An Apparent Blow to the SEC’s Regulatory Authority Over Crypto Exchanges 

By Samuel Licker

A federal district judge in New York has handed down a long-awaited ruling to determine whether sales by Ripple Labs Inc. of its cryptocurrency, XRP, was considered a security. 

In SEC v. Ripple Labs Inc., Judge Analisa Torres, presiding in U.S. District Court for the Southern District of New York, decided that the  token is a security when sold to institutional investors but not the general public. In so ruling, Judge Torres accepted the SEC’s argument to use the so-called Howey Test to decide whether XRP should be classified as a security and, therefore, fall within the SEC’s regulatory ambit. By way of background, the Howey Test requires four elements to be satisfied for a transaction to trigger SEC regulation: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profits, (4) to be derived solely from the efforts of others. 

Judge Torres’s ruling—that sales of XRP to sophisticated investors satisfied the Howey Test, yet sales to the general public through crypto exchanges failed the test because there was no evidence presented that these investors knew that Ripple was the seller and they were not investing in Ripple’s future efforts, but rather buying for any number of reasons, such as general cryptocurrency market dynamics—is certainly a blow to the SEC’s regulatory authority.  

The SEC has indicated it will appeal the ruling as it relates to programmatic buyers. In the meantime, pursuant to the ruling, it appears that XRP, and other tokens like it, are not securities under the Howey Test, though sales of cryptocurrencies could still be considered sales of securities if there are subjective expectations between buyers and sellers. For instance, in the case before Judge Torres, institutional buyers entered into lock-up agreements or agreed to resale restrictions, which led to her conclusion that the expectation was not that the tokens in these circumstances would be used as a currency.  

Back in May, M&R reported on Bittrex, a global cryptocurrency exchange, having been charged by the SEC with, among other things, failing to register as a national securities exchange. In the wake of the ruling in the Ripple Labs case, the SEC’s argument in Bittrex is called into question. If tokens sold on an exchange fail the Howey Test and are not considered securities, then the exchange itself likely cannot be considered a securities exchange. While the Bittrex case is pending in the Washington Western District Court, litigators defending Bittrex are optimistic that the determination in Ripple will bolster Bittrex’s position that the crypto assets the company sold should not be considered unregistered securities.   

With both sides gearing up for a long fight, other jurisdictions or the Second Circuit Court of Appeals might flip the switch on the SEC’s ability to regulate cryptocurrencies sold on consumer exchanges, especially as other companies are on the hotseat, including Binance, TerraForm Labs, Gemini Trust Company, and Coinbase. The corporate and securities pros at M&R are keeping their heads on a swivel as more rulings and analysis emerge in the crypto markets. We will be sure to report back. 

This blog post is not offered, and should not be relied on, as legal advice. You should consult an attorney for advice in specific situations.