Explainer: What makes a crypto asset a security in the US?

July 14 (Reuters) – Cryptocurrency companies that have resisted U.S. regulatory oversight, arguing digital assets are not securities, won a court victory this week. On Thursday Ripple Labs got a landmark ruling from a federal judge who said some of the company’s XRP token sales were not subject to securities laws.

WHAT DID THE RIPPLE JUDGE SAY?

U.S. District Judge Analisa Torres in New York found some digital token sales by Ripple did not violate the law as alleged by U.S. Securities and Exchange Commission. The SEC sued Ripple for conducting an unregistered offering of $1.3 billion in XRP between 2013 and 2020.

Torres ruled that Ripple’s sales on public exchanges to retail investors were not offers of securities under the law because purchasers did not have a reasonable expectation of profit tied to Ripple’s efforts.

Those sales were “blind bid/ask transactions,” she said, in which buyers “could not have known if their payments of money went to Ripple, or any other seller of XRP.”

It was the biggest win for a cryptocurrency company in a case brought by the SEC. The regulator got a partial victory because Torres also ruled that Ripple violated securities laws when it sold XRP directly to sophisticated investors such as hedge funds.

WHAT HAS THE SEC BEEN ALLEGING?

The regulator has brought more than 100 enforcement actions against crypto companies, claiming digital assets are securities.

The biggest case was brought this year. The SEC said Coinbase, the largest U.S. cryptocurrency platform, allowed users to trade at least 13 crypto assets that should have been registered as securities, including tokens such as Solana, Cardano and Polygon. Coinbase denied the allegation.

Industry players have insisted that most cryptocurrencies – which operate on a database shared across a network of computers, known as a blockchain – do not fit the U.S. legal definition of securities. They say the SEC has been vague and inconsistent and have called for new regulations or laws.

WHAT IS A ‘SECURITY’ UNDER U.S. LAW?

To SEC’s contends crypto assets are securities, citing a U.S. Supreme Court case from 1946 dealing with investors in Florida orange groves owned by the W. J. Howey Co.

The court ruled that “an investment of money in a common enterprise with profits to come solely from the efforts of others,” is a kind of security called an investment contract.

The SEC had jurisdiction to seek to prevent Howey from selling to out-of-state investors fractional land interests with a contract to provide profit from the harvest, the court said.

Securities, unlike assets such as commodities, are strictly regulated and require detailed disclosures to inform investors of potential risks.

WHAT HAVE OTHER JUDGES SAID?

Many of the SEC’s crypto-related cases have ended in settlements, with companies paying fines and agreeing to follow U.S. law or exiting the U.S. market.

Before the Ripple decision, judges in the few cases decided in court agreed with the SEC that specific crypto assets were securities.

Those rulings said developers’ statements tying the value of their digital assets to efforts to grow or maintain the associated blockchain systems showed investor profits depended on the “efforts of others.”

Courts have also decided that investors in those assets participated in a “common enterprise” because the funds they spent were pooled by the token issuer and used to develop relevant systems.

WHAT ABOUT BITCOIN?

Bitcoin is not considered a security because its anonymous and open-source origins mean investor profits are not dependent on the efforts of developers or managers, said Carol Goforth, a law professor at the University of Arkansas.

Some blockchain projects have tried to fund their operations in two stages, by offering securities under SEC regulations and later giving or selling those investors cryptocurrency after building a functional blockchain.

Goforth said the developers hoped that approach would remove the “common enterprise” element, but she added the SEC has never clarified what it would take to convert a security to a non-security.

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