Crypto as a Security – Applying the Howey Test

A US court recently handed down a landmark ruling addressing the question of whether the crypto token XRP falls under the definition of “security”. The US court ruled that the same crypto token may be classified differently depending upon the parties and the circumstances of the transaction. Namely, the court classified a token sold to institutional investors as a security, while classifying the same token as not a security when sold to the general public.

Ripple Labs Inc. and Its XRP Token

Ripple Labs developed the XRP token to enable the use of the technology they created, primarily for international transfers. Ripple sold the token to institutional investors. It also sold the token to the general public through third parties, and it was thus subsequently used as a means of payment, inter alia, within the framework of employee remuneration programs. The proceeds from sales to institutional and private investors and to the public, which reached more than USD 1.5 billion, helped fund the company’s operations.

The US Securities and Exchange Commission filed a lawsuit against Ripple Labs and its officers, alleging that Ripple’s token is a security and that sales of the token by the company and its officers constituted a violation of securities laws. Many in the industry perceived the lawsuit as a landmark case study, since the ruling will affect thousands of similar cases and dictate the future direction of the crypto industry in the United States.

Investment Contract and the Howey Test

American case law has adopted the Howey Test to ascertain whether an asset falls under the definition of an “investment contract,” and thus under the definition of a “security.” According to the Howey Test, an agreement counts as an investment contract only if it fulfills all three of the following criteria:

1. There is an investment of money;
2. The investment is in a joint venture;
3. The investor expects profits to derive from his investment as a result of a third party’s efforts.

The Court Ruling

The court differentiated between several instances when the token was sold or transferred to third parties during the activities of Ripple Labs and related companies:

1. Sales to institutional and private investors. Directly transacted between entities related to Ripple and investors, while agreeing on the legal terms of the agreement, such as vesting dates. In these instances, the court found fulfillment of all necessary criteria of an investment contract: The court’s rationale emphasized Ripple’s representations to investors. The fact the purchases were definitely made for investment purposes and not for use, and the connection between Ripple’s efforts to develop related products and maximizing the token’s value, such that the efforts of “others” to maximize value to the investors is evident. In other words, these activities fulfilled all three criteria of the Howey Test. Thus, during these activities, the token is deemed a security.
2. Programmatic sales to the public through designated exchanges. The court’s main rationale for ruling that the criteria of the expectation of profits as a result of Ripple’s efforts was not fulfilled was the fact that sales in the secondary market are inherently severed from Ripple. The court opined that when private investors bought XRP, they probably expected to turn a profit as a result of their investments, but there was not enough proof that they expected the profit to derive from Ripple’s efforts. The court also argued that many private investors were unaware of Ripple’s existence or of the connection between the value of the coin and Ripple’s success. Consequently, the SEC did not persuade the court of the fulfillment of the third criteria of the Howey Test. Thus, it ruled that, in such instance, the token does not fall under the definition of “security.”
3. Gifting tokens to suppliers and employees. The court ruled that since there was no “investment of money,” the activity here did not fulfill the first criteria of the Howey Test. Consequently, in this instance, the token is not a security.

Is This the Final Word?

Undoubtedly, this is an innovative and original court ruling, but it is hard to believe it marks the end of the line. The SEC may appeal the ruling. The court presented legal alchemy, whereby one may classify the same token in two different and opposing ways, relying on severance between seller and buyer (because Ripple didn’t sell the token directly). The court’s logic also fails to take into account common reality. There, the vast majority of “classic” securities are sold on stock exchanges with complete severance between buyer and seller, which usually does not cause them to be deemed “not securities.”

Why, then, does this “severance” mean that a token is not a security? It appears we have not yet heard the final word on this issue.

***

Barbnea Jaffa Lande’s Capital Markets Department is at your service for any question regarding Cryptocurrency.

Adv. Andrey Yanai is a partner in the department.