The SEC needs to get philosophical

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Todd Phillips is principal of Phillips Policy Consulting, and a fellow with the Roosevelt Institute.

The crypto industry got a rare win last week after a shocking ruling from a New York federal judge. But Judge Analisa Torres’s opinion in SEC vs. Ripple Labs makes for strange securities law, and if the SEC wants to win an appeal, it needs to get philosophical.

Unsurprisingly, the crux of the lawsuit is whether a crypto token is a security or not.

The SEC, as it has done in all its crypto-related cases, made the Howey test the centre of its argument. Named after the 1946 case SEC vs. W.J. Howey Co., the Howey test states that a contract, transaction, or scheme is an “investment contract,” and therefore a security, if a four-factor test is met: There is an (1) investment of money in (2) common enterprise with (3) the expectation of profits gained from (4) the efforts of others. If any of the four factors is missing, there is no investment contract, no security, and no need to comply with securities laws.

In its filings, the SEC argued that the XRP token, issued by Ripple Labs, was sold as an investment contract. And because the test to determine whether an “investment contract” exists is the Howey test, the SEC asked Judge Torres to apply the test.

And did she ever. Judge Torres did what the SEC asked her to do and applied the Howey test to Ripple’s distributions of XRP. And then she applied it again. And again. And again. She decided that only sometimes are XRP sales subject to the securities laws, depending on the facts specific to each purchase.

Her ruling states that XRP tokens are not themselves securities. Then it “examine[s] the totality of circumstances surrounding [Ripple Lab’s] different transactions and schemes involving the sale and distribution of XRP” under Howey to decide whether each type of sale constituted an investment contract.

So when Ripple sold XRP to institutional investors, those sales were securities because the buyers “expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP.”

But when XRP tokens were sold in the secondary market via an exchange, those were not securities; these sales were “blind bid/ask transactions, [purchasers] could not have known if their payments of money went to Ripple” or instead went to some other seller of XRP. And when Ripple paid employees with XRP, those were also not securities because the employees didn’t invest money in Ripple in exchange for the tokens.

Crypto advocates are clearly overjoyed about this result. But it is downright strange from a traditional securities-law perspective.

To understand why, it is necessary to examine the nature of traditional securities. Corporate stock is about as close to the platonic form of a security as one can get, and we can learn about how the securities laws should apply to XRP and other crypto tokens by examining how they apply to stock. Say Judge Torres’s logic was applied to a company’s stock, which is just a piece of paper (or, today, an entry in a DTCC database). When a company sells stock certificates via an IPO, both Judge Torres’s logic and traditional securities law say that they are securities. But if the company gives stock certificates to employees as a part of their pay, Judge Torres would say they are not securities, while traditional securities law says that they are. And if the firm sells stock via an exchange? The ruling implies they are not securities either, but the core premise of the Securities Exchange Act posits that they are. US securities laws are premised on corporate stock being securities.

Of course, crypto advocates claim this type of analysis is misleading, arguing that stock certificates are securities because Congress listed “stock” as one of the many assets that are securities, so applying the Howey test to stock is unnecessary. These advocates are wrong. In fact, the Supreme Court held in 1975 that some stock is not covered by US securities law. In United Housing Foundation, Inc. vs. Forman, the Supreme Court looked at a stock certificate offered by a housing co-op, which required prospective tenants to purchase 18 shares of this stock for each room desired. The Court applied Howey and decided that these certificates were not “stock” under the federal securities laws.

It is not simply that stock certificates are bought and sold as part of an investment contract that makes them securities. Instead, it is, as the Forman Court explained, “the presence of” the four factors that constitute the Howey test: The presence of an investment, a common venture, expectations of profit, and another’s managerial efforts. The stock certificate is the representation of the security.

I expect the SEC to appeal Judge Torres’s Ripple decision and continue litigating its cases against Coinbase, Binance and others. But apparently it can’t simply claim “Howey” to win. I don’t know whether XRP is as much of a representation of a security as a stock certificate is, but if the SEC wants to win, it needs to get philosophical about why it thinks certain assets are securities and others are not.