Amidst worldwide discussions regarding legal status of cryptocurrencies, the Securities and Exchange Commission of the United States of America ("SEC") filed a lawsuit against Ripple Labs, Inc. ("Ripple") on December 22, 2020, which accuses Ripple for unregistered securities offering through sales of XRP token.
Although there have been administrative considerations or interpretations for legal designation of crypto assets to a certain extent, the prospective decision to be rendered by the District Court of Southern District of New York ("Court") is of an important legal value, since it will be the first court ruling for assessing legal status of a crypto asset. This article examines the arguments set forth by SEC and Ripple's defenses in response, for the sake of conducting a comparative assessment with Turkish capital markets law.
I. SEC's Allegations
In brief, the SEC alleges Ripple with unregistered securities sale, though registration of securities is a mandatory requirement under the US Securities Act of 1993 ("Securities Act"). The complaint considers Ripple digital asset (XRP) as a security, and thereby deduces distribution of XRP in exchange for cash, labor service or market-making activities as a security offering.
A. The Howey Test
The SEC applied the landmark "Howey Test" precedent of the US Supreme Court1 ("Howey Test") to XRP and concluded that XRP should be deemed a security throughout its offering. Pursuant to the Howey Test, to determine whether a financial instrument is an "investment contract", the assessed instrument must respectively comprise (i) an investment of money, (ii) in a common enterprise, and (iii) with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.
1. Investment of Money
The complaint does not argue openly that XRP constitutes an investment of money; however, it could be argued that fulfillment of this criterion could not pose any dispute, as XRP was being issued in exchange of values, such as fiat currency, crypto assets, or performance of some services.
2. Common Enterprise
In terms of being a common enterprise the SEC argues that fortunes of XRP investors were tied to each other, as well as to the promoter of XRP, which is Ripple.
Since, "XRP investors stand to profit equally if XRP's popularity and price increase, and no investor will be entitled to a higher proportion of price increases.", the SEC concludes that investing in XRP constitutes a common objective for all investorsThe SEC relied on the fact that Ripple used funds raised by sale of XRP to finance architecting the Ripple platform, and Ripple continues to own majority of outstanding XRP tokens, which means increase in XRP value would bring financial power to Ripple.
3. Reasonable Expectation of Profit Derived from Efforts of Others
According to the SEC's findings, Ripple and its top executives explicitly marketed Ripple by numerous public communication, which are referred in the complaint document, "stating that Ripple's efforts sought to increase "demand" for XRP; assuring investors that Ripple would take steps to protect the market for XRP, including by fostering a readily available XRP trading market; highlighting XRP price increases and at times tying them to Ripple's efforts; and selling XRP to certain institutional investors at discounted prices".
More concretely, the SEC considered public statements of Ripple executives and tweets from official accounts mentioning the success of Ripple project, reporting price increases of XRP, emphasizing merchantability of XRP by exemplifying the exchange platforms it was being listed and/or fiat or cryptocurrency pairs investors could trade XRP with, as evidences for fulfillment of this criterion of the Howey Test.
B. Other Arguments
Apart from the Howey Test, the SEC's complaint also asserted Ripple has not offered sale of XRP for the purpose of usage or currency.
While XRP, today, can be used within Ripple's On-Demand Liquidity ("ODL") system, which enables overseas money transmission service, the SEC notes that although XRP has been offered at least since 2013, until mid-2018 Ripple did not even test usage of XRP within the ODL, and until October 2018 Ripple did not commercially launch ODL. Moreover, the SEC exemplified Ripple executives' public statements and e-mail correspondences that imply XRP's purpose of usage as investment and speculative.
Further, the SEC indicates that XRP cannot be designated as a currency, and thus is not exempted from security registration requirement. Again, the SEC used Ripple officials' statements that unequivocally disclaims XRP as a currency, and highlights the differences between XRP and Bitcoin.
II. Ripple's Responses
Ripple released a statement through its official website as of January 29, 2021 and published its preliminary response to the SEC's claims. According to Ripple's arguments, (i) XRP does not constitute an investment contract, thereby nor a security, (ii) other prominent financial regulators than the SEC, reportedly evaluated XRP as a virtual asset or crypto asset, but not as a security, (iii) the SEC does not act fairly within its security assessment between crypto assets, namely Ether.
To refute SEC's allegations regarding the Howey Test, Ripple argues that Ripple has not entered into a contract for an investment with any holders of XRP; Ripple has not held an ICO, nor offered future tokens to raise money and has no relationship with the vast majority of XRP holders; holding XRP does not mean the holder receives a portion of Ripple's revenue or profits; Ripple's XRP sales amounted to far less than 1% of the massive XRP market that has grown over the last 8 years; the XRP Ledger, on which XRP actually moves, is completely decentralized; and Ripple's XRP holdings do not create an investment contract any more than a company holdings convert commodities, which it markets, into securities (e.g. Exxon and its holdings of oil).
For its second plea, the Ripple puts forward that several prominent agencies for finance industry, including the US Department of Justice, Financial Crimes Enforcement Network (FinCEN), have identified XRP as a virtual currency. Indeed, in a press release of FinCEN regarding enforcement of anti-money laundering laws to Ripple, dated May 2015, XRP token has been called as a virtual currency.2 The other examples referred by Ripple were the financial regulators of the UK, Singapore and Japan. However, it should be mentioned that the UK Treasury's classification of XRP as an exchange token together with Bitcoin and Ether is sourced from a consultation paper3, not a binding judgment.
Finally, Ripple claims that the SEC did not act fairly against its XRP token, compared to the approach towards Ether. The response highlights a statement from William Hinman's, director of corporate finance division of the SEC, speech delivered in June, 2018: "[...] putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralized structure, current offers and sales of Ether are not securities transactions." Ripple interprets the statement as an admission by the SEC of Ether being a centrally governed security during its initial fundraising phase, which "accompanied the creation of Ether", whereas it has transformed to a decentralized structure afterwards. That being said, Ripple announced that it also filed for information request under the US Freedom of Information Act with the SEC, for explanation on how the SEC did not enforce Ether under Securities Act.
III. Assessment Under Turkish Capital Markets Law
Even though the concept of investment contract from the US securities law have been attempted to introduce to Turkish law during the preparation works of Turkish Capital Markets Law No. 6362 ("Capital Markets Law"), the lawmaker abandoned clarifying the meaning of "investment contract" shortly before enaction of the Capital Markets Law. Therefore, the definition and coverage of "securities" within Turkish law, materially differs from its US law definition.
Within this framework, under Capital Markets Law, a general phenomenon of 'capital markets instruments' has been defined as follows: "Securities and derivatives as well as other capital markets instruments, which the Capital Markets Board of Turkey ["CMB"] designated within this scope, including investment contracts." In this respect, Capital Markets Law also provides definitions for securities and derivative instruments, as follows:
- 'Securities': "Excluding money, check, policy and promissory note; (1) Shares, other shares-like assets and depositary receipt related to such shares, (2) Debt instruments or debt instruments based on securitized assets and incomes, and depositary receipt for such securities".
- 'Derivative Instruments': "Instruments listed
below or other derivative instruments designated in this scope by
(1) derivative instruments giving the right to buy, sell or interchange securities,
(2) derivative instruments the values of which depend on the price or return of a security; the price or a price change of a foreign currency; an interest rate or a change in the rate; the price or a price change of a precious metal or precious stone; the price or a price change of a commodity; statistics published by institutions deemed appropriate by the Board and changes in them; derivative instruments which provide the transfer of credit risk, which have measurement values such as energy prices and climatic variables and depend on an index level which is formed by these listed items or on changes in this index level; the derivatives of these instruments and derivatives giving the right to interchange the listed underlying assets,
(3) leveraged transactions on foreign exchange and precious metals as well as other assets to be designated by the CMB."
As referred above, Capital Markets Law defines securities and derivatives, whereas there is no clear reference to the scope of the other capital markets instruments and investment contracts. Nevertheless, it could be mentioned that the CMB defines the scope of the other capital markets instruments from time to time as it has been done for units of investment funds and sukuk.
On assessment of XRP under Turkish law, securities definition emphasizes that securities are share-like securities that provide equity rights or they are debt instruments. Having said that, XRP's assessment for Turkish capital markets law could be conducted in a simpler way than the SEC's evaluation under the Securities Act. Since XRP does not offer equity within its promoter, i.e. Ripple, nor constitute debts owed by Ripple, it could be argued that XRP is not a security under Turkish law.
Nonetheless, given the CMB's power to designate other capital market instruments including investment contract as a capital markets instrument, one cannot rule out the possibility of CMB issuing a secondary regulation in the future introducing a new term, such as virtual asset, crypto securities etc., which would cover features of XRP and potentially other crypto tokens by its definition.
In conclusion, it could be summed up that to date XRP cannot be considered as a security, nor any capital markets instrument under Turkish law due to lack of a relevant regulation; whereas Turkish capital markets legislation entitles the CMB to enact a regulation covering XRP and/or any other crypto asset.
1 SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946).
2 See: https://www.fincen.gov/news/news-releases/fincen-fines-ripple-labs-inc-first-civil-enforcement-action-against-virtual (last access date: March 26, 2021)
3 Her Majesty's Treasury, UK regulatory approach to cryptoassets and stablecoins: Consultation and call for evidence, January 2021. See: https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/950206/HM_Treasury_Cryptoasset_and_Stablecoin_consultation.pdf (last access date: March 26, 2021)
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