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…