On May 22, 2010, 10,000 Bitcoin (“BTC”) were exchanged for two Papa John’s pizzas.[1] Because BTC was the first cryptocurrency, this was the first publicly known transaction involving cryptocurrency.[2] Just a little over a decade later, the price per BTC reached $68,000.[3] To put this in perspective, the amount of BTC paid per slice from one of the Papa John’s pies purchased in 2010 would have been worth $42,500,000 in 2021.[4]
The cryptocurrency market reached three trillion dollars at its peak in 2021, which sent shockwaves throughout the economy.[5] One survey showed that 11% of people quit their jobs because of the cryptocurrency boom. In a different survey, 11.6 % of first-time home buyers said that gains earned during the cryptocurrency boom went toward their down payments.[6]
As the cryptocurrency market grew in the years leading up to 2021, cryptocurrencies caught the attention of the Securities and Exchange Commission (the “SEC”).[7]
The Supreme Court’s Test
For the SEC to have jurisdiction, the cryptocurrency in question must constitute a security.[8] The Securities Act of 1933 identifies investment contracts as securities.[9] Whether an asset constitutes an investment contract depends on a test the Supreme Court laid out in SEC v. W.J Howey (the “Howey Test”).[10] The Howey Test says that an investment contract is formed when there is an investment of money made in a common enterprise and the investors’ expectation of profit is to be derived from efforts of others.[11]
The SEC’s Application of the Howey Test
William Hinman, the former SEC Director of Division of Corporation Finances, addressed the SEC’s jurisdiction over cryptocurrencies in a speech he gave at the Yahoo Finance All Market Summit in 2018.[12] In Hinman’s eyes, many coins constituted securities.[13] By likening coins to the orange groves in Howey, Hinman determined that many cryptocurrencies constituted investment contracts.[14] While the orange groves and coins, on their own, would not constitute securities, the focus under the Howey Test is on how the alleged investment contract is being sold and what the reasonable expectations of the purchasers are.[15] Although digital assets are just code, Hinman reasoned that they can become an investment contract if they are sold to investors with the understanding that the investors will see a return on their investment, resulting from the efforts of others.[16]
Hinman pointed out that the Securities Act of 1934 was intended to protect investors from harms associated with asymmetrical information.[17] Under federal securities laws, promotors are subject to disclosure requirements and are held liable for their misrepresentative statements.[18] Therefore, treating cryptocurrencies as securities makes sense because the investors’ successes are reliant on the promoters’ efforts.[19] As such, asymmetrical information would impede the investors’ ability to make sound decisions regarding their investments.[20]
Hinman conceded that “sufficiently decentralized” coins may not be securities under a Howey analysis because purchasers would not rely on a promoter or group of promoters for the success of the coin or investment.[21] Notably, Hinman claimed that some cryptocurrencies—such as Ethereum (“ETH”)—are in fact already “sufficiently decentralized.”[22] Setting aside ETH’s crowdfunding, Hinman believed that ETH had reached a state of decentralization that no longer required the SEC’s oversight.[23] Hinman added that other cryptocurrencies may too reach a point where they become “sufficiently decentralized.”[24]
Subsequently, the Chair of the SEC, Gary Gensler, confirmed the application of the Howey Test in the context of cryptocurrencies.[25] Echoing Hinman’s views on the SEC’s jurisdiction, Gensler has maintained that many cryptocurrencies are securities.[26] Gensler has highlighted many of Hinman’s same concerns regarding the need to protect investors.[27] One notable difference, however, it that Gensler has never mentioned ETH, and nor has he indicated whether a coin can be “sufficiently decentralized” to a point that it is no longer a security.[28]
SEC v. Ripple
Under Gensler, the SEC filed a lawsuit in December 2020 against Ripple Labs, Inc.[29] In the complaint, the SEC argued that XRP is an investment contract because, among other things, Ripple promised that it would use the funds it generated to create value by developing and maintaining XRP. Therefore, the SEC contends that investors invested in a common enterprise when they purchased XRP because Ripple promised to improve and create value for XRP, leading investors to reasonably expect profits from Ripple’s efforts.[30] To support their claim, the SEC provides a number of examples of Ripple’s conduct.[31]
Ripple insists that XRP is not a security.[32] Among other things, Ripple argues that its sales are just “standard purchase and sale agreements with no promise of efforts by Ripple or future profits.”[33] Also, investors of XRP do not have shares of Ripple nor did Ripple sell XRP as an investment.[34] They argue that because there was no contract, the reasonable expectations of profits requirement under Howey cannot be satisfied.[35] They contend that XRP is a currency because it is a medium of exchange used to move value and facilitate transactions.[36] Furthermore, it is recognized as a currency in other countries such as the United Kingdom and Japan.[37] They also contend that the Department of Justice and Financial Crimes Enforcement Network have labeled XRP as a virtual currency.[38]
Conclusion
Both sides have been fighting for almost two years with Ripple reportedly spending over $100 million.[39] A motion for summary judgement and its replies is due by November 15, 2022, so an end to this legal dispute may be in sight.[40]Though this has been a difficult case, with compelling arguments on both sides, two things are certain: the lawsuit will (1) provide more clarity regarding the SEC’s jurisdiction of cryptocurrencies, and (2) have a “rippling” effect on the cryptocurrency market and the greater economy.
[1] Wayne Duggan, The History of Bitcoin, the First Cryptocurrency, U.S. News & World Rep. U.S, News (Aug. 31, 2021, 3:21 PM), https://money.usnews.com/investing/articles/the-history-of-bitcoin#:~:text=Bitcoin%20(BTC)%20was%20the%20first,currency%20in%20the%20world%20today.
[2] See id.
[3] Id. (explaining that BTC reached its peak in November of 2021, when one BTC was worth roughly $68,000).
[4] Id. (explaining that BTC reached its peak in November of 2021, when one BTC was worth about $68,000). The calculation assumes there were 8 slices per pie of pizza: 10,000 / (2 x 8) = 625. At 625 BTC per slice: 625 x $68,000 = $42,500,000.
[5] Yvonne Lau, Cryptocurrencies hit market cap of $3 trillion for the first time as Bitcoin and Ether reach record highs, Fortune (Nov. 9, 2021, 1:32), https://fortune.com/2021/11/09/cryptocurrency-market-cap-3-trillion-bitcion-ether-shiba-inu/.
[6] Nir Kaissar, Crypto Is Sticking Its Nose Into US Economic Woes, Bloomberg (July 20, 2022, 6:00 AM), https://www.bloomberg.com/opinion/articles/2022-07-20/crypto-is-sticking-its-nose-into-us-economic-woes.
[7] See Crypto Assets and Cyber Enforcement Actions, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/spotlight/cybersecurity-enforcement-actions (last visited Sept. 30, 2022).
[8] See Securities Exchange Act of 1934, 15 U.S.C. § 78d.
[9] Crypto Asset Regulation in the United States: What? Where? When?, Dentons (Aug. 19, 2021), https://www.dentons.com/en/insights/alerts/2021/august/18/crypto-asset-regulation-in-the-united-states-what-where-when.
[10] Id.
[11] Id.
[12] William Hinman, Director, U.S. Sec. Exch. Comm’n, Digital Asset Transactions: When Howey Met Gary (Plastic) (June 14, 2018), https://www.sec.gov/news/speech/speech-hinman-061418.
[13] Id.
[14] See id.
[15] Id.
[16] Id.
[17] Id.
[18] Id.
[19] Id.
[20] Id.
[21] Id.
[22] Id.
[23] Id.
[24] Id.
[25] Gary Gensler, Chair, U.S. Sec. & Exch. Comm’n, Kennedy and Crypto (Sept. 8, 2022), https://www.sec.gov/news/speech/gensler-sec-speaks-090822.
[26] Id.
[27] See id.
[28] See id.
[29] See generally Complaint, Sec. & Exch. Comm’n v. Ripple Labs, Inc., (2020) (No. 20 Civ. 10832).
[30] Id. at 36-57.
[31] See generally id.
[32] See Answer of Def. Ripple Labs, Inc. to Pl.’s Complaint at 2, Sec. Exch. Comm’n v. Ripple Labs, Inc., (2020) (No 20 Civ. 10832).
[33] Id. at 5.
[34] See id. at 4.
[35] See Def.’s Mem. of Law in Support of their Mot. for Summ. J. at 49, Sec. Exch. Comm’n v. Ripple Labs, Inc., (2020) (No. 20 Civ.10832).
[36] See Answer of Def. Ripple Labs, Inc. to Pl.’s Complaint, supra note 29, at 2.
[37] Id.
[38] Id.
[39] Jordan Major, Ripple has spent ‘over $100 million on legal fees fighting SEC’, the CEO says, Finbold (July 16, 2022), https://finbold.com/ripple-has-spent-over-100-million-on-legal-fees-fighting-sec-the-ceo-says/.
[40] Arti, Ripple vs SEC Final Verdict is Nearer Than We Thought! What to Expect?, Analytics Insight (July 28, 2022), https://www.analyticsinsight.net/ripple-vs-sec-final-verdict-is-nearer-than-we-thought-what-to-expect/.
