The Securities and Exchange Commission’s (SEC) case against Ripple, the largest case it has brought against a defendant working in the crypto industry to date, has been heating up this month with a series of summary motions and some big discovery losses for the SEC. The SEC alleges in that case that one test for a security required to register with the SEC, contained in the 1946 Supreme Court case SEC v Howey, applies to the XRP token that is used by Ripple.
The SEC should admit the secret it isn’t saying out loud to the court and everyone watching the case. The test used in SEC v. Howey is typically used by the SEC to sue hucksters, Ponzi schemers and other con men who sell fake securities. The Howey test is a way to stop them, not a means to facilitate registration with the SEC.
The Howey test is usually a cudgel to fight frauds that can't register, but it usually hasn’t mattered because the underlying project is a scam and a fraud, something not alleged or contemplated in the SEC’s case against Ripple.
Crypto projects are unlike traditional companies. There is no centralized board of directors or company or bank or underwriter in the middle intermediating capital. The state of technology has evolved such that a disaggregated group of individuals can design and deploy computer code that takes over all of these functions.
That’s not to say that regulated financial intermediaries won’t still be involved over the next ten or twenty years as financial markets evolve toward a decentralized crypto future, because they will. That transition will take time. Meanwhile the SEC’s rules need to rationally evolve.
The SEC could respond to the many calls for reasonable reshaping of rules like the Token Safe Harbor for crypto projects proposed by Commissioner Hester Peirce. Or it could also use its exemptive authority. But Chairman Gensler’s repeated exhortation to “come in an talk to us about registering your token” without defining what that means is not rulemaking.
These broader dynamics are not irrelevant to the decision in the case against Ripple. The judge should not ignore, in a case alleging that sale of XRP should have been registered with the SEC as a sale of a security, that Ripple literally isn’t able to register the XRP token.
As just one example of the complications here, under Generally Accepted Accounting Principles you cannot list on your balance sheet an asset you do not control.
Asking Ripple to list the XRP token and file financial information about the XRP network, much like asking the same for a party working on another crypto network like Ethereum, doesn’t make sense from a securities law or accounting perspective.
It would be the functional equivalent of telling Google they must list “the internet” as an asset on its balance sheet because Google’s value is closely connected to the internet. Securities laws and generally accepted accounting principles wouldn’t allow Google to make such a misleading balance sheet counting the internet as a Google owned asset, and they similarly won’t allow an entity to register XRP or ETH either.
The court should take judicial notice of the fact that the SEC’s admonition that XRP and every other crypto token should register as a security is obsequious, and that such a forceful statement is misleading given the barriers to registration.
Using the Howey test to halt the burgeoning trillion-dollar crypto market in this way, with a75 year-old test that doesn’t fit, seems a perfect fit for a growing Supreme Court doctrine called the “major questions doctrine.” That doctrine has already been used to strike down a similar effort by the Environmental Protection Agency to expand the reach of its power using ill fitting regulatory tools.
Rather than a Supreme Court showdown over the major questions doctrine that the SEC is likely to lose, the agency would be smarter to end its regulation by enforcement and engage with crypto reform proposals to update its approach to crypto regulation. It updated its rules, albeit slowly, to evolve with the times during the rise of internet communications. It should do the same thing now with crypto.
If not, courts should take a second look at Howey. They should also consider at the major questions doctrine, particularly in light of the fact that the SEC has ignored various calls for a reasonable way for crypto projects to comply with registration requirements and sought to stretch its authority far beyond what Howey contemplated.
