than direct investment in the entities behind these assets. The platform draws a parallel between this scenario and the difference between buying shares in a gold mining company and speculating on gold prices, highlighting the fundamental distinction between investment and speculation in the digital asset landscape.
This argument is further supported by referencing the Ripple case, where the court found that the SEC could not establish a “reasonable expectation of profits” based on the efforts of Ripple because buyers purchasing XRP on trading platforms lacked a direct connection to Ripple. The factors highlighted were: buyers did not know who was selling the token, could not ascertain if their payments went to Ripple, and Ripple made no promises or offers to the buyers as the sales were not contract-based, and profit expectations were not tied to Ripple’s efforts but possibly to broader cryptocurrency market trends.
Further, in the Coinbase case, the SEC frames its argument around the premise that Coinbase’s managerial efforts are pivotal for generating returns for investors, leveraging the Howey decision and further supported by SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476 (9th Cir. 1973), which underscores the importance of managerial efforts in determining profit expectations. Coinbase’s rebuttal hinges on the premise that rewards from staking do not stem from its managerial efforts but from the intrinsic mechanisms of the proof-of-stake consensus, challenging the expectation of profits derived from the efforts of others. Nevertheless, the court aligns with the SEC’s viewpoint. The staking programme indeed meets the criterion of expecting profits primarily from the efforts of Coinbase rather than the individual investor.
CONCLUSION
The ongoing confrontation between US regulators, notably the SEC, and the crypto sector is fundamentally redefining financial regulations for the new era of digital finance. Through its litigations against leading entities such as Kraken, Coinbase, and Ripple Labs, the SEC has unambiguously signalled its intent to closely monitor digital assets that exhibit characteristics akin to securities. Concurrently, the CFTC’s designation of virtual currencies as commodities introduces an additional dimension of regulatory intricacy. These legal confrontations are indicative of the trajectory of crypto regulation. At this juncture, the capacity of the crypto industry to align with these evolving regulations will be instrumental in shaping its trajectory.
Simultaneously, the conclusion drawn from our analysis underscores the criticality of the mechanisms through which digital assets are marketed and sold. Notably, the Ripple litigation elucidates a distinction between the informed institutional investors and the less informed non-institutional investors, particularly concerning transactions involving Ripple’s XRP token. In contrast, Kraken’s role as a facilitator implies that its operations may not directly correspond with the traditional definition of an investment contract. Moreover, the SEC’s focus on Coinbase’s staking programme strongly suggests its probable classification as an investment contract, highlighting the complex legal nuances in digital asset regulation.
Navigating a path where crypto assets can thrive within a secure and regulated framework necessitates a collaborative effort. Regulators innovate within their rule-making processes and the crypto sector by enhancing regulatory compliance measures. The dialogue between regulatory bodies and the crypto industry is vital for fostering an environment where technological innovation and investor protection are mutually reinforcing, paving the way for a balanced and forward-looking regulatory approach.
This article was written by Liza Lobuteva & Yuriy Brisov of Digital & Analogue Partners. Visit dna.partners to learn more about our team and the services.
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