Is Crypto Money Or Security? A case involving the SEC can provide guidance – Technology

  Is Crypto Money Or Security?  A case involving the SEC can provide guidance - Technology

Kane Russell Coleman Logan

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On December 22, 2020, the SEC filed a lawsuit against Ripple Labs, Inc.
(“Ripple”), and two of its executives, alleging that
the defendants failed to register the cryptocurrency XRP with the
SEC or satisfy any exemption from registration, in violation of
federal securities laws. As of the date of this writing, XRP is
currently the eighth largest cryptocurrency with a market
capitalization of approximately $53 billion.

What started with Bitcoin in 2009 has developed into a market of
over 6,500 digital assets increasingly competing with traditional
products offered by financial institutions. The rapid expansion of
digital assets, including cryptocurrencies, has led to increased
regulatory scrutiny in which the key question is whether these
assets should be classified as currencies or securities. This
classification is significant because it determines the laws and
regulations applicable to a particular asset. Determining whether a
cryptocurrency is actually a currency or security is challenging.
But a lawsuit filed by the Securities and Exchange Commission
(“SEC”) at the end of last year, which is currently
pending in the United States District Court for the Southern
District of New York, will likely provide additional guidance on
this issue.

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  • 09 November 2021

In recent years, the SEC has ruled that the two largest
cryptocurrencies by market capitalization, Bitcoin ($1.2 Trillion)
and Ethereum ($533 billion) are not securities, partly on the
grounds that they are decentralized with no person or company in
control of the cryptocurrencies. XRP differs from Bitcoin and
Ethereum in that the latter are created in a gradual process called
mining in which the tokens are created over time. By contrast, 100
billion units of XRP were all created in 2012 for Ripple. Ripple
presently owns the majority of XRP and is selling it in scheduled
allotments. This arrangement has led some observers to view XRP
more like a company’s stock than a currency.

In order to determine whether XRP is a security, the Southern
District of New York will apply what is known as the “Howey
test”-a test developed by the United States Supreme Court in
1946 in SEC v. W.J. Howey Co., 328 U.S. 293 (1946)-to
evaluate whether certain transactions qualify as “investment
contracts.” Under the Howey Test, a transaction is an
investment contract if: (1) it is an investment of money; (2) there
is an expectation of profits from the investment; (3) the
investment of money is in a common enterprise; and (4) any profit
comes from the efforts of a promoter or third party. The first
prong of the Howey test is typically satisfied in an offer
and sale of a digital asset because the digital asset is purchased
or otherwise acquired in exchange for value, whether in the form of
currency or other consideration. Further, in evaluating digital
assets, courts have typically found that a “common
enterprise” exists. Therefore, the main issues in analyzing a
digital asset under the Howey Test are whether there is an
expectation of profits from the investment and whether those
profits come from the effort of a promoter or third party.

In determining whether a reasonable expectation of profits
exists, the SEC has issued guidance stating that the more of the
following characteristics that are present, the more likely it is
that there is a reasonable expectation of profit:
The digital asset gives the holder rights to share in the
enterprise’s income or profits or to realize gain from capital
appreciation of the digital asset;

The digital asset is transferable or traded on or through a
secondary market or platform, or is expected to be in the

Purchasers would reasonably expect that a promoter or third
party’s efforts would result in capital appreciation of the
digital asset and therefore be able to earn a return on their

The digital asset is offered broadly to potential purchasers as
compared to being targeted to expected users of the goods or
services or those who have a need for the functionality of the

There is little apparent correlation between the purchase /
offering price of the digital asset and the market price of the
particular goods or services that can be acquired in exchange for
the digital asset;

A promoter or third party has raised an amount of funds in
excess of what may be needed to establish a functional network or
digital asset;

A promoter or third party is able to benefit as a result of
holding the same class of digital assets as those being distributed
to the public;

A promoter or third party continues to expend funds from
proceeds or operations to enhance the functionality or value of the
network or digital asset; and

The digital asset is marketed, directly or indirectly, using
the expertise of a promoter or third party, based on the future
(and not present) functionality of the digital asset, based on
promises to build a business or operation versus currently
available goods, and promising appreciation in value.

In evaluating whether any profit comes from the efforts of a
promoter or third party, the SEC has issued guidance stating that
the inquiry into whether a purchaser is relying on the efforts of
others focuses on two key issues: (1) does the purchaser reasonably
expect to rely on the efforts of a promoter or third party; and (2)
are those efforts the undeniably significant ones (including the
essential managerial efforts which affect the failure or success of
the enterprise) as opposed to efforts that are more ministerial in
nature. If a digital asset has the aforementioned characteristics, it is
highly likely that the SEC will consider it to be a security
subject to the SEC’s registration requirements. Indeed, it
appears that the SEC views most cryptocurrencies as securities. However, the SEC has provided some guidance on the
characteristics of digital assets which are less likely to be
considered securities. In particular, digital assets with the
following characteristics are less likely to meet the
Howey test:

The distributed ledger network and digital asset are fully
developed and operational.

Holders of the digital asset are immediately able to use it for
its intended functionality on the network, particularly where there
are built-in incentives to encourage such use.

The digital assets’ creation and structure is designed and
implemented to meet the needs of its users, rather than to feed
speculation as to its value or development of its network.

Prospects for appreciation in the value of the digital asset
are limited. For example, the design of the digital asset provides
that its value will remain constant or even degrade over time, and,
therefore a reasonable purchaser would not be expected to hold the
digital asset for extended periods as an investment.

With respect to a digital asset referred to as a virtual
currency, it can immediately be used to make payments in a wide
variety of contexts, or acts as a substitute for fiat

Any economic benefit that may be derived from appreciation in
the value of the digital asset is incidental to obtaining the right
to use it for its intended functionality.

The digital asset is marketed in a manner that emphasizes the
functionality of the digital asset, and not the potential for the
increase in market value of the digital asset.

Potential purchasers have the ability to use the network and
use (or have used) the digital asset for its intended

Restrictions on the transferability of the digital asset are
consistent with the asset’s use and not facilitating a
speculative market.
Essentially, the SEC’s guidance provides that the
Howey test may be avoided where there is a specific use
case for a digital asset and the asset has limited prospects for
appreciation-characteristics which are not present in the vast
majority of cryptocurrencies. Indeed, most crypto developers create
their digital asset first and develop a use case after introducing
the asset. This approach likely results in the creation of an asset
that will violate SEC regulations in the event that the asset is
not registered. Although the SEC’s case against Ripple is
ongoing, it will likely provide additional insight as to how the
factors set forth in Howey should be applied to digital
assets. But given the numerous regulations that may apply,
developers should coordinate with counsel to avoid violations of
SEC requirements, money transfer regulations and the other laws
that may apply to their digital creations.

Mitigating Supply Chain Cyber Risk Wilson Elser Moskowitz Edelman & Dicker LLP

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