At a recent event, crypto policy scholars discussed the Security and Exchange Commission’s lawsuit against fintech startup Ripple and how the case amounted to “regulation by enforcement.” They suggest that the abrupt decision was an attempt by the SEC to sidestep Congress for the needed procedural step to clarify the SEC’s authority in statute. The abrupt determination, after 7 years, that Ripple’s XRP payment protocol and distributed ledger is not a currency but rather a security, has caused many currency exchanges to delist XRP and XRP holders have lost billions of dollars in value. It is hardly the first time that a regulatory agency has overstepped its authority, causing widespread damage to markets, innovators, and consumers. The SEC justified its action under the so-called Howey Test, which comes from a 1946 Supreme Court case which defines the meaning of an “investment contract” within the Securities Act of 1933. Admittedly vague, the Howey Test defines securities as invested contracts dependent on the efforts of others. The scholars suggested that the SEC itself needs a “Ripple Test”, a set of clear, transparent, and objective guidelines on whether an asset like cryptocurrency is a security.
Two explicit criteria required
John Berlau of the Competitive Enterprise Institute suggests two minimum requirements to determine whether a digital asset is a security: (a) an explicit promise of ownership or share of the firm’s revenues or profits, and (b) an explicit promise of return on investment. Berlau suggests that these two disclosures are necessary to distinguish cryptocurrency investment from the larger world of investment in which the SEC has no jurisdiction even though vendors hawk the investment value of art, comic books, action figures, cars, and other collectibles. Notably, this determination should be defined in statue by Congress, lest the SEC will continue to freelance on ever-expanding regulatory turf as seen presently in the fractionalized non-fungible tokens (NFTs) used for the distribution of digital art.
Berlau notes that state and federal fraud statues already encompass cryptocurrencies and that these laws could be further clarified to assign jurisdiction of cryptocurrency to a specific agency. However if the assets don’t convey ownership or promised return on investment then they should not be subject to regulation. Notably the Sarbanes-Oxley framework already limits opportunities for legitimate investors and entrepreneurs in the field. Berlau describes these issues in Cryptocurrency and the SEC’s Limitless Power Grab.
Assumption of investment with exception from SEC registration
University of Arkansas School of Law’s Carol Goforth has written extensively on the notion of a Ripple Test. She suggests that all cryptoassets should be classified as securities so that the antifraud provisions could be enforced to protect consumers. However there would be exemptions from SEC registration for certain kinds of cryptoassets under her model. Goforth notes the following conditions which would exempt the asset from registration:
- the issuer notifies the SEC of a planned sale or distribution with a description of the terms of the issuance and the nature of the asset, including the rights that purchasers are acquiring as a result of ownership of the asset
- if neither the issuer nor its affiliates or control persons have been convicted of fraud or are the subject of a stop order or similar decree issued by the SEC or pursuant to an action by the SEC within 5 years of the date of the sales
- information about the general terms or functionality of the blockchain on which the cryptoassets are issued is publicly available at the time of issuance, including how many assets are authorized, how many of the assets are controlled by the issuer or its affiliates or control persons, and the general conditions that must be met before assets are issued or the issuer can sell the assets
- the cryptoassets are functional at the time of the sale, and the proceeds of the sale are not needed or intended to support development of the token’s functionality (provided that the general assets of the issuer may be used to support additional or improved functions, even if part of those assets are derived from the sale of the cryptoassets)
- the issuer specifically avoids selling the token by promoting the possibility of appreciation or profitability or otherwise as a speculative investment
- the asset does not give the purchaser a right to any share of or interest in the management, profits, or assets of the issuer
- the issuer does not have the unilateral right to modify the terms of the underlying blockchain or programming
- a 2 year statute of limitations on litigation over a company’s failure to register, to be stayed by initiation of an administrative enforcement action, with the start of that period beginning when the SEC reasonably learns the facts relative to the sales.
Goforth is appalled that the SEC would wait so long prior to initiating its action against Ripple and says that Congress must reign in the agency.
Other frameworks for cryptocurrencies
Bronwyn Howell, an expert in digital economy, notes the deficiency of the SEC’s approach to distributed ledger systems (DLS), which focuses on funding, rather than the function. She observes that tokens can exhibit some characteristics of securities, but they perform very different functions and hence need a new regulatory framework which takes into account applications and users. This has also been described as the utility token approach, developed in statute in Montana and Wyoming.
Mathematician Petrus Potgieter observes that any expectation of profit from ownership is significantly related to the general outlook on cryptocurrencies and not solely to the efforts of Ripple Labs. He cites the evidence that XRP’s fluctuation is highly correlated (around 0.3) with Bitcoin and supports a “Ripple Test” which would recognize that the asset may have some aspect of a currency, have no explicit claim of profit, and whose value is not solely attributed to the efforts of the promoter or third party.
Berlau and Goforth are two among many scholars which have detailed the overreach at the SEC. Nobel Prize Economist George Stigler introduced the term regulatory capture in 1971 in an article describing the SEC to describe how the agency came to be dominated by the interests it regulate and not by the public interest, consumers, or voters. Stigler’s groundbreaking study documented how the SEC systematically engaged in misinformation to justify intervention in the market. The egregious lawsuit by the SEC against Ripple has ignited outrage in the cryptocurrency community and a counter lawsuit, putting the SEC itself on trial. A Ripple Test could create the humility the SEC needs to determine first whether it is in the right to pursue regulatory action.