The Breakdown - Judge Hands SEC a Massive Loss Denying Theory That Tokens Are Always Securities

Episode Date: July 14, 2023

The judge has handed a summary decision in the Ripple-SEC case, and while it was a mixed decision, the reality is that the SEC's position is much weaker today than it was yesterday. NLW runs down the ruling and what people think the implications might be.  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Friday, July 14th, and today we are talking about a significant decision in a big, big court case when it comes to the crypto industry. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us. on the Breakers Discord. You can find a link of the show notes or go to bit.ly slash breakdown pod. All right, friends, some massive news to close out the week. One of the most significant cases the crypto industry has been fighting with the SEC has been ruled upon. And while it may not be a total slam dunk, the at least partial victory is still massively significant and weakens the

SEC's arguments in other cases in fairly fundamental ways. So let's get into the details and then will move on to what it all means. TLDR, Ripple chalked up a major success in their defense against the SEC on Thursday. The judge in the case granted them a partial victory on multiple issues surrounding the sale of XRP tokens. The judge found that in some circumstances, the sale of XRP tokens were not breaches of securities law. Sale of tokens into the open market did not qualify as the sale of unregistered securities. However, the sale of tokens to institutional investors on fixed terms was ruled to be illegal. Most importantly, the XRP tokens themselves, were not to be considered securities on their own. Everything instead was about the investment contract.

So the court's decision was made on what's known as summary judgment. That means the judge was only able to make a determination about whether the party's arguments were based on a correct analysis of the law using a set of undisputed facts. Disputed and unclear facts will be explored at a full trial in due course. And given how much this case and so much else that's happening right now has to do with the definition of securities, it's worth a quick recap on the Howie test. The Howie Test is, of course, the legal theory set out in a 1946 Supreme Court decision, which determines under what circumstances an agreement should be considered a sale of securities. The test deals with what's known as investment contracts, which don't need to be formal contracts,

but can be simply implied to exist by the surrounding circumstances. For an agreement to be considered an investment contract, it needs to contain three elements, sometimes known as the prongs of the Howey Test. One, there needs to be an investment of money. Two, the investment of money needs to be made into a common enterprise. Three, the investor needs to be led to expect profits. And what's sometimes considered a fourth piece, those profits need to be based solely on the efforts of the promoter or a third party.

In other words, the investor isn't expecting profits based on their own labor. The Howie Test has, of course, been the central theme of all token cases as the reason the SEC has jurisdiction to bring lawsuits over the sale of tokens. So back to Ripple then. The biggest outcome of this order was that the judge rejected the notion that XRP tokens themselves are securities. The judge wrote, XRP, as a digital token, is not in and of itself a contract, transaction, or scheme that embodies the Howie requirements of an investment contract. End quote. Now, this is a pretty stark refusal to recognize the legal theory that has been used

by the SEC, which is known as embodiment theory. Effectively, the concept that the SEC has been using is that tokens are originally created and sold as part of an investment scheme, and because of that, the tokens embody that investment scheme, and are concerned. And are considered to be securities forever after that point. The judge substantially narrowed that notion, instead asserting that the Howey test applies to each sale of the tokens individually, rather than finding that the tokens take on this quality as securities. This is a massive rebuke of the SEC's point of view. The rest of the judgment deals primarily with specific examples where Ripple the company sold or transferred tokens. Firstly, Ripple sold tokens directly to institutional

investors on fixed terms with surrounding marketing materials promoting XRP tokens as a sound investment. The judge found these sales to be the sale of unregistered securities. They focused on the marketing materials as evidence that there was an expectation of profit from the investment scheme. Crucially, the judge noted that Ripple directly and transparently took in money from investors at this stage, pooling the money in corporate bank accounts and used it to fund operations to improve the functionality of the Ripple network. The judge wrote, from Ripple's communications, marketing campaign, and the nature of

the institutional sales, reasonable investors would understand that Ripple would use the capital received from its institutional sales to improve the market for XRP and develop uses for the XRP ledger, thereby increasing the value of XRP. A second set of sales, however, were known as programmatic sales. These sales occurred when Ripple sold tokens into the open market, where retail investors were able to purchase those tokens at the prevailing market rate. During this period, there was an active market for XRP tokens, with sales from Ripple representing less than 1% of overall market volume. The judge found that these circumstances meant that sales of XRP tokens were not a sale of securities. The judge concluded that, quote,

the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. And this is the key point. Retail token buyers did not know whether they were purchasing from Ripple or from other market participants, so couldn't be considered to be making an investment into the Ripple investment scheme. The judge found that a speculative intention surrounding the price of tokens was not enough. Quote, buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple's efforts, as opposed to other factors such as general cryptocurrency market trends, particularly because none of the programmatic buyers were aware that they were buying XRP from Ripple. In fact, the judge accepted evidence from numerous

XRP buyers who said they were unaware of Ripple's promotional material, with many, quote, entirely unaware of Ripple's existence. As part of this decision, then, the judge has substantially narrowed the scope of securities violations surrounding token sales in the open market. For the SEC to get involved based on this precedent, buyers would need to be specifically buying tokens to fund the efforts of a promoter or issuer who they expect to work to improve the value of the tokens. The final set of token transfers were made to employees of Ripple and to developers working within the Ripple ecosystem. The judge found that these transfers were not sales of securities because there was no money invested in this process. The SEC had advanced

the theory that Ripple used these token distributions as a means to indirectly fund their operations by having these employees and developers sell the tokens, but there was no evidence that Ripple received the proceeds of any sales. This part of the decision could be in interpreted as a pretty narrow reading of the Howie requirement that there is a, quote, investment of money, implying that doing work for a venture cannot be considered analogous to investing money into that venture. It could also be correct to read this part of the order as simply finding the SEC's argument to be underdeveloped. The SEC again had argued specifically that these transfers were an indirect funding mechanism for Ripple, but ultimately failed to deliver sufficient

evidence to convince the judge of that assertion. Now, a few other points that were addressed in the order. Ripple argued that the SEC failed to provide them with fair notice of how the securities law applied to their token sales. The judge only addressed this point in relation to the institutional sales, and found that the securities law was sufficiently clear to determine that Ripple ought to have known that those sales were illegal. Ripple had in fact received legal advice along those lines, and apparently decided to take the risk in relation to institutional sales. The judge therefore rejected a fair notice defense. Ripple also proposed an extension of the Howie test, which would require an investor to have some kind of underlying rights regarding the investment,

not just an expectation of profit based on the promotion. The judge rejected this argument as having no basis in existing law. Brad Garlinghouse and Chris Larson, two Ripple executives sold a large quantity of XRP tokens into the open market, but this was determined not to be a sale of securities for the same reasons underpinning the sales from Ripple the company. The lawsuit also alleges that Garlinghouse and Larson aided and abetted the sale of unregistered securities, which hinged on them knowingly assisting in the violation of securities law. The judge found that there were material disagreements on the facts surrounding this allegation, so ordered that this issue should proceed to a full trial. Finally, secondary sales of tokens were not specifically considered

in the orders, but it seems heavily implied that they would not be treated as the sale of securities. If Ripple's own selling of tokens into the open market were not found to be illegal, it's pretty hard to make the argument that third-party selling would be. So a reasonable question at this point is how binding or final is this type of decision? While it's ground-bring, for the industry, you have to remember it was only the decision of a federal district court judge. That means that the SEC may be able to appeal this decision, first to the circuit court and then, of course, to the Supreme Court. However, each of these steps require the consent of the original judge as well as the appellate court, so we'll have to wait and see on that. There seems to be

some disagreement out there on whether the SEC can take this specific order to appeal immediately or needs to wait until the full trial, so at this stage the timeline is pretty unclear. What's more, while the decision was made in a lower court, it will still carry sufficient substantial weight in other token cases. There are so few token cases that have delivered a court verdict that each one of them is cited in other cases. However, other judges are generally not bound to follow this decision. As a matter of practicality, judges do typically consider and follow other judgments to maintain consistency across different courtrooms, but at the same time, it's certainly not unimaginable that a judge could find a factual or legal reason to differentiate

from this decision. Now, let's move to different reactions from the parties involved, and we'll start with how the SEC are handling the outcome. The agency released a statement, which read, We are pleased that the court found that XRP tokens were offered and sold by Ripple as investment contracts in violation of the securities laws in certain circumstances. The court agreed with the SEC that the Howey test governs the securities analysis of crypto transactions, and rejected Ripple's made-up test as to what constitutes an investment contract. Instead emphasizing that Howie in subsequent cases have held that a variety of tangible and intangible assets can serve as the subject of an investment contract.

furthered the court rejected Ripple's fair notice argument, noting that the Howey test is clear and that claiming ignorance is not a defense for violating the securities laws. Now, trying to give the most generous interpretation to this statement. Sure. If the goal of this lawsuit was to bring Ripple to heal for securities violations, then the SEC did succeed on one of their arguments. Again, the direct sale of tokens to institutions was found to be illegal, and Ripple will need to pay a fine for losing that part of the case. It will also mean that direct token sales to accredited investors will need to file for SEC forms and seek an exemption. However, and this is a big however, that was never really what

this lawsuit was about. Instead, this was the first big test of the SEC's theory that most tokens are securities and carry that classification with them into secondary markets under all circumstances. On that front, the SEC unequivocally took a big loss yesterday. Responding to their statement, Investor Adam Cochran wrote LMFAO, the SEC trying to full-on gaslight here. Utterly embarrassing for a government institution. that is supposed to be neutral. Katie Byber, the chief legal officer at Paradigm writes, SEC statement on Ripple has vibes of young campaign hacks spinning on bad facts versus powerful government agency expected to tell the truth. Consensus lawyer Bill Hughes wrote,

If you know anything about admin agency public affairs, this statement says, we lost okay, you know it, we know it, we got smoked, and yeah, we are reeling, so just got off our backs for two damn minutes, God damn it. Marvin Amori, the chief legal officer at Uniswap said, the SEC lost on everything. thing that matters to them and the industry. Retail sales, airdrops, employee comp, implicitly all exchange trades. SEC won on one past relic, certain non-exempt institutional sales that have been uncommon for years, just crushed from a practical point of view. Ripple Chief Legal Officer Stewart Alderati wrote, pathetic statement coming from the SEC today, take the loss, you earned it.

And of course, that gets us to the next set of reactions which come from Ripple itself. Stuart Alderati again says, A huge win today. As a matter of law, XRP is not a security. Also as a matter of law, sales on exchanges are not securities. Sales by executives are not securities. Other XRP distributions to developers, to charities, to employees are not securities. The only thing the court found constitutes an investment contract is pass direct XRP sales to institutional clients. There will be further court proceedings only on these institutional sales per the court's order. Maybe we can now start a rational conversation about crypto-regulatory.

in this country. Now, if words are nice, actions are, of course, better. On that front, Coinbase wrote, W, W, W for ripple, W for the industry, W for the builders, W for a clear rulebook, W for updating the system. Oh, and XRP is now open for trading. Cracken also relisted XRP, and while Gemini haven't relisted yet, their co-founder Cameron Winklevoss wrote, the sale of XRP on exchanges is not a security, which means the sale of all cryptos on exchanges are not securities, and the SEC and Gary Gensler have no jurisdiction over them. This is a watershed moment that relegates the SEC to Tradfai and makes it a dinosaur regulator. What about community reactions in general?

Well, the first part of that is just the vibe. At Defyte Events, Law Carlo, wrote, The vibes on this app today are immaculate. Feels like maybe we are turning the corner. Gabe Shapiro, the general counsel at Delphi, said, even though I thought Ripple would lose, this is one of the best days of my life, and truly the interests of justice are served by this result. My two cents was that I tweeted that the vibe around Twitter was what I imagined it was like the day after Voldemort was defeated when Harry lived.

Now, on top of just a vibe shift, some are already talking about the return of ICOs. Adam Cochran again writes, The next rally, while it would be good for the majors, is likely going to be wild for new projects. Not new projects that we have now, but new ones that don't exist yet. Every new project and every new tokenless project just got a blueprint for how to go hard on tokenomics. Shapeshift founder Eric Voorhees wrote, The XRP case today suggests that a project can do an ICO, so long as it sells the tokens publicly on an open exchange,

at the same time that other holders can also sell on the same terms. Sounds reasonable. Transparent pricing, equal access by all parties, no secret deals. But what about the lawyers who are actually in a position to know the legal details about this and what comes next? Bill Hughes again, a lawyer at consensus writes, I'd be shocked if the SEC doesn't immediately appeal this to the Second Circuit. The SEC's enforcement strategy is dealt a serious blow. The SEC's pseudo-legislation via overly expansive rulemaking is seriously undermined.

The chairman's credibility in the administration and on Capitol Hill will be at an all-time low. Brown and Rudnick partner Stephen Paley wrote, definitely more of a win than I was expecting for the defendants, and maybe trending hopefully in the direction that secondary sales not securities transactions. I think overall, if I had to sum up the one big sense coming out of this, is that the SEC was dealt a serious blow. Lexproof CEO Orlando Cosme writes, What I don't understand is the audacity of the SEC. Literally every lawyer who had any experience with crypto was shouting from the mountaintops

that it's ambiguous how securities laws apply. Did the SEC just think we were all crazy and they were right? Paradigm policy director Justin Slaughter says yes. The claim was that this couldn't happen because no court would take this position. They were in a bubble. Jacob Franek from Alliance Dow wrote, This is our Super Bowl. RIP embodiment theory, the notions that tokens embody the spirit of contracts they might have been sold through. Remember when Prometheums Aaron Kaplan smugly said that tokens embody token warrants and SAFs?

RIP the theory that secondary transactions of tokens are securities transactions and that crypto exchanges are unregistered securities exchanges. RIP Gary Gensler and his unlawful attack on the industry. It's almost as if the smart people in crypto were right and all the fin-tuit idiots were wrong. Now, even some lawmakers got in on the action. House GOP whip Tom Emmer wrote, The Ripple case is a monumental development in establishing that a token is separate and distinct from an investment contract,

it may or may not be a part of. Now, let's make it law. My bipartisan bill, the Securities Clarity Act, carves this concept in stone to provide the regulatory confidence needed to make sure the next iteration of the internet is designed with American values. Now, speaking of emmer and legislation,

another big topic of conversation was what this was going to do to the Democrats posturing that they've had for the last six months or so, that we shouldn't make new rules or write new laws because the old ones apply just fine. Another lawyer at Consensus Matt Corva writes, there will be appeals, but there will also be a pivot from the Dems and the SEC to we need new laws, which I think is the right outcome. People still should have access to info and disclosures, and there are plenty of sensible ideas for logical regimes. Justin Slaughter agreed saying, man, this probably just shifted the math on McHenry Thompson and Lummus Gillibrand. The

secondary market decision is striking. Attorney Collins-Belton wrote, From what I'm hearing from other respected lawyers in this space, it sounds like the SEC is about to severely regret not engaging in rulemaking the past few years. They may have just unleashed Pandora's box beyond what even I could have expected as the most improbable scenario. Justin Slaughter also reported on Scuttlebutt from D.C. saying, we have several live pieces of legislation on Capitol Hill and I'm already hearing policymakers questioning whether this case shows its time to get legislation passed. It's about to be a very intense and accessible. It's about to be a very intense and exciting 96 hours in Washington, maybe the most consequential few days in crypto policy history.

If there's no movement towards bipartisan legislation now, there probably won't be before the 2024 election. Now reinforcing the emboldening of lawmakers, Representative Richie Torres also called for a public investigation into the SEC. If you stick around for Long Read Sunday this week, I actually read his letter and it is definitely worth listening to. He also in a tweet referenced the fact that the judge in the case also had the last name Torres, and tweeted, Worth noting the judge's last name in this first of its kind case today out of the Southern District of New York, never met a Torres who was wrong on crypto. So finally, does the SEC just slink back into its hole now? The betting is no, it doesn't.

Bill Hughes again writes, I think the chair doesn't like getting swatted on the nose. It's embarrassing and that he does not do kindly. With that being so, I'd place a bet that we see a new crypto complaint early next week. They were keeping at least one round chamber to front-run a markup of the market structure bill, I assume, but this merits a response. No retreat, no surrender is the alpha move, so that's what I kind of expect. He has to remind his people he is the guy to bet on. Justin Slaughter agreed, saying, I actually think this is correct. The SEC's vaunted 140-0-win-loss record is now broken, and policymakers are whispering the SEC has definitely lost control of the situation. Chair Gensler isn't just going to throw up his hands and say, well, we tried.

And from Andrew AP Abacus, the crypto rumor mill with a fairly pretty good record this year, he writes, Update, Gensler isn't done inflicting undue burden on the crypto industry. Today's developments will serve to harden his stance. An agency source said, contrary to today's narrative, there isn't a meaningful change in enforcement commitment or philosophy. And that, of course, brings us to the next big legal question, which is Coinbase. James Murphy at Meta Lawman writes, The ruling that XRP is not itself an investment contract is a significant blow to the SEC's case against Coinbase and the other crypto exchanges.

While Judge Torres's decision is not binding precedent, it is extremely well-reasoned and it will be cited in all motions to dismiss. However, put even more simply, LBRY, who are of course on the bad end of a lawsuit, tweeted yesterday, The Ripple case should end the SEC versus Coinbase lawsuit. I suspect, however, that it will not. So get your popcorn ready. Until next time, guys, be safe and take care of each other. Peace.