Either/Or — the Ripple conundrum
Malt Liquidity 106
A little while ago, I wrote about the vagueness of defining what exactly a security is:
Pretty much all cases involving token sales revolve around whether said tokens were unregistered securities. To determine whether an offering is a security, the courts developed a test called the Howey test, from a 1946 SCOTUS decision in SEC v. W.J. Howey, which states that “an investment contract … means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
This, naturally, is intentionally vague — the proliferation of the administrative state basically means that the SEC can go after whatever they want to. As I predicted back then, due to the ruling…
it seems that any token created for utility that has been sold as having value will be chased after and sued. It’s hard to see how any token with utility that has a fluctuating value can avoid being categorized as a security if the company makes any comment regarding its potential valuation. It really seems like we’re on the pathway to any tradable token being regarded as a security…
and I highlighted that this is the enforcement route that the SEC chose.
I further noted that without a clear idea of what a security is, most things could arguably be a security:
Once something starts trading, realizing volatility, and liquidity develops, it becomes impossible to see how the Howey test is supposed to matter. Everything that isn’t consumed fluctuates in value due to supply and demand, and everything is “traded” if there is sufficient liquidity to transact beyond an individual scale. Purportedly deadstock Nikes are sold with the intention of being utilized as footwear, but let’s be honest, I’d be willing to bet that 80%+ of “in demand” sneakers never see the light outside the shoebox. And yet these aren’t securities, but HarryPotterObamaSonic10Inu is?
This rumination came to a culmination a couple days ago, when a filing regarding the SEC’s actions versus Ripple came out, which resulted in an extremely bizarre ruling where in some instances XRP was a security, while in other transactions it wasn’t. So let’s take a closer look.
First off, this is concerning various motions for summary judgment — a ruling, if granted, that indicates that there’s no legal issue to be tried. The SEC split XRP sales into three types: Institutional Sales, Programmatic Sales, and Other Distributions (for example, employee sales or private executive transactions) — and claimed that these were unregistered securities offerings. Ripple, naturally, argued the opposite. What follows is a ruling that muddies the water even more.
Let’s start with Institutional Sales, assessed by the Court as Ripple’s sales of XRP to accredited (institutional) investors. These sales were almost trivially found to be sales of securities given the marketing materials Ripple used to close sales of XRP. What’s notable is that the standard the Court uses for the sales is set — the investors knew that their purchase of XRP was going to Ripple and Ripple repeatedly touted XRP as an opportunity to capture appreciation in value of Ripple as a company. This created a “common enterprise” with the expectation of profit:
If you’ve read the other cases I’ve written about, this is par for the course. But wait, there’s more!
Much more interesting are the Programmatic Sales, which the Court treats as essentially a blind, automated liquidation into a traded market. In a weird contortion of logic, XRP sales in this manner were not sales of securities because the buyer could not have known whether the money was flowing to Ripple as a result of the sales, and the court does not speculate on the intentions of buyers (as, for example, they could just be purchasing XRP as a market beta correlated long.)
A dissonance is created in that the programmatic buyer’s intentions and the “tieing in” with Ripple as a corporate entity itself don’t clearly connect. Thus, while the marketing statements were relevant in the Institutional Sales, they aren’t relevant here because it’s unclear whether the buyers on the other end of these Programmatic Sales even knew what Ripple was.
The quirk here is that XRP as a token is definitively not equity — it holds no claim on Ripple’s forward earnings or their assets in case of bankruptcy. It is not part of the cap stack. It’s just kind of… there. A simple example is Pokémon cards: when I’m buying cards from an online marketplace, it’s unclear whether the seller is the company itself or some random individual. (Indeed, it’s almost certainly not the company itself.) I may believe the cards will appreciate in value, and enrich the seller in the process, but unless I’m told specifically by the company that they will appreciate and I know that I have given them my money in the process to enable them to create an appreciation in value, obviously the Pokémon cards are not unregistered securities.
The Other Sales are significantly less interesting, as the Court states plainly that a distribution of Ripple’s stash of tokens as compensation or incentives to develop for them can’t amount to an investment on the part of the receiving party. The executives’ sales follow the trajectory of Programmatic Sales, in that they could not have known who was buying what they were selling, thus destroying the opportunity to satisfy the third Howey factor.
This ruling, in my eyes, is deeply unsatisfying, but understandable. Recall what I wrote in my prior examination of what a security is:
Beyond the actual text of the Securities Acts of 1933 and 1934, let’s think about the motivation: the Great Depression had just occurred, and with it, a calamitous bank run that destroyed a lot of the economy and stretched the financial system to its absolute limits (or collapsed it, depending on how you think about it.) Note that while speculation is the foundation of the financial system, too much of a useful thing is still, in fact, a bad thing. Two principles arise out of these pieces of legislation:
The government wants to prevent false, unrealistic promises that don’t quite amount to fraud from being marketed to investors
The government wants to know what exactly is being offered as an investment…
Look, the subtext of securities regulation is that the government wants to make sure that market volatility that’s going on in whatever speculative instrument doesn’t lead to a fucking bank blowing up, which is exactly what happened to Silvergate. Hilariously enough, the original Howey case was about orange groves. But the wrong way to look at it is “if bananas can qualify as a security, then the Howey test shouldn’t apply to cryptocurrencies because it’s too broadly applicable.” The construction and precedent of Howey is built such that an administration can pick and choose what is and isn’t a security…
The fact of the matter is that Howey was never meant to deal with the environment that allowed crypto to proliferate, where the tethering of price movement to real forward earnings and fundamental value was markedly shattered. ZIRP broke Howey because the logical reality that profit-seeking is supposed to entail warped to the end result of profit justifying the speculative deployment of capital in the first place. Thus we end up with a postmodern definition of security, where something can look and act and resemble a security in every manner other than actually being defined as one, due to the fact that
everything that isn’t consumed fluctuates in value due to supply and demand, and everything is “traded” if there is sufficient liquidity to transact beyond an individual scale.
The absurd part of this ruling is that, if we are to treat an unregistered securities offering as exploitation of a gullible investor (which, as highlighted above, was the intention with which I read the Securities Acts with), somehow the institutional investors receive protection here while the laymen don’t. But, contextually, this makes sense! The Institutional Sales resembled a classic offering of an investment, while the Programmatic Sales essentially amounted to Ripple capturing some liquidity in the market for XRP anonymously. The laymen got what they wanted, which was some volume/supply to use to punt longs. Why should securities regulation insulate someone from making a decision that they want to make, regardless of how little context it’s made with?
I don’t see this ruling as a victory for Ripple or the crypto industry at large — indeed, we’ll have to see if it even holds on appeal — but it highlights that what we speculate on nowadays is our beliefs, which are entirely detached from the reality of the equity marketplace. It’s almost a collective nihilism as an “investment” philosophy — we are invested in the number going up, not the creation and success of technologies and innovations bettering society. This is the only logic that can explain the decision of the Court that a random buyer of a XRP could not be deemed to have done so on the basis of the belief and statements of Ripple management that XRP would appreciate along with the company’s success.
To slightly modify Journey to the End of the Night:
“High-class [regulators] have a certain way of talking that intimidates you and frightens me personally... It’s really just a lot of half-baked, pretentious phrases, but as highly polished as antique furniture. Meaningless as they are, their phrases are terrifying. When you try to answer, you’re afraid of slipping up.