Digital Assets—Investment Contracts or Howey Test Unicorns? (Part 6 of 6)

In the final segment of his six-part series, Professor Ari Gabinet compares the ongoing SEC v. Ripple Labs case against the Kik case. He concludes the series by calling for a consistent regulatory model for cryptocurrency. Professor Gabinet draws on his expertise in securities law, accrued through experience as a private practice litigator, a private sector in-house counsel, and as a district administrator of the SEC.

SEC v. Ripple Labs—the Next Chapter

Ripple Labs is the creator of a distributed ledger network for transaction processing and is the issuer of XRP, the “native token” for its network. The SEC recently brought an enforcement action against Ripple and two of its principals, alleging that their sales of XRP over a six year period constituted an unregistered offering of securities. As alleged in the SEC’s complaint, filed by the SEC’s New York Regional office, the Ripple case is factually very different from Kik Interactive. The SEC alleges that Ripple distributed and sold XRP in order to finance its continued operations and to build a market that would enhance XRP’s value. The SEC alleges, among other things, that Ripple’s ongoing efforts to develop the market in which it would be traded and the legal advice it received early on that XRP could be viewed as a security as evidence that the sales of XRP over a seven year period constituted an unregistered offering of securities. 

Ripple—represented by former SEC Chair Mary Jo White and former director of the SEC’s division of enforcement, Andrew Ceresney—to date have only filed an answer with affirmative defenses, so the details of the company’s response are not fully fleshed out. Among the affirmative defenses, however, is the assertion that in 2015 the U.S. Financial Crimes Enforcement Center (FinCEN) and the Department of Justice entered into a settlement agreement with Ripple in which XRP was described as a virtual currency, and that through various representations the SEC staff led Ripple to believe that the SEC would look at the current status of the XRP network, rather than its origins. Ripple also contends, on information and belief, that a trading platform that listed XRP for trading did so after discussing XRP’s status as a security with the SEC staff. 

The fact that the SEC brought suit against Ripple after so many years of public trading of XRP does raise interesting questions, not only of fairness and equity, but of what may have triggered the decision to bring the suit. It would not be unusual for the enforcement staff to have been investigating a potential enforcement action for an extended period before bringing suit; nor would it be unusual for a favorable decision like Kik Interactive to be a catalyst for a filing. In any event, the merits of the SEC’s enforcement action against XRP cannot be assessed until the facts and legal contentions are fleshed out in motion practice in the coming months.

Conclusion

The world of distributed ledgers, the applications that run on them, and the digital assets that become their currency, are all still in formation. Entrepreneurs are creating new models and new uses regularly. It is not surprising that the regulators have not found and promulgated a consistent regulatory model. Yet one can hope that there is a regulatory model that, in the words of Richard Epstein, “offer a simple set of intuitive precautions that facilitate, not frustrate, voluntary transactions,” and “whose value increases as underlying deals become more valuable and more complex.” Epstein, The Dangers of Investor Protection in Securities Markets, 12 Texas Review of Law and Politics 412 (2007). It would be regrettable if the SEC, the CFTC, or other financial market regulators were to issue regulations with an imperfect understanding of a still evolving technology. At the same time, the lack of clarity, and the potentially ruinous impact of enforcement action, means that regulatory ambiguity stifles legitimate innovation.

The author gratefully acknowledges the invaluable assistance of Shingo Lavine in connection with this paper. Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review appreciates his support as our Faculty Advisor.