In January, Ripple filed its defense against the U.S. Securities and Exchange Commission’s (SEC) suit against the company over its offering of XRP, which the SEC says amounted to the offering of unregistered securities.
Based on the legal test for determining whether something is a security or not (Howey), the SEC has a case. However, in filing its defense, Ripple Labs made an excellent point worthy of discussion (albeit unintentionally): why should the SEC consider XRP a security when the likes of BTC and ETH have remained free from SEC scrutiny?
In some ways, the answer is very straightforward: it should. Yet, the question of why it hasn’t is somewhat more complicated.
A brief history of SEC v Ripple
On December 22, 2020, the SEC announced that it was taking action against Ripple Labs and two of its executives—co-founder Christian Larsen and CEO Bradley Garlinghouse—over the offering of unregistered securities to the tune of over $1.3 billion. The offering was related to Ripple’s XRP token. The two named individuals were included because they individually sold enormous volumes of XRP—almost 2 billion combined.
The specifics of the SEC complaint are simple: under the Howey test for determining whether something is a security or not and under U.S. securities law, the offering of XRP amounted to the offering of an unregistered security. In terms of Howey, this means:
- There was an investment of money
- The investment was into a common enterprise
- There was a reasonable expectation of profits reliant on the effort of others
In digital asset cases, the first two elements are typically straightforward. The third prong is usually where most analysis is directed. In the case of Ripple, the SEC cites numerous instances of the company telling investors that Ripple’s efforts with regard to XRP are meant to spur demand for the asset, and did in fact endeavor to increase the value of XRP by, for example, working to have it listed on third party exchanges and addressing specific concerns with the protocol expressed by investors.
In January, Ripple filed its defense to the claims made by the SEC. At its core, Ripple is not attacking the SEC’s Howey analysis: rather, they are arguing that the SEC was obligated to give Ripple notice that it was violating U.S. securities law before filing its suit—the fair notice defense.
XRP, BTC and ETH: securities?
However, Ripple does make one argument in particular that is worthy of attention:
“The SEC’s filing, based on an overarching legal theory amounts to picking virtual currency winners and losers as the SEC has exempted bitcoin and ether from similar regulation.”
When it comes to regulators, the absence of a stance with regard to a particular product or activity is not an indication that it is permitted. For instance, we only discovered that the SEC considers Ripple’s XRP offering to be unlawful because it eventually took action against it. However, in the case of BTC and ETH, the SEC has made statements indicating that they currently consider both of those products to be within the bounds of the law. The then-director of the SEC’s Division of Corporation Finance Bill Hinman gave a speech at the Yahoo Finance All Markets Summit where he said:
“If the network on which the token or coin is to function is sufficiently decentralized — where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts — the assets may not represent an investment contract. Moreover, when the efforts of the third party are no longer a key factor for determining the enterprise’s success, material information asymmetries recede. As a network becomes truly decentralized, the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.
“When I look at Bitcoin today, I do not see a central third party whose efforts are a key determining factor in the enterprise. The network on which Bitcoin functions is operational and appears to have been decentralized for some time, perhaps from inception. Applying the disclosure regime of the federal securities laws to the offer and resale of Bitcoin would seem to add little value.”
He went on to say the same about Ethereum, and after the remarks were released to the public, the price of ETH shot up by 11% after spending the year to that point in a steep decline—perhaps lending credibility to Ripple’s accusation that SEC enforcement is the picking of winners and losers in the digital asset space.
Regardless, this statement—released well before the XRP action—shows that the notion of decentralization has played a significant part in the SEC’s to-this-point choice not to consider BTC or ETH securities.
Where Ripple is wrong is in the conclusions it draws from this fact. The SEC’s apparent double standard between BTC and ETH on the one hand and XRP on the other is not an indication that XRP isn’t a security, it’s an indication that BTC and ETH are. Like XRP, neither of those projects can be properly described as decentralized. In the same way that, as the SEC argues, investors in XRP were relying on the work of others to ensure the success of Ripple, those who buy BTC and ETH are relying on the actions of a concentrated group of core developers to develop and maintain the network.
Especially in the case of BTC, where people are still trying to argue that it is going to be a viable payment method, one has to ask how investors expect BTC to be able to someday transform from its current status as a speculative instrument into a practical method of payment if not through the work of a small group of identifiable developers.
Likewise, if it’s true that Ethereum is decentralized, for example, then it shouldn’t be possible to identify the same exact group of people responsible for each major code and non-code development on the Ethereum network since before it was released.
Compare XRP, BTC and ETH to the likes of BSV, the protocol of which is fixed, and which already functions as a scalable payment method. It does not require highly centralized action to work as intended and increases in its value come from third parties using the protocol to create real-world use cases. Incidentally, those in control of Ethereum make a point to denigrate BSV rather than one another, including as recently as last month.
Legal consultant Johnny Jaswal, writing for CoinGeek, took a close look at Ethereum 2.0’s status under Howey: validators on the network are making an investment of money into a common enterprise by staking funds, and this was done with the expectation of profits arising from the work of others – namely the Ethereum Foundation’s ability to execute on its four-phase plan to merge the Ethereum 2.0 network with the mainnet. He writes in conclusion:
“It is my view that the myth of decentralization and a lack of understanding regarding the state of digital assets and platforms have allowed assets such as BTC and ETH to secure the ‘SEC pass’…The SEC has taken a positive step with respect to its XRP complaint and should similarly revisit other assets such as ETH, especially in the context of the Ethereum 2.0 analysis above.”
In other words, the answer isn’t that none of XRP, BTC or ETH are securities: it’s that all of them are.
Why the disparity?
It’s certainly possible that the SEC themselves are still teasing out the boundaries of which offerings are subject to SEC regulation, and which are not. However, there is some reason to question why at least ETH has managed to avoid drawing the ire of the SEC when in reality, it meets the Howey test and the SEC’s focus on decentralization.
William Hinman, the former SEC Division of Corporation Finance Director who spoke about the lack of centralization in both BTC and ETH, was a partner at law firm Simpson Thacher, a position to which he returned following the end of his SEC term. Simpson Thacher also happens to be a member of the Enterprise Ethereum Alliance, a members’ organization aimed at driving the adoption and use of Ethereum blockchain technology.
When Hinman left Simpson Thacher to join the SEC, it was a retirement. This is the presumed justification for the firm agreeing to pay Hinman an almost $1.6 million annual pension, and indeed a pension is one of the few ways federal employees are permitted to receive compensation from private companies; accepting outright payments is illegal.
But $1.6 million is a lot of money for a pension. Business Insider reported that a previous holder of the office, who had also come from a private sector law firm, received an annual pension of around $75,000; two other public officials who served in the Trump administration after a career in private law disclosed annual pension payments of $169,000 and $311,000.
Hinman is now no longer with the SEC, having returned to his job at Simpson Thacher and put his brief, multi-million-dollar retirement behind him.
All of this is why Ripple is deposing Hinman in their SEC case. They want to show that in his Yahoo speech, Hinman was signaling to the market that the likes of BTC and ETH are SEC compliant, and that because Ripple is in largely the same position as those two assets, it was a signal that XRP is, too. Ripple hopes that this will mean a validation of their fair notice defense, but it seems more likely that it causes the SEC to re-examine the Hinman position and realize their next enforcement actions need to be addressed to BTC and ETH—particularly since the SEC has already tried to distance itself from Hinman’s speech, which is still available on the SEC website.
For all the discussion that has come as a result of the SEC’s action against Ripple, most miss the real implications: that under the standards set in Howey and by the SEC themselves, there are few digital asset offerings which do not amount to a security. If the SEC are going to punish Ripple, then they should be punishing those responsible for BTC and ETH, as well. It’s an astute point made by Ripple, albeit unintentionally, but it won’t save them. It does highlight that sooner or later, the SEC will have to revisit the BTC and ETH question: applying the same standards they used to take action against Ripple, action against those two projects is long overdue.
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