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.
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.
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 future;
- 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 purchase;
- 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 asset;
- 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 currency.
- 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 functionality.
- 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.
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