The crypto world is abuzz over the recent decision issued in the SEC’s case against Ripple Labs, Inc., which concerns its sales of the XRP token. The day the decision issued, XRP shot up in value, as did the stock of Coinbase, Inc., which has also been sued by the SEC. The decision has been hailed as a clear victory for Ripple, as well as for the crypto industry in general, as it hopes to evade or at least limit SEC regulation.

The SEC’s case against Ripple seeks to hold it liable for the unregistered sale of a “security,” as that term is defined under the Federal securities laws. In short, the SEC contends that XRP is within that definition, and as such, a registration statement must be filed with the SEC before a public sale is permitted. Ripple, of course, filed no such registration statement, and so the SEC is claiming that this violated securities laws.

The registration requirement for the public sale of securities goes back a long way. In the wake of the 1929 Great Depression, Congress acted to restore public confidence in a stock market that was rife with fraudulent conduct. It passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These two pieces of legislation, as amended, form the core of modern Federal securities regulation. The ’33 Act requires that securities offered to the public must first be registered, absent an exemption. As the SEC puts it, the goal of registration is to “provide public investors with material information about the issuer and the offering, including financial and managerial information, how the issuer will use offering proceeds, and the risks and trends that affect the enterprise and an investment in its securities.”

Specifically at issue in the Ripple case is § 5 of the ’33 Act. Subsections (a) and (c) make it “unlawful for any person, directly or indirectly” to “sell,” “offer to sell” a “security” unless a registration statement is in effect or has been filed as to such security. Thus, the main question is whether XRP is a “security” within the meaning of § 5. The starting point is the definition section of the ’33 Act, which features a broad definition of “security,” sweeping in “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate [or] certificate of deposit for a security,” among other things. The breadth of this definition is designed to promote investor protection in light of the “virtually limitless scope of human ingenuity” in designing financial products.

The US Supreme Court in SEC v. W. J. Howey Co., 328 U.S. 293 (1946), applied this definition’s term of “investment contract” to contracts concerning orange groves, creating what would become known as the “Howey Test”—which is still used by courts to determine if a financial product is a “security” subject to SEC regulation. The Howey Test provides that an investment contract, and thus security, is present where “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” This too paints with a broad brush, as it was intended to “meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

In the Ripple case, the SEC argued to the court that XRP satisfies the elements of the Howey Test for the following three reasons: First, a purchase of XRP is an investment in a common enterprise with other XRP holders and with Ripple. That is, all XRP tokens are fungible, and their price will rise or fall equally. Second, defendants led investors to expect a “profit” from buying XRP by doing such things as directing “investment” inquiries to its “how to buy XRP” webpages, specifically targeting “speculators” when offering and selling XRP, and promoting XRP price “rallies” and investors’ ability to buy and sell XRP on exchanges. Third, Ripple publicly tied the potential for profit to its promised entrepreneurial and managerial efforts, i.e., attempts to find a “use” for XRP and to create an “ecosystem” around Ripple’s technology. Defendants responded by arguing that the court should be guided by pre-1933 securities law decisions at the state level, and apply an “essential ingredients” test Defendants themselves fashioned from these cases.

The Ripple court began its analysis by unsurprisingly dismissing Defendants’ proposed “essential ingredients” test as at odds with the Howey Test. It then stated that the inquiry should not merely focus on the token itself, but rather the transaction in which it is sold; taking into consideration the “contracts, expectations, and understandings” concerning the particular sale of XRP.

For this purpose, the court divided up the XRP sales activity into three categories: (1) Institutional Sales; (2) Programmatic Sales; and (3) Other Distributions. As to the Institutional Sales (transactions with institutional investors, hedge funds, and market makers), the court found an “investment of money in a common enterprise” under the Howey Test for basically the reasons the SEC contended, i.e., all XRP tokens are fungible, and their price will rise or fall equally, being dependent on the success of the enterprise. There was also an expectation of “profits to come solely from the efforts of others.” This was because, “[f]rom Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP [blockchain], thereby increasing the value of XRP.” In other words, under these circumstances, buying XRP was not the purchase of a “commodity or a currency,” but rather “an investment in Ripple’s efforts.” Thus, the court concluded that the XRP offered in the Institutional Sales is a security under ’33 Act.

The court, however, reached a different conclusion with regard to the Programmatic Sales. These were algorithmic, blind bid/ask transactions, whereby the buyers “could not have known if their payments of money went to Ripple, or any other seller of XRP.” As such, the court concluded that, unlike the institutional buyers, these purchasers would not necessarily conclude that their money was going to Ripple to be used to improve XRP’s ecosystem and thereby increase the price of the token. The court compared these buyers to a “a secondary market purchaser who did not know to whom or what it was paying its money.” This failed to satisfy the third aspect of the Howey Test, which again requires “profits to come solely from the efforts of others.” Thus, the XRP token of these sales did not constitute a “security” under the ’33 Act.

This decision is a clear, albeit partial, victory for Ripple and those similarly situated, and the conclusion that tokens sold on public exchanges are not securities would doom much of the SEC’s enforcement efforts, such as its case against Coinbase. But will the decision stand? That’s an unknown, but some of its aspects warrant caution. Analogizing the Programmatic Sales to sales activity in the secondary market does not seem to be a firm a basis to avoid a finding of a security. Every day, stocks and bonds are traded in blind transactions without knowledge of who the counterparty is, but there can be no doubt those assets are securities. Also, the court acknowledged that Ripple made public statements tying the value of XRP to its efforts to develop and support the blockchain. It’s not clear why this did not create the expectation of profits from these efforts by the exchange buyers. The court seems to have placed too much emphasis on a line of cases counseling disregard of a buyer’s speculative motive in this context.

Notably, a former SEC enforcement official expressed the view that the decision is vulnerable on appeal:

“The Ripple Decision holds that the same exact token can be a security sometimes but not a security other times. And the more ignorance and willful blindness by retail investors, than the less protection the retail investors will receive. And the less disclosure about the token, then the less liability for the token issuer. That just can’t be right.”

Don’t get me wrong, I personally do not favor SEC regulation of crypto in the same manner as non-digital assets. But there is definitely some merit to this former SEC official’s criticism of the Ripple decision. The best thing would be legislation from Congress setting clear boundaries. Now that some big players are getting behind Bitcoin, a final resolution of this issue seems more important than ever.