The SEC’s approach to crypto must be modified to more clearly articulate how securities laws should apply to digital assets.
Most crypto enthusiasts are less than pleased with the United States Securities and Exchange Commission’s past approach to crypto. This is not because legitimate businesses oppose regulation but because of the breadth, complexity and uncertainty associated with the current regulatory regime. Even in the context of general discontent, few actions by the SEC have engendered as much widespread criticism as the Dec. 22, 2020 complaint that initiated a civil enforcement action against Ripple Labs and two of its executives.
Not everyone opposed the action. For example, Coin Center, a pro-crypto nonprofit advocacy and research group, declined to argue against the idea that XRP is a security. In my previous Expert Take, I suggested that the case was consistent with prior SEC enforcement initiatives and the Howey investment-contract test, simply known as the Howey test, which has long been used by the SEC to determine when crypto assets are securities.
On the other hand, there are plenty of voices condemning the SEC’s case. This includes complaints by former SEC official Marc Powers, current SEC Commissioner Hester Peirce, and a pending lawsuit arguing that Ripple’s XRP token is not a security, in which thousands of XRP holders have sought to participate. The Regulatory Transparency Project, a nonprofit, nonpartisan group associated with the Federalist Society, sponsored a teleforum on June 24 titled “SEC v. Ripple Labs: Cryptocurrency and ‘Regulation by Enforcement.’” With a preenrollment of more than 500 members of the public, the audience was overwhelmingly unhappy (and unimpressed) with the SEC’s action against Ripple and its XRP token.
This general dissatisfaction with the Ripple case, often denigrated as “regulation by enforcement,” has led some to call for the development of a “Ripple test” to more clearly articulate how securities laws should apply to crypto assets.
Who is calling for a Ripple test?
The label of a Ripple test might have first been used in a specious post from Dec. 22, 2020 falsely claiming that the SEC was abandoning the Howey test in favor of an approach that reportedly required “new companies to operate for eight years to find out if what they’re doing violates securities law.” However, more thoughtful commentators have joined the call for a Ripple test to prevent businesses from operating for years without knowing whether they might be called into court for having run afoul of U.S. securities laws.
On May 18, Roslyn Layton, a senior contributor and well-respected technology policy writer for Forbes, publicly called for a Ripple test to “stop the SEC’s overreach on cryptocurrency.” Part of the overreach she identified was the SEC’s claim that it could initiate an action reaching back to sales that started more than seven years ago, potentially leading to a fine of billions of dollars. Layton’s response was that “those seven years have a broad public record of refusal by the SEC to provide any clarity over XRP.” She noted, convincingly, that during those years, the SEC declined to announce how it intended to treat Ripple’s XRP token.
Since the original piece in Forbes, several other commentators have joined the call for a “Ripple test.” One published opinion, authored by George Nethercutt Jr. — a former member of Congress — noted:
“Recent calls to establish a more appropriate standard for technologically complex digital assets have turned into a firestorm since the Ripple case was filed. Some tech policy experts closely following the case have called for a ‘Ripple Test’ to replace Howey.”
Curt Levey, president of the Committee for Justice — an organization devoted to advancing constitutionally limited government and individual liberty — also raised the Ripple test during the Regulatory Transparency Project’s June teleforum, noting that the need for a Ripple test is continuously evolving regardless of the outcome of the SEC lawsuit.
Existing approaches that might become the Ripple test
The difficulty, of course, is in fully explaining what a Ripple test might entail (other than not being the Howey test, of course).
The utility token approach
One possibility is to look at the functionality of the underlying asset, essentially resurrecting the utility token analysis. At one point, commentators made a concerted effort to distinguish between utility and security tokens. Unfortunately for entrepreneurs, as former SEC Chairman Jay Clayton noted, under the SEC’s approach, “Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.”
Some states, however, have adopted a utility token analysis to determine how such assets should be regulated. Not surprisingly, Wyoming, the most crypto-friendly state in the nation, enacted the “Wyoming Utility Token Act” back in 2017 — and passed two related house bills in 2019 — which allows issuers to proceed with tokens created for a consumptive purpose. In order to satisfy the requirements of this act, the predominant purpose of the token must be consumptive; the token cannot be marketed as a financial investment; and there either must be a reasonable belief that the token is sold to the initial buyer for consumption, the consumptive purpose must be available at or near to the time of the original sale, or the original buyer must be precluded from reselling the token until the consumptive use is possible. Tokens that comply with these requirements can be sold after the issuer files a notice containing specific but limited information with the secretary of state and pays a $1,000 fee to cover the costs of administering the statute.
Similarly, Montana has chosen to specifically exempt utility tokens (i.e., those with a consumptive purpose) from its securities laws. Section 30-10-105(23) of the Montana Code exempts utility token transactions from the registration requirements under state law. This provision requires the token to be designed primarily for consumptive purposes and not marketed for speculative or investment purposes. In addition, resales of the tokens are prohibited until the consumptive purpose is possible, and initial purchasers must acknowledge their intent to use them for the consumptive purpose. Colorado, through its Digital Token Act, has also chosen to exempt the issuance of tokens with a primarily consumptive purpose from the state’s securities laws.
While it would probably take an act of Congress to encourage (or force) the SEC to move in this direction, a Ripple test adopting the utility token (or consumptive purpose) approach could have precluded the application of securities laws to Ripple’s XRP tokens.
Excluding crypto assets that are regulated as virtual currency
An alternative Ripple test could limit the scope of the SEC’s authority under the securities laws so that an interest determined by the Financial Crimes Enforcement Network (FinCEN) to be a currency is not a security. In 2015, FinCEN and Ripple Labs Inc. made headlines with the announcement of the first enforcement action under the Bank Secrecy Act against a digital currency exchanger. As part of the release announcing the imposition of a $700,000 penalty against Ripple, FinCEN explained that the actions of the company were problematic because it had sold “its virtual currency, known as XRP,” without registering as a money services business.
This determination by FinCEN led commentators to widely speculate that XRP could not also be a security. There is certainly a logic to that position, as the settlement with FinCEN allowed Ripple to continue its operations and sales, which presumably should not have happened if the sales were illegal under federal law. Despite the existence of such commentary, the SEC remained quiet about how XRP should be regarded, even while its officials made public statements indicating first that Bitcoin (BTC) was not a security and then that Ether (ETH) was also outside the scope of securities laws.
Given this history, it is understandable that the decision of the SEC to initiate litigation against Ripple has been particularly polarizing. That decision could have been forestalled if the courts decided to remove digital currencies from the ambit of securities laws, or if the SEC reached that same conclusion.
However, those alternatives seem unrealistic, meaning that it would likely take an act of Congress to give the Department of the Treasury and FinCEN exclusive authority over digital currencies, thereby limiting the SEC’s authority. This approach could easily be identified as a Ripple test, as the impetus for this change is SEC vs. Ripple and the change would clearly preclude the SEC’s decision to act against Ripple and its XRP token.
A statute of limitations
A significantly more limited response, which could also be called a Ripple test, might involve something as simple as limiting how late the SEC can act after the commission becomes aware of the distribution of an interest it regards as a security. Even if the SEC was not fully aware or did not understand what Ripple was doing when it began marketing XRP tokens in 2012, clearly there was a general understanding of the company’s activities by 2015 when the FinCEN settlement was announced. Even so, the SEC did not initiate its enforcement proceedings until Dec. 22, 2020. It is this delay that has been the most widely criticized.
For claims by private plaintiffs under the Securities Act of 1933, Section 13 requires that the suit be initiated within one year of the violation as to that particular person and in no event more than three years after the security was first offered to any purchaser. This is a reasonable balance between the need of purchasers to obtain redress and some need for eventual certainty and closure for the issuer. However, the federal securities laws currently provide no statute of limitations on the right of the SEC to initiate enforcement actions. Presumably, it will take an act of Congress to amend the law to limit the SEC’s authority to act, but the very fact that the SEC has been willing to sue Ripple for decisions and actions initiated more than seven years earlier suggests that such action could be justified.
Problems with existing approaches
There are some obvious benefits to a Ripple test, not the least of which would be to remedy what is seen by many as a serious overreach by the SEC. Increased certainty would also be a sizable benefit to legitimate crypto entrepreneurs, but there are some problems with each of the approaches identified above.
First, a test that is focused on whether a particular crypto token has utility (or consumptive value) in order to determine whether or not the asset in question is a security may leave members of the public with inadequate remedies in the event that there is fraud. An alternative to saying that utility tokens are not securities would be to provide a simple exemption from registration for utility tokens. This would at least allow the anti-fraud provisions of the securities laws to continue to apply. A problem with saying that utility tokens are exempt is that it might be too easy for issuers to evade applying the securities laws by pretending that tokens are being sold for a consumptive purpose when the real hope is that they will be bought by speculators, pushing the price up.
In addition, it is likely to be difficult to determine whether the purpose of a token is “primarily” consumptive or whether it was really marketed as an investment rather than on the merits of its promised utility. Each of these are reasons that using a straight-forward utility test as the Ripple test might be problematic.
There are also problems with saying that an interest cannot be a security if it is regulated as a currency by FinCEN. First, FinCEN does not regulate to protect against fraud in the sale of interests, so this approach could easily leave members of the public who are scammed without a remedy. Because federal agencies are protective of their jurisdiction, this approach could also produce a race to regulate, which might not lead to the optimal results.
Alternatively, if FinCEN has the ability to determine that a crypto asset is a digital currency even after the SEC has acted first, this could lead to the very kinds of uncertainty and inconsistency that crypto entrepreneurs protest against under the current system. Because the mission of FinCEN is so different from that of the SEC, there would seem to be good reasons for allowing both to retain some jurisdiction in the space.
Finally, there are also some issues around setting a strict statute of limitations for enforcement actions. The SEC has limited resources, and when a new class of assets arises, it takes time to understand what those assets entail. It may have taken the SEC a considerable time to figure out exactly what was going on with XRP tokens precisely because they do have some utility and they work in an extremely complicated space. It is difficult to know what statute of limitations would be fair, and if the issuer in question (or its affiliates) continues to sell the asset, the SEC could still have jurisdiction over more recent sales, leading to the anomalous situation where some sales cannot be attacked while other sales are treated as illegal.
An alternative approach
The preceding discussion raises the question of what alternative approaches might work better. First, because it is absolutely clear that there are bad actors in the crypto space, it is important to have an active federal regulator that can intervene when members of the public are defrauded. The SEC has the resources and experience to enforce the anti-fraud provisions of the securities laws. This can be accomplished without the problems that are exemplified by SEC vs. Ripple if the regulatory approach is changed to recognize a broad, consistently applied exemption from registration for offerings that meet certain requirements.
The most obvious requirement for such an exemption is that it should be limited to issuers that are not subject to a stop order and have no past history of securities violations and that have no affiliates or control persons that have been convicted of a felony or fraud in the recent past. A “bad actor” disqualifier already appears in other exemptions, so it would not be unusual for this to be included in a new crypto transaction exemption.
Second, it makes sense for any issuer to have to notify the SEC of a planned sale or distribution of crypto assets. The notice does not need to include a huge amount of information, but it should include such things as the terms of the issuance, the consideration that they are paying and the general terms and functionality of the asset specifically including the rights that purchasers are acquiring as a result of ownership of the asset. In addition, not only does the SEC need information about the general terms and functionality of the blockchain on which the crypto assets are issued, that same information needs to be publicly available at the time of issuance. The information that must be readily available should include the quantity of assets authorized, the number that are controlled by the issuer or its affiliates or control persons, and the general conditions that must be met before assets are issued or the issuer can sell the assets as well as any limits on resale.
It might also be appropriate to have reasonable restrictions on the nature of the underlying program. One substantive requirement that makes sense is that the issuer should not have the unilateral right to modify the terms of the underlying blockchain or programming. It also makes sense to require that the crypto assets be designed with a consumptive purpose and that the tokens should be functional at the time of the sale. (Absent a consumptive purchaser, the only likely justification for purchase is speculation on future profitability.) Similarly, the proceeds of the sale should not be needed or intended to support development of the token’s functionality (provided that the general assets of the issuer may be used to support additional or improved functions, even if part of those assets are derived from the sale of the crypto assets). This is also intended to ensure that the tokens are being purchased because of the intended functionality rather than in the hopes that the issuer’s efforts will increase their value as an investment. As an alternative to this approach, it could also be acceptable if the functionality of the asset is intended to be available reasonably quickly and that resale by initial purchasers is precluded until such functionality develops.
Another requirement should be that the issuer specifically avoids selling the token by promoting the possibility of appreciation or profitability, or otherwise as a speculative investment. Finally, to avoid the possibility that this exemption is used to evade the securities laws, the asset should not give the purchaser a right to any share of or interest in the management, profits or assets of the issuer and must not be created primarily to evade application of the securities laws. These restrictions seem necessary to limit the new exemption in a reasonable manner while still offering a broad-based exemption for many assets.
These suggestions may be just another version of a Ripple test, they may be seen as a modified utility token test, or they may be regarded as something else. Regrettably, given the SEC’s actions to date, it will probably take an act of Congress to move regulation in this direction. Nonetheless, the need for a clearer, more reasonable path to regulatory compliance is illustrated by SEC vs. Ripple, where no fraud is alleged, yet the SEC waited to bring an enforcement action for more than seven years after the company began selling its token.