Original Source and Article: Coin Desk
In four acts, we examine the history of cryptocurrency securities law and its future ahead: Kik, Telegram, Library, and Ripple.
As American law sees it, an ICO (initial coin offering) consists of four acts: Kik Interactive, Telegram, LBRY, and Ripple Labs.
The dénouement of this decade-long saga draws to a close with the verdicts in three of the four cases, and the dueling responses to Ripple Labs’ motions for summary judgment exchanged on Friday, Dec. 2.
As American crypto developers leave the mother country for greener pastures abroad, the story begins with long-forgotten projects like Mastercoin and Counterparty.
Ripple’s defeat would be highly symbolic if it loses, as I anticipate it will sooner or later. One of the country’s oldest and most significant cryptocurrency projects, the company’s protocol is one of the longest-running and most significant in the world. There is hardly anyone who hasn’t heard of XRP.
During the time of the founding of Ripple in 2012, the term “initial coin offering” did not exist. In addition, enforcement actions against the then-miniscule crypto industry did not result in any results. Accordingly, the SEC didn’t announce its first settlement for alleged registration violations until November 2018 when it announced the Airfox and Paragon ICO settlements. A nearly six-year-old Ripple network went into production on January 1, 2013.
The Ripple project has not only ranked among the top 10 coins in market capitalization for nearly a decade, but it also posed a unique approach to consensus at a time when alternative approaches to blockchain coordination were still in their infancy.
The four main ways blockchains worked between 2013 and 2015 were as follows:
- Security is provided by proof-of-work, which requires computation energy
- Validation of blocks through proof-of-stake
- It is permissioned, that is, some entity chooses the block creators, and
- Something Ripple does that’s weird
Using a novel consensus mechanism called the “UNL” or Unique Node List, ripple uses round-robin voting to determine which transactions should be appended to a chain when 80% of them agree. Delegated proof-of-stake is similar to this model (except without the stake).
According to Ripple’s proponents, this round-robin approach allows the network to process many more transactions at lower costs. In addition, it does not offer true decentralization, say detractors.
It’s not the protocol that’s causing Ripple’s legal troubles – it’s the tokens. To fund Ripple Labs’ operations, Ripple Labs minted 100 billion XRP tokens on genesis, which were later distributed to the company and early employees, and then sold to larger crypto markets.
The question of whether such tokens constituted securities was hotly debated at the time. On one hand, crypto entrepreneurs argued that token sales could act as a governance mechanism and a crowdfunding tool. The SEC was believed to crack down on this practice by many lawyers, myself included.
It turns out that the skeptics were right after all.
Kik Interactive was the first ICO to go big. In 2017, at the height of the first great ICO boom, Kik pivoted into crypto from a lightly-used messaging app. Without a registration statement in place, Kik sold tokens directly to the public. Kik lost a motion for summary judgment 16 months after the SEC sued.
Next up for the SEC was Telegram. In 2009, Russian billionaire Pavel Durov founded Telegram, an allegedly encrypted messaging app. Even though Telegram is one of the most popular messaging apps on the planet, it doesn’t generate any revenue. Through various private placement transactions over the course of 2018, Telegram raised an incredible $1.7 billion through issuance and sale of cryptocurrency tokens.
Kik Interactive differed most from Telegram in that its tokens were initially sold privately to high-net-worth and offshore investors, who presumably unloaded them later on U.S. markets to retail buyers. An emergency restraining order was obtained by the SEC prior to the tokens being issued. An SEC motion for preliminary injunction would also quickly be granted. (Various and unrelated forms of the Telegram token project have continued since then).
As the next project on the chopping block, LBRY (pronounced “Library”) was slated for cancellation. In contrast to Google and Facebook’s censorship policies, LBRY is a reimagining of YouTube with decentralized monetization tools. A real application used the token for a real purpose. This token was viewed as an investment contract, however, for the purpose of its sale.
The LBRY cryptocurrency was also unsuccessful in a motion for summary judgment, this time in New Hampshire. According to LBRY, the company will likely go out of business within a few years.
This brings us up to the present day. XRP, which represented an investment contract, raised $1.3 billion between 2013 and 2020, according to the SEC. In what should be the last shot fired (or at least among the last shots fired) between Ripple and the SEC on Dec. 2, they exchanged dueling motions, before a judge in the Southern District of New York decided whether a token project is legal once again.
Stuart Alderoty, Ripple’s company counsel, reduced the company’s argument to a single line on Twitter. As part of his argument, he argued that there is no investment contract thanks to the absence of a formal contract between Ripple and its XRP purchasers, and that the tokens were sold for consumption.
As the SEC points out, Ripple’s sales are “based on economic reality” not less than 15 times, and it asks the court to consider “beyond boilerplate disclaimers” to the facts as they actually stand – such as who bought the tokens and how they were used. According to Ripple, this economic reality destroys any argument that XRP is primarily used for consumption.
It is pretty clear from the precedent lawsuits which argument has had more success in federal courts. The judge in Kik stated that “form should be disregarded for substance, and economic reality should be the focus” (citing 389 U.S. 332, 336 from 1967).
Using the example of Glen-Arden v. Constantino, 493 F.2d 1027, 1034 (2d Cir. 1974), Judge P. Kevin Castel stated in Telegram that “Congress intended [the securities laws] to be applied to economic realities, rather than based solely on the name appended to the transaction.”
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According to Judge Paul Barbadoro in LBRY, “the inquiry focuses on the objective economic realities of the transaction, rather than its form” (citing United Housing Foundation v. Forman, 421 U.S. 837, 848 (1975)).
“The federal securities laws do not regulate industries. They regulate conduct for the benefit of investors,” the SEC concluded in its reply brief to Ripple and the court.
Is that true?
At this point, the crypto industry has more or less accepted that a typical ICO probably meets all of the limbs of the Howey Test, which determines what is considered a security. This will be confirmed by the outcome of the Ripple litigation.
Cryptocurrency, however, is another economic reality that needs to be considered: crypto is here to stay. Despite all the precedents discussing “economic reality,” the most material fact is that there are hundreds of millions of crypto users around the world, and that number is growing exponentially.
It is like trying to take a Ford Model T into space by telling them they must “come in and register” or they will die. Unlike paper forms signed in wet ink and mailed to a transfer agent or broker-dealer, crypto’s primary method of operation relies on self-custody and peer-to-peer transactions over the internet. There are no national securities exchanges that support the trading of crypto assets. Exchange-traded funds (ETFs) will not even be approved by the SEC, despite many proposals and many requests from the market. There are many more items on the list.
The SEC is clearly selling something that a huge class of investors don’t want. They actually want the opposite. Trustless smart contracts are used every day by millions of digital natives to grant loans and other financial beasties, or to grant fractional royalty cash flows to third parties. Using handheld supercomputers smaller than a chocolate bar, they do so instantly, anywhere, with anyone in the world. The use of artificial intelligence (AI) will enable them to do this very soon. Investing in this platform gives investors access to superhuman abilities.
A Depression-era regulatory scheme has dominated crypto for the last six years. America’s only choice at this point is whether to back off just a little bit from that regime so we can continue to nurture and supervise these new crypto companies right here at home – or to persevere and drive them offshore.
It doesn’t matter how Congress feels about it, the old ways are over.