SEC Fees Pressure to Define Crypto Assets

A judge denied a motion April 11 filed by the Securities and Exchange Commission (SEC) to clarify the content of several emails and internal communications about the classification of the digital assets Ethereum and XRP for the upcoming Ripple Labs trial. This may seem a small defeat for the regulator, but it may have implications not only for this case, but for the whole cryptocurrency community.

The SEC has been using almost exclusively enforcement powers against token issuers to encourage them to register their digital assets as securities. Yet, as there isnt a specific rule to determine which digital assets (e.g. cryptocurrencies, tokens, stablecoins, etc.) are considered securities, the number of legal disputes has increased. Many of these cases go unnoticed because the parties have reached an amicable solution, but the case with Ripple Labs may have long-lasting consequences.

The SEC has been using the Howey test, which defines what an investment contract is, to defend that most of the digital assets are securities and therefore fall under its supervision. Under the Howey test, adopted by the U.S. Supreme Court in 1946, an investment contract exists if there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

Therefore, if digital assets, whether cryptocurrencies or tokens, are used as an investment contract, they may be qualified as a security, and the SEC can demand disclosure and registration requirements under the Securities Act of 1933 and the Securities Exchange Act of 1934. This is exactly what the SEC is defending in its enforcement actions, and in particular in its lawsuit against Ripple, that a digital coin like XRP is a security, not a means of payment, and the company should have registered the asset. However, if the digital asset is used as a currency or as a commodity, these requirements are not applicable. Ripple claims that XRP is exempt from these federal laws.

At the core of this litigation is the question, yet unanswered by the SEC or by any other agency, whether cryptocurrencies are securities, commodities or what they are, for regulatory purposes.

The SEC didnt have a clear position when the litigation began about what defines a digital asset as a security, so the case is based on statements made by William Hinman, the SECs director of its Division of Corporation Finance, on what is and what isnt a security. For instance, Ripples argument is that Hinman made a statement in 2018 saying that ether, the second most valuable cryptocurrency, was a token, not a security, and that the market understood this speech as a public notice that digital coins would avoid classification as security.

The litigation has an additional layer of conflict of interest, that if proven, would benefit Ripple in the case. According to Ripple, Hinman had an interest in promoting ether given his previous (and post) involvement in a law firm advising the Enterprise Ethereum Alliance. His speech declaring ether a token, not a security, and not doing the same for similar digital assets, could be seen as evidence of this conflict. The SEC argued that Hinmans speech reflected his personal views, not the SECs.

But District Judge Analisa Torres was not convinced by this argument and said, the SECs assertion that the speech was intended to communicate [the SEC Division of Corporation Finances] approach to regulating digital asset offerings is inconsistent with the SECs and Hinmans previous position that the speech was intended to and did reflect his personal views.

Now, the SEC will have to release all the emails and draft versions of the 2018 speech in the coming weeks.

The outcome of this case is still unclear, and it may not provide a conclusive resolution for the classification of cryptocurrencies as tokens, currency or securities, but it is adding more pressure on the SEC to provide more clear guidance via rulemaking than via enforcement in individual cases.

See also: SEC Chair Emphasizes Investor Protection in Crypto Regulation