Law 360 Article Challenging SEC Abuse of Howey Test

(This article originally ran in Law360 and can be viewed behind the paywall here.)

SEC's Ripple Case Shows Limits Of Outdated Securities Test

By J.W. Verret (March 18, 2022)

The multitrillion-dollar digital asset market has caught the attention of Washington policymakers, including the U.S. Securities and Exchange Commission.

SEC Chair Gary Gensler has stated in public comments and in congressional testimony that at least one of the hundreds of tokens listed on most digital asset exchanges must be a security, therefore requiring crypto exchanges to register with the SEC.

Yet when Gensler is asked by members of Congress to provide more guidance about what he means, which tokens are securities and why they are deemed so, he will often respond that the SEC "doesn't give legal advice." That sort of gotcha game is inconsistent with the rule of law and the principles of a free
society. It is worth paying close attention to the U.S. Supreme Court's Howey test, which determines
whether an asset is an investment contract or security required to register with the SEC. A sizable component of the over $2 trillion invested in digital assets may well hinge on the correct interpretation of that test, established in the Supreme Court's 1946 SEC v. W. J. Howey Co. decision that has since been reinterpreted in many lower court cases in increasingly expansive ways.

The SEC's case against Ripple Labs Inc. for sales of the XRP token shows the limits of the Howey test.

This case, SEC v. Ripple, was in the news earlier this month, when, in a win for the defendants, the SEC's motion to strike their fair notice defense was denied by the U.S. District Court for the Southern District of New York. That defense argues that the SEC's nearly decadelong delay in bringing the case means that the SEC failed to give fair notice of the violation.

The ruling likely improves Ripple's odds. If the case continues to drag on, it may even provide circuit courts or the Supreme Court with an opportunity to curtail the Howey test's current application, as in subsequent interpretations the test has strayed far from its original meaning in the Howey decision, particularly with respect to the "common enterprise" and "profit from others" elements implicated in this case.

The digital asset ecosystem is one that the drafters of the securities laws never anticipated. Many crypto projects are more like computer systems or information transmittal systems than they are like publicly traded stock. They will often have tokens associated with the project that can be used to approve changes to the code to facilitate the transmission of information.

The SEC is using a test that was originally applied to orange groves to determine whether tokens associated with digital asset projects need to register with the commission. That has consequences for other participants in the blockchain ecosystem, which may also be required to register simply for investing in these tokens or facilitating their transfer. We need a new test to determine what digital assets should register with the SEC. We also need to reshape the disclosure requirements so that digital asset investors in those projects that must register are getting information tailored to their needs.

The SEC's ongoing case against Ripple — just one example of the SEC's aggressive approach to defining securities required to register with the commission — puts the digital asset community at risk.

Two elements of the Howey test include that the owners of the token have a common interest and that they expect profits solely from the efforts of others. Ripple is a blockchain software company whose founder helped to create the XRP token, which is an alternative payment system.

The SEC sued Ripple and its founders, alleging that sales of XRP in 2013 were unregistered securities. The SEC waited to bring the case until 2020.

The SEC alleges that Ripple's history of limited involvement in helping the XRP payment system maintain viability meets the second and fourth elements of the Howey test. Tens of thousands of XRP owners — the individuals the SEC asserts it is protecting — filed an amicus brief against the SEC. That brief lays out the case for why XRP is not an investment contract.

Individuals purchasing XRP typically know nothing about Ripple Labs; they purchase XRP for its value as a commodity and as a form of quasi-currency. Notably, XRP is classified as currency by the U.S. Department of the Treasury.

In the case of XRP and many other tokens, there may be a group of individuals performing basic maintenance of the code or providing market-making activities, but otherwise, profit potential principally derives from widespread valuation of the commodity, as in more analogous cases like gold or soybeans.

The feature that a common enterprise has in common is the source of its profit expectations, but in the case of tokens the source of most profits is entirely unrelated to a foundation — or here, individuals at Ripple — with some incidental link to the commodity. The Supreme Court hasn't provided much guidance on how to interpret the commonality element, and the SEC's aggressive expansion of the definition in the Ripple case and other cases against digital asset owners may well eventually spark a loss in the Supreme Court that resolves splits between the circuit courts of appeal over how this element is defined. This ongoing litigation may be where that happens.

The digital asset community is not asking the SEC for legal advice, but instead for regulatory clarity. And merely pointing to a 90-year-old law and demanding compliance is not a reasonable answer.

J.W. Verret is an associate professor of law at George Mason University's Antonin Scalia Law
School. He is a member of the SEC's Investor Advisory Committee.
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article is for general information purposes and is not intended to be and should not be taken
as legal advice.