Looking at the approach of US agencies over the past two years, it’s hard not to miss the days when regulatory concerns and opinions hadn’t really ventured beyond “if something is illegal without crypto, it’s still definitely illegal with crypto”.

The early days when the Silk Road, ransomware attacks, and run of the mill money laundering where the dominant (or even only) concerns that regulators had about crypto seem like a lifetime ago. Even though just 3 years ago, we saw every attempt to effectively curtail the use of local wallets balanced by equally strong support from another political or regulatory contingent elsewhere in the US government.

While many of us thought the US could be permanently closed to web3 and crypto, this week has provided reason for optimism.

https://opensea.io/assets/ethereum/0x028532526d75BC5B4817624059eA936598C6769f/0

Thursday (July 13th) saw the release of an order from Judge Analisa Torres in the ongoing case between the SEC and Ripple Labs, creator of $XRP. While many of us hoped for an update like this, I don’t know anyone who expected a win of this magnitude.

So what happened?

The case against Ripple was first filed by the SEC in December of 2020. The SEC alleged that Ripple, in selling and distributing $XRP, its native crypto-token, violated US securities law by failing to register these sales with the SEC.

The SEC argues that $XRP was sold as an “investment contract”, making it subject to their jurisdiction per the 1933 Securities Act. As the definition of an investment contract is not cut and dry, Ripple counters this allegation, claiming that they were under no obligation to register the sales.

Although there is no definition of an investment contract found in the 1933 Securities Act, the US Supreme Court did provide a test to decide if something is an investment contract when it ruled on a case about a citrus grove. Depending on how you slice it, the Howey Test has either 3 or 4 prongs that must all hold true for a transaction to be considered an investment contract.

Directly from Judge Torres…

In SEC v. W.J. Howey Co., the Supreme Court held that under the Securities Act, an investment contract is “a contract, transaction[,] or scheme whereby a person [(1)] invests his money [(2)] in a common enterprise and [(3)] is led to expect profits solely from the efforts of the promoter or a third party.”

It is through applying this test that the requests for summary judgement made by Ripple and SEC were decided this week.

Defending the lawfulness of their sales, Ripple advanced a novel theory suggesting that in addition to the Howey Test, there is a second “essential ingredients” test that must be applied as well. Ripple’s team argues for 3 essential ingredients to an investment contract.

(1) “a contract between a promoter and an investor that establishe[s] the investor’s rights as to an investment,” which contract (2) “impose[s] post-sale obligations on the promoter to take specific actions for the investor’s benefit” and (3) “grant[s] the investor a right to share in profits from the promoter’s efforts to generate a return on the use of investor funds.”

Judge Torres, in my opinion rightfully so, quickly dismisses Ripple’s essential ingredients argument for two key reasons.

First, Ripple failed to provide a single example of this test being applied since the Securities Act was passed nearly 90 years ago. Second, this test requires an extremely narrow interpretation of securities laws that were explicitly designed to be flexible and to focus on intent and circumstances over precise legalese and technicality. An excellent quote from the 5th Circuit Court of appeals captures the intended flexible nature of US securities law quite aptly,

The securities laws are intended to protect investors, not merely to test the ingenuity of sophisticated corporate counsel.

Having provided a token win to the SEC in dismissing Ripple’s essential ingredients test, Judge Torres next confirms a line of argument that many have long advocated for. She separates $XRP as an asset from the sale of $XRP as a transaction, noting that while “ordinary assets--like gold, silver, and sugar--may be sold as investment contracts” the gold, silver, or sugar are not themselves investment contracts beyond that particular transaction.

In this way, the Court affirms the view found in the case between the SEC and Telegram that securities law must be applied to particular transactions, taking into account those specific facts and circumstances, and cannot simply be cast generally against an asset.

With the groundwork in place, Judge Torres next divides Ripple’s sale of $XRP into three buckets:

1. Direct sales to institutional investors totaling $728 million;

2. Programmatic sales through crypto exchanges totaling $757 million;

3. Compensation provided to partners and employees totaling $609 million.

For the $728 million in direct sales to investors, it was ruled that these were in fact investment contracts and thus unregistered securities sales. Ripple’s institutional buyers “provide[d] the capital” into Ripple’s “common enterprise” where their funds were pooled together and, based on Ripple’s marketing to investors, these buyers expected that they would “derive profits from Ripple’s efforts”.

While I don’t think we should find any of this reasoning surprising, it’s definitely worth noting for anyone considering their own token sales that the existence of lockup provisions is highlighted by Judge Torres. The fact that investors are subject to lockups and restrictions is considered as additional evidence that these tokens were purchased for speculative profit rather than utility.

This is a loss for Ripple to be sure as they are now potentially subject to recission, meaning the sales can be cancelled and Ripple is open to some pretty major liability. For well meaning crypto actors thought, this is still a fairly narrow decision that can easily be accommodated.

Turning to the programmatic sales of $XRP through exchanges, US crypto scores its second major win.

In considering the process of how Ripple sold its tokens through existing exchange markets, the ruling keys in on the fact that these sales “were blind bid/ask transactions”. Buyers purchasing $XRP through these exchanges “could not have known if their payments of money went to Ripple". Coupled with this lack of knowledge regarding whom they were buying from is the simple fact that because these sales ehere happening in an already deep market, only a very small portion of the buyers (less than 1%) were actually providing money to Ripple.

Even if buyers expected profits from purchasing $XRP, they could not have expected that this profit would come from Ripple efforts in using the proceeds of their sales because they simply did not know if their money was even going to Ripple in the first place.

Finally, when answering the status of the $609 million in other distributions, Judge Torres quickly dismisses the SEC’s arguments on the grounds that there was no “tangible and definable consideration” paid to Ripple. Put simply, these distributions, made part of compensation and incentive programs fail to qualify as securities transactions under Howey Test as their is no investment of money.

Overall, the ruling on Thursday was certainly a win for the entire web3 sector in the US. Having co-founded two blockchain startups right here in Texas, I know first hand the amazing talent and potential that countless developers and changemakers in the US have and the genuine desire of so many individuals and teams to use web3 to solve real and exciting problems.

Parts of this case will still be moving to trial and appeals from the SEC are likely inevitable, but if this ruling holds, I think the next few years will see a lot of promising crypto innovation begin to take root again here in the US as our industry begins to receive what we have long asked for, clarity and an opportunity to prove the value of our innovation.

For anyone interested, I highly recommend reading the actual order from Judge Torres, linked here. It’s both insightful and surprisingly accessible.

None of this has been legal or financial advice, I’m not a lawyer or finance professional in any sense, just someone with the scars of 12 years in crypto. If you disagree or have questions about anything I’ve written, I’d love to hear from you.

Looking at the approach of US agencies over the past two years, it’s hard not to miss the days when regulatory concerns and opinions hadn’t really ventured beyond “if something is illegal without crypto, it’s still definitely illegal with crypto”.

The early days when the Silk Road, ransomware attacks, and run of the mill money laundering where the dominant (or even only) concerns that regulators had about crypto seem like a lifetime ago. Even though just 3 years ago, we saw every attempt to effectively curtail the use of local wallets balanced by equally strong support from another political or regulatory contingent elsewhere in the US government.

While many of us thought the US could be permanently closed to web3 and crypto, this week has provided reason for optimism.

https://opensea.io/assets/ethereum/0x028532526d75BC5B4817624059eA936598C6769f/0

Thursday (July 13th) saw the release of an order from Judge Analisa Torres in the ongoing case between the SEC and Ripple Labs, creator of $XRP. While many of us hoped for an update like this, I don’t know anyone who expected a win of this magnitude.

So what happened?

The case against Ripple was first filed by the SEC in December of 2020. The SEC alleged that Ripple, in selling and distributing $XRP, its native crypto-token, violated US securities law by failing to register these sales with the SEC.

The SEC argues that $XRP was sold as an “investment contract”, making it subject to their jurisdiction per the 1933 Securities Act. As the definition of an investment contract is not cut and dry, Ripple counters this allegation, claiming that they were under no obligation to register the sales.

Although there is no definition of an investment contract found in the 1933 Securities Act, the US Supreme Court did provide a test to decide if something is an investment contract when it ruled on a case about a citrus grove. Depending on how you slice it, the Howey Test has either 3 or 4 prongs that must all hold true for a transaction to be considered an investment contract.

Directly from Judge Torres…

In SEC v. W.J. Howey Co., the Supreme Court held that under the Securities Act, an investment contract is “a contract, transaction[,] or scheme whereby a person [(1)] invests his money [(2)] in a common enterprise and [(3)] is led to expect profits solely from the efforts of the promoter or a third party.”

It is through applying this test that the requests for summary judgement made by Ripple and SEC were decided this week.

Defending the lawfulness of their sales, Ripple advanced a novel theory suggesting that in addition to the Howey Test, there is a second “essential ingredients” test that must be applied as well. Ripple’s team argues for 3 essential ingredients to an investment contract.

(1) “a contract between a promoter and an investor that establishe[s] the investor’s rights as to an investment,” which contract (2) “impose[s] post-sale obligations on the promoter to take specific actions for the investor’s benefit” and (3) “grant[s] the investor a right to share in profits from the promoter’s efforts to generate a return on the use of investor funds.”

Judge Torres, in my opinion rightfully so, quickly dismisses Ripple’s essential ingredients argument for two key reasons.

First, Ripple failed to provide a single example of this test being applied since the Securities Act was passed nearly 90 years ago. Second, this test requires an extremely narrow interpretation of securities laws that were explicitly designed to be flexible and to focus on intent and circumstances over precise legalese and technicality. An excellent quote from the 5th Circuit Court of appeals captures the intended flexible nature of US securities law quite aptly,

The securities laws are intended to protect investors, not merely to test the ingenuity of sophisticated corporate counsel.

Having provided a token win to the SEC in dismissing Ripple’s essential ingredients test, Judge Torres next confirms a line of argument that many have long advocated for. She separates $XRP as an asset from the sale of $XRP as a transaction, noting that while “ordinary assets--like gold, silver, and sugar--may be sold as investment contracts” the gold, silver, or sugar are not themselves investment contracts beyond that particular transaction.

In this way, the Court affirms the view found in the case between the SEC and Telegram that securities law must be applied to particular transactions, taking into account those specific facts and circumstances, and cannot simply be cast generally against an asset.

With the groundwork in place, Judge Torres next divides Ripple’s sale of $XRP into three buckets:

1. Direct sales to institutional investors totaling $728 million;

2. Programmatic sales through crypto exchanges totaling $757 million;

3. Compensation provided to partners and employees totaling $609 million.

For the $728 million in direct sales to investors, it was ruled that these were in fact investment contracts and thus unregistered securities sales. Ripple’s institutional buyers “provide[d] the capital” into Ripple’s “common enterprise” where their funds were pooled together and, based on Ripple’s marketing to investors, these buyers expected that they would “derive profits from Ripple’s efforts”.

While I don’t think we should find any of this reasoning surprising, it’s definitely worth noting for anyone considering their own token sales that the existence of lockup provisions is highlighted by Judge Torres. The fact that investors are subject to lockups and restrictions is considered as additional evidence that these tokens were purchased for speculative profit rather than utility.

This is a loss for Ripple to be sure as they are now potentially subject to recission, meaning the sales can be cancelled and Ripple is open to some pretty major liability. For well meaning crypto actors thought, this is still a fairly narrow decision that can easily be accommodated.

Turning to the programmatic sales of $XRP through exchanges, US crypto scores its second major win.

In considering the process of how Ripple sold its tokens through existing exchange markets, the ruling keys in on the fact that these sales “were blind bid/ask transactions”. Buyers purchasing $XRP through these exchanges “could not have known if their payments of money went to Ripple". Coupled with this lack of knowledge regarding whom they were buying from is the simple fact that because these sales ehere happening in an already deep market, only a very small portion of the buyers (less than 1%) were actually providing money to Ripple.

Even if buyers expected profits from purchasing $XRP, they could not have expected that this profit would come from Ripple efforts in using the proceeds of their sales because they simply did not know if their money was even going to Ripple in the first place.

Finally, when answering the status of the $609 million in other distributions, Judge Torres quickly dismisses the SEC’s arguments on the grounds that there was no “tangible and definable consideration” paid to Ripple. Put simply, these distributions, made part of compensation and incentive programs fail to qualify as securities transactions under Howey Test as their is no investment of money.

Overall, the ruling on Thursday was certainly a win for the entire web3 sector in the US. Having co-founded two blockchain startups right here in Texas, I know first hand the amazing talent and potential that countless developers and changemakers in the US have and the genuine desire of so many individuals and teams to use web3 to solve real and exciting problems.

Parts of this case will still be moving to trial and appeals from the SEC are likely inevitable, but if this ruling holds, I think the next few years will see a lot of promising crypto innovation begin to take root again here in the US as our industry begins to receive what we have long asked for, clarity and an opportunity to prove the value of our innovation.

For anyone interested, I highly recommend reading the actual order from Judge Torres, linked here. It’s both insightful and surprisingly accessible.

None of this has been legal or financial advice, I’m not a lawyer or finance professional in any sense, just someone with the scars of 12 years in crypto. If you disagree or have questions about anything I’ve written, I’d love to hear from you.