Bitcoin remains the only clear winner in the ongoing battle between the SEC and the crypto industry.
The SEC made waves in December 2020 when it filed a lawsuit against Ripple Labs, accusing them of conducting an unregistered securities offering. After almost three years, Judge Analisa Torres finally ruled on the motions for summary judgment. While some pundits have framed the ruling as a "win" or "loss" for either side, the reality is that the case is far from over. The SEC has been granted a motion to put the trial on hold pending an appeal, which could potentially reverse Judge Torres' decision and the precedent it set.
Keeping up with the unfolding legal process has become a challenge, as has separating fact from opinion in the discourse on the case. In this resource, we aim to provide readers with a clear breakdown of the case, its implications for the digital asset ecosystem, and what it means for Bitcoin users in the United States. For an in-depth discussion of the initial ruling, read this article by our Legal Fellow, Zack Shapiro.
The digital asset industry has grown rapidly in recent years, pushing government officials to meet the growing demand for consumer protections and regulatory clarity, particularly in the realm of securities law. Unfortunately, regulators, policymakers, courts, and members of the cryptocurrency ecosystem each have varying interpretations of the ways that existing rules ought to apply to digital assets.
Traditionally, as founders looked to raise capital for their startup or early stage company, they sought investments from private equity firms, venture capitalists, or other institutional pools of money. Importantly, in order to raise capital, companies are required to either register with the SEC or, as is more common, to rely on an exemption based on specific criteria; companies cannot simply offer shares of their company to members of the public in exchange for money without following these steps. Registered securities face significant disclosure and reporting requirements with the SEC, while unregistered securities that qualify for exemptions such as Regulation D or Regulation S have their own restrictions (e.g. they can only be sold to accredited investors). The stated purpose of these disclosures and regulations is to help investors identify good investment opportunities and avoid scams. Ultimately, if an asset issuer sells unregistered securities without qualifying for an exemption, it is a violation of federal law.
While it is both possible and common for cryptocurrency issuers to qualify for Regulation D and S exemptions and offer their tokens to accredited investors, the primary roadblock to their current business models is their inability to offer tokens to retail investors via digital exchanges. Broadly, this breaks down into two primary issues: 1) the process for registering digital assets as securities is unclear under existing frameworks, and 2) even if digital assets were to successfully register as securities, the infrastructure to list them for retail investors does not exist (i.e. the SEC has not yet granted licenses to exchanges to sell registered crypto securities).
There is currently no clear avenue for digital asset issuers to legally offer tokens to retail investors if they are deemed to be securities. And even if there was, many proponents of the crypto industry posit that selling cryptos only on registered securities exchanges would defeat the purpose of the peer-to-peer blockchain technology underlying these projects in the first place (i.e. cryptos will lose their value proposition if they become like every other security). It begs the question: is the SEC acting unfairly towards the digital asset industry, or are they simply fulfilling their mandate to protect investors based on recent events in the industry1 and their best understanding of the law?
In the end, both digital asset issuers and the SEC have reasonable complaints about the other's actions. On the one hand, the SEC argues that digital asset issuers have circumvented existing rules designed to protect American investors, leading to billions of dollars in fraud and scams. On the other hand, digital asset issuers feel as though the SEC has treated them unreasonably by offering no practicable path toward legal public offerings. Both sides agree that the status quo is unsustainable. Considering Congress has not passed legislation to assuage these issues, many of the key questions surrounding the regulation of digital assets have been left up to the federal courts.
Assets or financial products generally fall into one of two categories: commodities or securities. Because of the turmoil in the crypto markets, courts and regulatory bodies are facing increasing pressure to clarify which digital assets fall under which category so that regulations can be more effectively enforced.
Securities include investment contracts, stocks, bonds, and other financial instruments. They are subject to strict reporting, disclosure, and trading rules with the SEC. In the U.S., the Howey Test, established in the 1946 SEC v. W. J. Howey Co. ruling, is commonly used to determine whether a transaction qualifies as an “investment contract” and should be considered a securities offering. The test consists of four criteria, all of which must be met for a transaction to be considered a securities offering: 1) an investment of money, 2) in a common enterprise, 3) with an expectation of profit, and 4) derived from the efforts of others.
In contrast, commodities are interchangeable goods or products without a central authority offering profit for investors. The commodity spot markets are less regulated than securities markets, and commodities like wheat, gold, and oil are easily accessible to retail investors. However, most cryptocurrencies trend toward centralized governance and ownership, leading to skepticism about their classification as commodities.
Bitcoin stands apart from the rest of the cryptocurrency ecosystem. It is a fully decentralized network, with no centralized issuer and no CEO or entity able to act solely on behalf of the network. There is no “Bitcoin company” to register with the SEC in the first place. This is why both the chairs of the SEC and the CFTC have repeatedly declared Bitcoin to be a commodity in public speeches.
Using the Howey Test, courts have primarily assessed the representations made during the issuance or initial sale of digital assets to determine their status as securities offerings. If an offering represents an investment in efforts to generate profits by the issuer or others, it is considered a securities offering. While this is usually clear for traditional equity securities, the link between something like XRP and Ripple Labs is less straightforward. Things become even more complex as asset issuers relinquish control in more decentralized digital assets like Ethereum. In fact, during a speech at the Yahoo Finance All Markets Summit for Crypto in 2018, former director of the SEC’s Corporation Finance Division, William Hinman, made this exact point. During his speech he noted:
"If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful."
Ultimately, courts are left asking the question: do purchasers have a reasonable expectation of receiving profits based on the issuer or manager’s efforts (or the efforts of some other specific party) to deliver a return for purchasers? When the answer to this question has been yes, courts have viewed transactions with certain digital assets to be securities offerings.
Judge Torres granted the SEC’s motion for summary judgment on Ripple’s institutional sales of XRP tokens, deeming them unregistered securities offerings without proper exemptions, in violation of U.S. securities law. She determined that representations made to institutional investors caused all Howey Test prongs to be met. Ripple can still raise investments from institutional investors through Regulation D or S exemptions, provided they comply with associated formalities. However, fines for the breach will be significant and require further litigation.
On the other hand, Judge Torres denied the SEC’s motion for summary judgment on all other instances cited in the initial complaint. These instances included “programmatic sales'' which primarily referred to the sales of XRP on digital exchanges. In this matter, Judge Torres determined that investors on digital exchanges were not directly investing in Ripple Labs, but rather in the XRP token itself as a separate concern. This argument in part boiled down to the notion that investors on digital asset exchanges “could not have known if their payments ... went to Ripple'' and were “generally less sophisticated” than institutional investors (23-25, 27-28). More importantly, Judge Torres focused on the idea that those who purchased XRP tokens might not have been investing in the success of Ripple Labs but rather had some other motivation for purchasing the tokens, and it would be impossible to know the motivations of every individual investor. This conclusion was reached despite the fact that Ripple Labs was actively making efforts to integrate the XRP token with traditional finance rails like banks.
Many digital asset proponents saw this portion of the decision as a significant “win”, especially when viewing Ripple’s litigation as a proxy for regulatory clarity – and, indeed, leniency – in the larger digital asset industry. This is particularly true as the logic of Judge Torres’ ruling appears to apply equally well to secondary trading of tokens between third parties on cryptocurrency exchanges like Coinbase and Binance as it does to the primary “programmatic” sales of XRP at issue in this case.
Finally, Judge Torres ruled in favor of Ripple regarding specific XRP token distributions, such as employee or service provider compensation. She determined that these offerings didn't meet the Howey Test's first prong, requiring an investment of money, and that there was insufficient evidence of Ripple directly profiting from the eventual sale of these tokens. The throughline of Judge Torres’ decision was her assessment of whether sales of XRP had a clear link to Ripple Labs, towards the end of driving profits for XRP holders.
Judge Torres’ decision has come under fire from the legal community. In more recent news, one of Judge Torres’ colleagues in the Southern District of New York Federal Court challenged her analysis in the SEC vs. Ripple Labs Inc decision. Judge Rakoff, responsible for the proceedings between the SEC and Terraform Labs, the issuers of the TerraUSD stablecoin which collapsed, ultimately found fault in Judge Torres’ decision. He believed that the SEC should be permitted to proceed with their case against Terraform Labs notwithstanding Judge Torres’ decision. On this matter, he stated: “That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.”
On August 9th, the SEC filed a letter with the court outlining their intent to appeal the decision, and on August 17th, Judge Torres granted the SEC’s request for leave to file for an interlocutory appeal. A favorable ruling from the Court of Appeals for the SEC has the potential to negate any progress Ripple Labs gained from Judge Torres' decision. The SEC aims to expedite the process, as her analysis could affect other cases they are involved in. As it stands, the precedent could allow many digital assets to be sold as non-securities. However, it is clear that the impacts of this court decision are not yet set in stone.
These proceedings will likely drag on for the foreseeable future, and given the SEC’s suits against other digital asset issuers and digital exchanges, onlookers should expect more litigation. In many ways, these cases will continue to demonstrate Bitcoin’s unique status within the current regulatory regime. Bitcoin is a commodity and therefore does not have to face the uncertainty that the rest of the digital asset ecosystem faces when it comes to securities law. In fact, the entire conversation above is completely inapplicable to Bitcoin and in some ways irrelevant. As continues to be the case when the SEC goes up against the crypto industry, there is presently only one clear winner: Bitcoin.
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1 In the past 18 months, numerous cryptocurrency projects have either collapsed due to improper management or exit scams. Most notably, in May of 2022, Terraform Labs’ stablecoin Terra, collapsed after it came to light that Terraform Labs had improperly managed the asset leading to over $50 billion of losses. Although many in the digital asset industry argue that the collapse will lead to more robust offerings in the future, we believe that regulators and policy makers will view it as too little too late and potentially with good reason.
