December 06, 2023 - 6 min read
It didn’t always look so good, but a few recent wins have started to give hope to many that crypto won’t be regulated away so easily.
Since 1973, SWIFT has provided the international infrastructure for cross-border, interbank payment services through a private messaging network. It set the standard for how most nations around the world conduct business, or how some of us wire money to our relatives abroad. However, it has meant that a third party is always needed to clear and settle transactions between individuals.
While SWIFT has its benefits, it is undoubtedly a bit inefficient as it involves several steps which must be taken during business hours. This can create days of lag when it comes to operating in time zones on opposite sides of the world. This is totally unacceptable when it comes to digital money.
Naturally, the use of SWIFT also means that transactions don’t ever settle on holidays, evenings, or weekends. It is also prone to censorship and perhaps even frozen assets. In fact, several sanctioned nations and their people are currently excluded from SWIFT altogether.
The status quo left a void which would be filled by one company or another. There are people to serve and the technology to offer a better user experience has been around for decades. It is also not surprising that the powerful establishment players first ignored, and then later sought to stifle the emerging competition in a variety of ways, one of which happens to be litigation.
The demand for upgraded financial infrastructure takes many forms, but it is difficult to make a case for clinging to technology from the early 1970’s. This leads us to the present day and the proliferation of digital assets and smart contract networks.
Ripple is a blockchain company that sought to answer this demand by providing a cheaper and more efficient network for domestic and international payments. One of the most prominent use cases for this took the form of cheaper cross-border payments and remittances from abroad back to family members.
Back in 2013, Ripple Labs sold their native cryptocurrency XRP in a variety of ways. Consequently, the US Securities and Exchange Commission (SEC) filed a lawsuit against Ripple Labs in 2020, alleging that unregistered securities had been sold illegally.
Many have argued that this is simply a power play by a regulatory agency with economic interests and a political status quo to protect. In order to get a grasp on the situation and how this whole Ripple ordeal will create ripple effects throughout the crypto and finance sectors.
The Securities Act of 1933 was enacted by federal legislation during the Great Depression, aimed at regulating the selling of financial products on the New York stock exchange. The act was a response to the stock market crash of 1929, using the ensuing economic downturn and financial calamity to push through increased federal oversight in private markets. Of course, the legislation was sold to the public as a way to restore investor confidence and protect the public from fraudulent activities that might lead to further catastrophic losses.
A few key provisions of the Act include registration of securities with the SEC before they can be offered for sale to the public. This registration process requires declarations of the company’s financial conditions, company management, and the nature of the securities being offered.
The Act also prohibits fraudulent activities, like misrepresentations and omissions of material facts in the offering of what the SEC deems to be securities. Whether or not a financial product is a security is really opaque, and has only been determined by something called the Howey Test used in a 1946 Supreme Court decision. We’ll get to that in just a moment.
It also established civil liabilities for violations. Investors who suffer losses due to material misstatements or omissions in a registration statement may bring lawsuits against the parties responsible, creating disincentives for tomfoolery.
Remember that the SEC’s action against Ripple was centered around the belief that the sale of digital tokens like XRP is an investment contract, or a security according to the Securities Act. The SEC alleged that Ripple and two of its executives raised over $1.3 billion from the sale of XRP through unregistered securities offerings, violating Section 5.
In contrast, Ripple rejected the presumption that XRP is a security, and therefore believed they didn’t need to publicly file registration documents with the SEC. Courts ruled partially in favor of the SEC, only granting the SEC’s motion as it related to institutional sales of XRP. All other SEC motions were denied.
Of course, to appreciate the full impact of the ongoing litigation, it’s necessary to understand the legal standard by which the case was tried. That is to say we need to revisit Securities regulations and more specifically, the Howey test.
The SEC v. W.J. Howey Co. (1946) decision found that three characteristics could determine whether an investment contract would be a security, and, therefore, subject to securities regulations. The Howey Test helps one determine a security by considering the following:
This leads us to some of the most recent findings coming out of New York’s district courts.
On October 19, a NY District Court judge dismissed (with prejudice) the SEC’s allegations against Ripple executives Brad Garlinghouse and Christian Larsen for selling unregistered securities via XRP. However, the judge ruled that institutional sales of XRP was actually a violation of the Securities Act via unregistered offers and sales of investment contracts.
The Court found that institutional sales of XRP passed the Howey Test, specifically that reasonable investors would have purchased XRP with the expectation of profiting from Ripple’s efforts. On the other hand, programmatic sales of XRP were ruled to not have constituted the sale of unregistered securities as they did not fully pass the Howey Test.
The logic used in the ruling was that none of the Programmatic Buyers were aware that they were buying XRP from Ripple, and so may have expected profits from market trends rather than the efforts of Ripple themselves. Since executives had anonymously sold XRP on various exchanges, the sales didn’t really satisfy the third prong of the Howey Test, similar to the court’s ruling on programmatic sales of XRP.
In short, the Court ruled in favor of the SEC, granting its motion as it related to institutional sales of XRP without declaring that the digital asset itself is a security. In other words, the precedent is being set that the particular circumstances surrounding the sale of a digital asset must be examined, and that they are not investment contracts by default.
All other SEC motions were denied, and public figureheads like Gary Gensler have publicly voiced their disappointment in the court’s findings. That is to say that it is still a controversial case. Following the ruling, Coinbase relisted XRP on its platform.
Despite regulatory scrutiny, the emergent nature of innovation in the crypto industry continues to flourish. However, we can set a precedent now as to whether or not the crypto industry will be welcome in the US or fear punitive legal action.
Nobody is really arguing that crypto shouldn’t be subject to increased regulation, but punishing builders for innovating faster than the law can keep up is hardly a way to create such an environment. At the very least, if the SEC wants to establish rules governing digital assets then they need to use a softer, grandfather clause approach.
That is to say that a new rule will apply to all future cases while exemptions are made for those who have been “grandfathered” in. This is the most sensible approach as it adheres to the notion of rule of law, which is inherently neutral, as opposed to rule by law, which is contrastingly more punitive, and in some cases can have the appearance of selective enforcement.
On its face, the recent court rulings appear to be positive for digital asset firms and users. However, it may be too early to celebrate except for the lawyers who will surely continue fighting this case for the SEC in other courts. As such, political wins will be as important as technological innovations in the months and years to come. We can only get in our own way now.
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