The recent ruling in SEC v. Ripple is deeply concerning for SEC oversight of crypto and non-crypto assets alike, said securities law experts in a recent discussion held by public interest group Better Markets. The “counterintuitive” ruling could raise customer protection issues for both retail and institutional investors, panelists said.
Panelists also discussed crypto’s promises and flaws, the “regulatory gap” in crypto oversight, and proposed legislation as part of the group’s “Crypto Week of Truth”.
According to the panelists:
- Potential loopholes created by the Ripple ruling and proposed legislation could allow market participants to evade the securities laws even for non-crypto securities. This would widely damage investor protection.
- Crypto currently has no legitimate use. It facilitates criminal activity and financial predation and will cause systemic risk in the traditional financial system.
- The “regulatory gap” in crypto oversight is detrimental to the investing public.
- The Howey test has “stood the test of time” and can accommodate crypto.
Ripple bombshell. In an SEC enforcement action alleging that Ripple Labs made unregistered sales of the XRP crypto token, summary judgment largely turned on whether the XRP token was a security under the federal securities laws. On July 13, Judge Torres in the U.S. District Court in Manhattan found that sales of the XRP crypto token constituted the offer and sale of an “investment contract” in the context of institutional investors, but not in programmatic sales to public buyers on digital asset exchanges or in other distributions.
The ruling is widely seen as significant and in the crypto industry’s favor. Some have called the ruling surprising because it gives retail investors less protection than institutional investors, who are usually seen as better able to fend for themselves.
Allen said it is important to note that many court decisions where courts have agreed with the SEC’s analysis that other crypto tokens satisfied the definition of an investment contract under the Howey test. And in fact, the Ripple judge did find that XRP was an investment contract in the institutional investor sales, and therefore a security.
That said, Allen said it “seems very counterintuitive” that the institutional investors got the protection of the securities laws and the retail investors did not.
Berkovitz thinks it might be even more dramatic than that.
“I don't think even the sophisticated investors get anything out of this,” said Berkovitz. “Because frankly, the court ruled that, yes, these transactions were investment contracts, but what will happen in the future as a result of this is they say, Okay, they're securities, but they're exempt from registration, because they're accredited investors.”
So you would get distributions to accredited, sophisticated investors without registration, taking advantage of a registration exemption to distribute it, said Berkovitz. And then they will turn around and put it on an exchange to the public.
Berkovitz emphasized he wasn’t saying this will happen. In fact, he does not think things will go that far. But depending on follow-on cases on whether secondary markets are an investment contract, it could lead to a result where you could get to a public market with virtually no public disclosure.
Berkovitz noted that on a stock exchange, you don’t know who you’re giving your money to, it’s anonymous. The anonymity of transactions on an exchange was one reason the judge found XRP was not an investment contract.
The other way to look at this, said Berkovitz, is that rather than looking at each element of this as a contract individually, to look at the whole thing being an investment scheme.
The implications of the Ripple ruling are yet to be fully seen, said Berkovitz. He doesn’t know whether the case will go on appeal or not.
No legitimate use for crypto. Turning to an economic perspective, in Kelleher’s view, crypto has no legitimate uses after 14 years of trying. Kelleher pointed to crypto’s facilitation of criminal activity, citing charges in the FTX and Celsius cases, along with hundreds of SEC and CFTC civil enforcement actions.
“It has plenty of antisocial, illegal and criminal uses,” said Kelleher. “It's great for ripping off customers and investors, money laundering, tax evasion, and ransomware.”
Most of the use cases for crypto so far have been “purely speculation,” said Allen. Crypto “diagnoses pain points” in the traditional financial system, like slow payment systems, unbanked people without access to financial services, and payday lending. But crypto does not provide any real solutions, she said.
For example, the claim that crypto will “bank the unbanked” is ridiculous, said Allen. People aren’t paid in crypto, and you can’t buy a loaf of bread in crypto, so crypto only works if you can convert it in and out of fiat currency. Conversion is done on crypto exchanges—which require customers to have a bank account. So crypto does not get around the need for bank accounts.
Conflicts and predation. Another criticism is that crypto entities often have major conflicts of interest from occupying many roles at once.
“It would be like if JPMorgan Chase had a hedge fund, was a clearinghouse, was a custodian, and was an exchange all at the same time, and commingled customer assets and funds while at the same time betting against them and front running them,” said Kelleher.
According to Allen, the crypto industry promises that crypto will help with financial inclusion, but this is illusory and predatory. She compared this to rhetoric around subprime mortgages in the lead-up to the 2008 financial crisis, which was revealed to be predatory inclusion.
Predatory inclusion is a particular risk with crypto because ultimately there are no assets backing it, said Allen. What you're purchasing is a computer file that’s value depends on whether someone else wants to buy it from you. And because crypto needs to always seek out new fiat money, somebody will be left holding the bag, she said.
“There is a real concern that the more vulnerable communities are being targeted as potential bag holders to allow the more affluent people who got in earlier to exit,” said Allen. “It sort of casts a bit of a pall over claims that, look, recently we've had this many black or Hispanic or LGBT or young investors pile into crypto. Maybe they're the bag holders.”
Kelleher said he has seen literature showing that parts of the crypto industry target marginalized communities and rip them off “quite extensively.” Brookings and The Atlantic have published pieces on this, he said.
Non-compliance is a matter of choice. It is entirely possible for the crypto industry to comply with existing laws and regulations, said Allen. But to profit, businesses have done things that would not be allowed under traditional securities regulation because of their propensity to harm.
“No one's found a way to make a profitable business out of this without the more predatory practices. Or at least if not predatory, conflicted practices that are inherent to the industry,” said Allen.
Crypto causes systemic risk. Allen described several systemic risk issues with crypto.
One concern is that a lot of proposed legislation suggests bringing stablecoins into the regulated banking system, said Allen.
“So you're essentially giving government backing to stablecoins. And stablecoins are not used for payments, they're used primarily for speculation in crypto,” said Allen. “So essentially, you're putting government safety nets behind crypto speculation.”
In Allen’s view, the crypto industry had to invent stablecoins because the crypto ecosystem was so unstable that it impeded transactions, and the industry had to come up with something more stable.
“And where do stablecoins get their stability from? Investing in government securities. So they’re sort of vampires in that respect,” said Allen.
Another risk is that legislation on crypto would inevitably legitimize crypto as an asset that institutional investors can invest in, said Allen. The crypto industry needs to gain institutional investors because it is essentially a Ponzi scheme and there is a desperate need for new money, she said.
With 75 percent of Americans who have heard of crypto lacking confidence in its safety and reliability, crypto is looking for a new bag holder, said Allen.
“So what they're trying to do is create legislation that will allow institutional investors to invest. And that's a problem from a financial stability perspective,” she said. “That means when crypto blows up, it doesn't just hurt crypto and individual investors. It hurts banks, pension funds, etc.”
Allen added that although crypto leads to technological decentralization, it causes economic centralization worse than the traditional financial system.
Howey stands the test of time. According to Berkovitz, the linchpin in determining if crypto tokens are securities really comes down to SEC v. Howey, a Supreme Court case decided in 1946. The test is clear.
Howey has been disparaged by some as “just being about orange groves” and not possibly applicable to digital assets, said Berkovitz, but it’s not just about orange groves and it has been applied to a whole variety of things. The real estate developer in Howey sold not just the crop, not just the oranges, but how the crops would be cultivated and marketed and how investors would be paid. And the Supreme Court held that this business scheme was an investment contract, which is an investment of money in a common enterprise with an expectation of profit based solely on the efforts of others, Berkovitz explained.
If something is an investment contract—if somebody's trying to get you to give them your money, on a promise that they'll give you more money in the future—that is a security and there are disclosures and there are requirements that you have to be accurate in your disclosures, said Berkovitz.
“So the Howey test has stood the test of time,” said Berkovitz. “It's applied to a whole variety of things consistent with what the Supreme Court says. Countless and variable schemes devised by those who use the money of others on the promise of profits. We’re talking about whiskey, cosmetics, chinchillas, cattle embryos, fruit trees, cryptocurrency. You name it, the Howey test could apply to it if somebody's trying to get your money on the promise of making you wealthier.”
Kelleher noted that some have called Howey old and asked if it is still valid, good law.
Berkovitz said yes, absolutely, it has been the bedrock of securities law. The Supreme Court quoted it as recently as 1990 in the Reves case. Berkovitz quoted from Reves:
“In defining the scope of the market at which to regulate, Congress painted with a broad brush that recognized the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’”Berkovitz noted that the SEC has held a number of crypto assets to be securities as investment contracts, and there are a number of pending enforcement cases on that. The SEC has also been successful in a number of other cases that it has already brought, he said.
The “regulatory gap.” Turning to the big picture of crypto oversight, Kelleher asked Berkovitz how he would respond to the crypto industry’s claim that it needs special rules and laws and that there are regulatory gaps that need to be filled.
“The regulatory gap really is a narrow area where neither the CFTC nor the SEC has jurisdiction over the trading of crypto assets,” said Berkovitz. “And it's not only crypto assets in this regard. It's commodities in general. And that specific regulatory gap is with respect to assets that are not securities, and they're not derivatives.”
Berkovitz said the law is “really pretty clear.”
- CFTC has regulatory authority over derivatives—futures, swaps, options—including derivatives on commodities and securities.
- A “commodity” is defined in the Commodity Exchange Act as either a specified product (wheat, corn, etc.) or anything that is or may be in the future the subject of a futures contract.
- So essentially, a commodity is anything you could have a futures contract on.
- The CFTC has enforcement authority in cash or “spot” commodity markets in the case of fraud or manipulation. However, it does not generally have regulatory authority over cash commodity markets.
- SEC has regulatory authority over securities.
- Some instruments are both a commodity and a security, like stock futures. The CFTC and SEC have dual jurisdiction over these.
For example, the CFTC would have authority to take enforcement action if there was fraud or manipulation relating to the Bitcoin cash market, said Berkovitz. But neither agency has authority to write prescriptive regulations for Bitcoin—to say it has to be traded on an exchange, or to say how intermediaries should be regulated.
Berkovitz believes the regulatory gap in crypto assets oversight is detrimental to the investing public, given the prominence of unregulated cryptocurrency exchanges. He noted that the CFTC and SEC have incorporated tremendous changes in technology over the last 80 or 90 years.
“The regulatory system can handle all types of assets and commodities, and I don't think it’s unable to handle crypto assets,” said Berkovitz.
Legislation. Kelleher touched on several legislative proposals on crypto:
- A proposal by Rep. Patrick McHenry (R-NC), chairman of the House Financial Services Committee, and Rep. Glenn "GT" Thompson (R-Penn), chairman of the House Committee on Agriculture;
- An old version of a bill sponsored by Sen. Debbie Stabenow (D-Mich), chairwoman of the Senate Committee on Agriculture, Nutrition, and Forestry, and Sen. John Boozman (R-Ark), ranking member. They have been saying that a version 2.0 will be introduced, said Kelleher, adding that this bill was “embraced wholeheartedly” by FTX and it has now arrested former CEO Sam Bankman-Fried. Not only did Bankman-Fried support it, there were some reports that he actually wrote it, said Kelleher.
- A bill by Sens. Cynthia Lummis (R-Wyo) and Kirsten Gillibrand (D-NY) that was filed last year and recently refiled.
Allen warned that the bills would eviscerate the securities laws for non-crypto securities. There is nothing particularly special about a digital asset, she said. You could convert almost any financial asset to a computer file on the blockchain, then take advantage of the new legislative regime.
“A lot of the legislative proposals we see on crypto, a lot of them, in trying to create a new regulatory structure for crypto, are actually decimating the securities laws writ large,” said Allen.
Allen continued, “I think policymakers need to be aware that any new regime they set up will not just be a regime for crypto, but it will attract, if it's lighter touch, all kinds of other financial assets. And that's something that has not been adequately acknowledged or prepared for.”
Allen added that she doesn’t think there is any way to avoid this because digital assets cannot be defined in a way to exclude traditional assets.
Kelleher pressed for clarification.
“What you're really saying is, if you're going to provide a lighter touch or different regulatory regime for crypto, do not fool yourself into thinking it will only apply to some little subset called crypto,” said Kelleher. “Because with regulatory arbitrage, it will be a loophole that will get expanded to cover lots and lots of other stuff and cause lots and lots of other collateral problems. Is that right?”
Yes, said Allen.
Berkovitz said in the Ripple case—whether you agree with the result or not—Judge Torres focused on the economic reality and that is what Howey stands for. If legislation instead focuses on the technological aspects, that creates a bifurcated system, he said.
It raises all sorts of problematic possibilities in raising capital to do the exact same things that are now regulated under the securities laws and takes them out of the securities laws when, in fact, they are really securities type transactions, said Berkovitz.
In Berkovitz’s view, it is possible to provide the certainty needed to close the regulatory gap and provide the regulatory certainty needed without changing the underlying nature of what is a security or not. The SEC can be provided to declare upfront whether these are securities or not rather than solely on retrospective enforcement actions, as is now the case. A system can be constructed that enables the SEC to do its job, enables the CFTC its job, and gives the industry the regulatory certainty they need on the nature of these assets without undermining securities law, said Berkovitz.
Kelleher replied that it would take an “extraordinary level of faith” that Congress can get this done with the nuance described.
“Even after all these years, I have faith that it can happen, and that we can get good legislation,” said Berkovitz. “But, you know, it takes work.”