Ripple Labs Inc. (the company behind XRP) secured a major win late last week as it obtained emails and documents from the Securities and Exchange Commission. The company believes these so-called Hinman documents could help turn the tide in its high-profile legal battle with the Commission concerning its XRP crypto token.
What Is The Hinman Document?
Although these documents are confidential, they relate to William Hinman’s speech in 2018. Hinman was the former SEC director of Corporation Finance. In the speech, he discussed how the SEC could apply federal securities laws to regulate digital assets. Ripple believes it could use some materials and references from these documents to support its arguments. According to reports, the company already did so by referencing the document in its reply brief.
What is Ripple’s Legal Battle All About?
In 2020, the Securities and Exchange Commission filed an action against Ripple Labs Inc and its executives. The Commission alleged that the company had raised over $1.3 billion through an unregistered Initial Coin offering (ICO). ICO is a means that crypto firms and businesses use to raise funds for their project. SEC alleges that Ripple raised funds, beginning in 2013, by selling its token XRP in unregistered security offering to investors in the U.S. and globally. According to them, Ripple’s actions violated federal securities laws.
On the other hand, Ripple has maintained that XRP isn’t a security but a commodity. As such, it doesn’t fall under the SEC’s jurisdiction. Much of the debate has centred around whether the XRP sale was an investment contract and if it passes the ‘Howey Test’ to determine whether or not it is an investment contract. If it does, then it is considered a security. The outcome of this case could have a ripple effect (pun intended) on the crypto space as it could further strengthen the SEC’s regulation by enforcement in the face of regulatory uncertainty in the cryptocurrency space. That is why the crypto industry has broadly backed Ripple and called on the SEC to let Congress do its job and lead in developing crypto regulations.
Ripple getting a hold of the Hinman documents is a big win for the company considering that the SEC had sought to block the release of these documents since Ripple requested them 18 months ago. But the big question is how much of a significant role these documents play and whether or not they will help Ripple prevail in the $1.3 billion suit against it for selling XRP as an unregistered security.
Furthermore, it is unlikely that the thoughts of a SEC official will guide the court as the court will most likely avert its mind to precedents, and that is where the Howey Test comes in. Although none might have related to cryptocurrencies, the court has handled cases that border on securities in the past and has never strayed from the test established in the Howey Case. On the other hand, one may argue that the Howey Test never contemplated the use cases of cryptocurrencies, so the test can’t be applied strictly in this scenario. One thing is for sure though; The resolution in the Ripple case will serve as a precedent in future cryptocurrency-as-a-security cases.
What Is The Howey Test?
Much of the XRP debate has centered on whether or not the XRP sales qualify as an investment contract, which is why it’s important to discuss what this test entails, although crypto didn’t exist in 1946. The Howey Test is simply what the U.S Supreme Court has applied in the past to determine whether or not a transaction qualifies as an “investment contract,” and if so, then it is considered a security. And this test probably didn’t envisage something like this.
Firstly, let’s look at what the SEC considers an investment contract. According to the Commission, an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The so-called ‘Howey Test’ applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.”
Elements of the Howey Test
A transaction qualifies as a security if it passes these three elements of the Howey Test:
An Investment Of Money
This first element is satisfied if the transaction involves an exchange for value. It could be in fiat currency or some other type of consideration. In Ripple’s case, it is safe to say that the offer and sale of the XRP satisfy this element.
In A Common Enterprise
There is no clear definition for the term “common enterprise.” However, courts have analyzed it as a distinctive element of investment contracts. Generally, it refers to a situation whereby investors pull their funds together to achieve a common goal.
Reasonable Expectation Of Profit Derived From The Efforts Of Others
This element is arguably the main issue when applying this test. For a transaction to be considered a security, the purchase must have expected profits or other financial returns from the actions of others. One wouldn’t expect cryptocurrencies to pass this test, considering that most crypto traders and investors are aware of the volatility of these tokens. This test is objective and would focus on the intricacies of each case rather than grouping the industry. Therefore, the court would likely consider Ripple’s actions and whether or not the company gave investors reason to believe they would ultimately make profits from the token.
As mentioned earlier, Ripple’s case will play a significant role in determining whether or not the Howey Test should explicitly apply to crypto projects. Till then, the SEC will continue to use its discretion to determine whether or not a particular crypto project qualifies as a security. On the other hand, crypto projects that intend to carry out an Initial Coin Offering need to be diligent to avoid the regulatory eyes of the SEC.
This article was written by Patrick Hagerty on the Exploring Digital Assets on 25.10.2022 and has been published here with permission.