In the “crypto case of the century,” SEC v. Ripple Labs, Inc. et al. securities law litigation (SDNY 20-CV-10832), parties lock horns on the question if defendent, Ripple Labs’ cryptocurrency, XRP is a “security” (or, should the court sidestep the question, if XRP offer and sale agreements and scheme, viewed together, an unregistered, un-exempt securities offering).
To answer yes is to retroactively declare XRP offering an illegal unregistered offer or sale of XRP “violating…Sections 5(a) and 5(c) of the Securities Act”, and its $1.4 billion offering proceeds “ill-gotten gains” to be disgorged. See SEC v. Ripple Labs complaint.
It is important, therefore, to understand why XRP, intangible and trading as a blockchain powered, digital currency, is labeled as a “security” in the first place. SEC and complex securities law regime regulate securities, not commodities or currencies.
To assert agency jurisdiction, SEC cites to the famous “Howey Test” initially developed by US Supreme Court in 1946: “an investment contract, for purposes of the Securities Act, means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.” SEC v. W.J. Howey Co., 328 U.S. 298-99 (1946).
The Supreme Court’s “Howey Test” thus cuts through forms and pushes ahead on the economic substance/reality, namely, an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. As the form is to be disregarded for substance and “economic reality”, SEC takes the position that “Howey test” applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of securities. See: SEC Framework for “Investment Contract” Analysis of Digital Assets.
SEC’s analysis for the nascent digital assets and currencies, however, further extending the jurisdictional “Howey Test” to resale or prospective secondary market sale, asks if the agreements, circumstances and manner in which the cryptocurrencies is offered, sold and/or resold satisfy the two key elements, namely, reasonable expectation of profits derived from efforts of others. The extending of jurisdictional analysis makes a difference.
To get the key elements of “Howey Test,” Supreme Court proceeded on the following stipulated fact pattern:
“W. J. Howey Company and Howey-in-the-Hills Service, Inc., are Florida corporations under direct common control and management.
The Howey Company owns large tracts of citrus acreage in Lake County, Florida. During the past several years, it has planted about 500 acres annually, keeping half of the groves itself and offering the other half to the public ‘to help us finance additional development.’ Howey-in-the-Hills Service, Inc., is a service company engaged in cultivating and developing many of these groves, including the harvesting and marketing of the crops.
Each prospective customer is offered both a land sales contract and a service contract, after having been told that it is not feasible to invest in a grove unless service arrangements are made. […]
The land sales contract with the Howey Company provides for a uniform purchase price per acre or fraction thereof, varying in amount only in accordance with the number of years the particular plot has been planted with citrus trees.
Upon full payment of the purchase price, the land is conveyed to the purchaser by warranty deed. Purchases are usually made in narrow strips of land arranged so that an acre consists of a row of 48 trees. […]
The service contract, generally of a 10-year duration without option of cancellation, gives Howey-in-the-Hills Service, Inc., a leasehold interest and ‘full and complete’ possession of the acreage. For a specified fee plus the cost of labor and materials, the company is given full discretion and authority over the cultivation of the groves and the harvest and marketing of the crops. The company is well established in the citrus business, and maintains a large force of skilled personnel and a great deal of equipment, including 75 tractors, sprayer wagons, fertilizer trucks, and the like. Without the consent of the company, the landowner or purchaser has no right of entry to market the crop; thus, there is ordinarily no right to specific fruit. The company is accountable only for an allocation of the net profits based upon a check made at the time of picking. All the produce is pooled by the respondent companies, which do business under their own names.
The purchasers, for the most part, are nonresidents of Florida. They are predominantly business and professional people who lack the knowledge, skill, and equipment necessary for the care and cultivation of citrus trees. […]”
SEC v. W.J. Howey Co., 328 U.S. 295-298 (1946)
Vary the fact pattern a bit, the “investment contract security” construct, however, may be called into question and fall apart. For example, what if the service agreement stipulates that investors take home (presumably for consumption) all specific fruits (citrus oranges) grown and harvested in the tract or strip of land he/she purchased and owned? Would the court find a security in this deed and service agreement scheme?
Presumably the amount of oranges will exceed investor’s normal household consumption; he/she would be able to discard, donate, or sell them in a secondary market. Would the sale in secondary market (but not consumption, discarding or donation) operate to convert the non-security, here excessive amount of citrus oranges, to a security and thereupon impose full plethora of federal securities law regulations regime upon Howey and company? Or, re-construct the original land deed transfer and service agreement as an illegal securities offering and sale (when the excess amount of citrus oranges are sold in a secondary market, not when they are discarded, donated or otherwise not disposed of for profit)?
A digital cryptocurrency, same as oranges, can and normally would be consumed by purchasers (in blockchain network, games or virtual market to buy goods and services, etc.), discarded, donated or sold in a secondary market same as the excess oranges. Would the sale in secondary market operate to convert the excessive amount of cryptocurrencies, to a security and thereupon impose full plethora of federal securities law regulations regime upon crypto issuer? Or, more likely in the SEC v. Ripple Labs case discussed here, when a prospect or likelihood of sale in a secondary market is found, the economic substance doctrine applies, so much so the original crypto offering and sale scheme would be ruled an illegal, unregistered securities offering (while it probably would not if the cryptocurrencies purchased are consumed, discarded or donated).
There is no simple, logically smooth answer.