Is the crypto token sold as a security, the security itself? This question has arisen in both Congress and court cases and is ripe for discussion. “Separation theory” refers to the notion that the crypto token itself is separate from the security and until recently, this theory had not been adopted by any judge in any “crypto token offered as a security” case. Recently however, the Honorable Judge Analisa Torres adopted the theory in SEC v. Ripple, establishing a precedent. Since the Ripple ruling, two other judges, the Honorable Amy B. Jackson (SEC v. Binance) and William H. Orrick (SEC v. Kraken), have agreed with it.
As evidence of the theory’s validity, both judges, Jackson and Orrick, largely rely on judge Torres, first quoting, “Howey and its progeny have held that a variety of tangible and intangible assets can serve as the subject of an investment contract. … In each of these cases, the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.” (SEC v. Ripple)
This statement merely assumes that because the subjects of past security offerings were not inherently securities, Ripple’s subject, XRP, the crypto token brought to the public market by Ripple, is not a security either. More fundamentally, this statement assumes that the was merely the “subject” of Ripple’s security scheme. What this statement does not do however, is prove anything. Correlation is not causation. Judge Torres failed to even examine, much less appreciate the material difference between the role that XRP plays in Ripple’s security scheme vs the role that prior subjects played in their respective schemes. This difference in role, is the difference between an inherent security, and a mere “subject”. Unfortunately, both Judges Orrick and Jackson, made the same mistake.
What is a security?
The Supreme Court has defined a security as the creation and offer of an investment relationship. “[Congress] recognized the virtually limitless scope of human ingenuity, especially in the creation of “countless and variable schemes devised by those who seek the use of the money of others on the promise of profits… [Congress] enacted a definition of “security” sufficiently broad to encompass virtually any instrument that might be sold as an investment.” (Reves v. Ernst & Young) Notice, all the “countless and variable” types of securities schemes are defined by one common element, an economic relationship where an entity/issuer offers a “promise of profits” in exchange for investment.
How can a product consisting of a “promise of profits”, which is intangible, be offered or purchased? It has to be made tangible. Voilà, the security instrument. In the modern era securities instruments are usually digital tokens or documents. These instruments embody or denominate the relationship and “promise” being offered. In other words, they are necessarily unique to a particular issuer’s scheme because they serve as the means of participation in it. In the words of the Supreme Court in SEC v. Joiner, “… the term “security” was defined to include by name or description many documents in which there is common trading for speculation or investment.”
Crucially, most securities schemes can be categorized by the profit mechanism through which issuers “promise” to reward their investors. The two broad categories are (a) earnings-distribution: schemes involving forms of yield or interest; and (b) investment-instrument-capital-appreciation: schemes where a token or other investment-instrument unique to the issuer is devised, the value of which is primarily reflective of and dependent on the issuer’s efforts. Notice, the profits in both categories are derived primarily by the efforts of the issuer. In the first type of scheme the security issuer generates and delivers the “promised profit” from the actual earnings of the enterprise in form of yield, interest, or dividends, to holders of the security instrument. In the second type of scheme, the issuer does NOT generate the “promised profit” from the earnings of the enterprise, rather the efforts of the issuer determine the value of the investment-instrument itself. Stocks fall into the second category, dividend stocks fall into both, and bonds and various profit-sharing arrangements fall into the first.
The misinterpretation of the SEC v. W.J. Howey Co. case
Much has been made regarding the SEC v. Howey (orange groves) case, where prominent crypto lawyers such as John Deaton cried out that labeling a crypto token a security is akin to calling oranges or orange groves, securities. Both judges Orrick and Jackson also cite the Howey case in their “separation theory” sections, with judge Orrick writing “Orange groves are no more securities than cryptocurrency tokens are.” (SEC v. Kraken)
These assertions are simplistic and imprecise, to the point where they muddy the real issue and hold back progress. Their assertors simply assume that crypto tokens are merely the “subject” of their respective schemes without regard to the profit mechanism used by crypto schemes, and the implications thereof. As will be shown below, due to Howey’s profit mechanism, orange groves were mostly irrelevant to the security offered by Howey.
What was the Howey Co.’s security instrument?
The Supreme Court labeled Howey’s “product” a security as it constituted the opportunity to make “an investment of money in a common enterprise with profits to come solely from the efforts of others.” (SEC v. Howey) What did Howey sell? Howey sold orange groves with service contracts. Howey would cultivate the purchaser’s groves, sell the oranges and distribute the associated earnings. Notice the profit mechanism that Howey offered: earnings-distribution “by the efforts of Howey”.
Howey did NOT use the “subject” of his scheme (orange groves) as the investment-instrument whose value is reflective of and dependent on, Howey’s efforts. In other words, Howey’s efforts were neither directed at, nor reflected in, the market value of orange groves. Rather, Howey’s efforts were directed at, and reflected in, the earnings generated by his cultivation of specific orange groves. This can clearly be seen by cause/effect. Howey’s efforts for his purchasers did not cause the value of orange groves to go up or down depending on Howey’s performance. Orange groves were merely the “subject” of Howey’s scheme.
Second, how did Howey denominate his security “product”, the opportunity to invest and receive the promised “earnings-distribution”? In other words, what was Howey’s security instrument? Clearly, not orange groves. By simply purchasing an orange grove, no-one could invest money to receive Howey’s earnings-distribution. Orange groves were not unique to Howey, thus, by far most orange groves purchased during Howey’s security offer had zero relation to Howey.
Howey devised a unique instrument offering participation in his scheme. Howey denominated his “product” by a pair of contracts. Holders of these contracts were invested in Howey Citrus Enterprise and received the “promised” earnings from Howey’s efforts. It was impossible to participate in Howey’s security scheme without the contracts, and it was impossible not to participate having purchased or entered them. In other words, the contracts, not orange groves, evidenced “shares” in Howey’s citrus enterprise. Therefore, the Supreme Court called those contracts, not orange groves, the securities: “The investment contracts in this instance take the form of land sales contracts, warranty deeds, and service contracts which respondents offer to prospective investors.” (SEC v. Howey)
As an aside, this has something to do with the fact that orange groves are not fungible. Howey’s pairing of his specific groves with a “promise of profits” had nothing to do with any other orange groves. How do crypto schemes compare?
What was Ripple’s security instrument?
Judge Torres deemed that, like Howey, Ripple created and offered the opportunity to make “an investment of money in a common enterprise with profits to come solely from the efforts of others.” What did Ripple sell? In the words of judge Torres, “Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts. From 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 Ledger, thereby increasing the value of XRP.” (SEC v. Ripple)
Ripple created distributed ledger software and issued an investment token, XRP, transactions of which are recorded on the ledger. Ripple, as a matter of fact, develops, markets, and drives the use cases and adoption of the XRP software ledger/network and helped(s) develop the secondary market, which in turn increases the market price of XRP. Ripple sold the XRP token to both retail and institutional investors. Ripple’s “product” was deemed a security even though it does NOT involve any earnings-distribution from the Ripple/XRP Software Enterprise. Earnings-distribution is not the only way to “promise”, generate and deliver, profit to investors. Ripple offered investment-instrument-capital-appreciation by “the efforts of Ripple”, generating and delivering profit to institutional investors from the association between the value of the XRP in the secondary market and Ripple’s efforts.
Despite widespread discussions about the novelty of crypto, Ripple’s profit mechanism is not anything new. In its fundamental nature it is identical to the approach used by stock issuers, where an investment token is devised whose value in the secondary markets is primarily reflective of the issuer’s efforts. Its utilization by Ripple is not surprising as crypto tokens are literally the same thing as stock tokens, fungible digital tokens transacted on investment exchanges.
Second, how did Ripple denominate their security “product”, the opportunity to invest and receive the promised XRP price appreciation? Put another way, what is Ripple’s security instrument? This is easy, in investment-instrument-capital-appreciation schemes, the investment-instrument that appreciates/depreciates is always the security, but this can be fleshed out.
Judge Torres held that institutional sales of XRP were securities, i.e. that the profits that Ripple “promised” were derived “solely from the efforts of others”. What profits did Ripple “promise”? The price appreciation of XRP. Further, how would institutional investors be harmed if Ripple’s efforts failed? The price depreciation of XRP. Thus, in holding that Ripple’s scheme met the requirements of Howey, Judge Torres held that the market value of XRP appreciates or depreciates “solely from the efforts” of Ripple. In other words, the market value of XRP is primarily reflective of and dependent on Ripple’s efforts.
Because XRP itself is the investment vehicle through which Ripple generates and delivers the “profits” that Ripple “promised” to institutional investors, XRP itself is NOT a stand-alone commodity, it is Ripple’s security instrument. It is impossible to participate in Ripple’s security scheme without XRP, and impossible not to participate having purchased XRP.
Crypto tokens are NOT merely the “subject” of their respective “schemes”
Think about this a moment. Notice the key difference between the “subject” of a securities scheme and the security instrument (the means of participation). No one received Howey’s “promised” earnings-distributions by simply purchasing the “subject”, an orange grove. On the contrary, because Ripple “promised profits” by impacting the price of XRP (investment-instrument-capital-appreciation), all purchasers of XRP receive “profit” by Ripple’s efforts. Crypto tokens are fungible, meaning they are all identical. It is impossible for Ripple’s “promise of profits” to be paired to some XRP tokens and not all XRP. Ripple cannot impact the price of only some XRP. This effect is mirrored in investor’ fortunes. Whereas the fortunes of 99% of orange grove owners had no relation to Howey, the fortunes of ALL XRP holders are dependent on Ripple. XRP is not merely the “subject” of Ripple’s scheme, it is the security instrument- the necessary AND sufficient means to participate in Ripple’s security scheme.
Further, note the similarities between Ripple’s security instrument- XRP, and Howey’s security instrument- Howey’s contracts. Just like the sole means of receiving Howey’s earnings-distribution was to simply purchase Howey’s contracts, the sole means of receiving XRP price appreciation by the efforts of Ripple is to simply purchase XRP. Just like the fortunes of ALL holders of Howey’s contracts were dependent on Howey’s performance, the fortunes of ALL XRP holders depend on Ripple’s performance. It begins to make sense.
Crypto tokens are not like “ordinary assets”.
The failure to examine gets worse. Judge Torres, requoted by both judges Jackson and Orrick, further writes, “Here, defendants argue that [the crypto token] does not have the ‘character in commerce’ of a security and is akin to other ‘ordinary assets’ like gold, silver, and sugar . . . This argument misses the point because ordinary assets – like gold, silver, and sugar – may be sold as investment contracts, depending on the circumstances of those sales.” (SEC v. Ripple)
A cursory examination shows that the opposite is true, that “ordinary assets like gold, silver, and sugar” cannot be sold as investment contracts akin to Ripple’s XRP sales. That is, they cannot be sold as security instruments which appreciate and depreciate by the efforts of the issuer. Ironically, the listed “ordinary assets” have actually been the subject of courts cases where judges ruled the opposite of Judge Torres’ assertion; ruling that when ordinary assets are sold on the expectation of price appreciation (as crypto tokens are), the sales cannot be investment contracts.
In a case invoilving investment in sugar, a federal court in the Southern District of New York ruled that “The purchaser, Sinva [institutional investor] in this case, gained no share in a common enterprise, … Moreover, the purchase of commodities futures involves no reliance upon the efforts of promoters, managers, employees or any third party… the expected return is not contingent upon the continuing efforts of another.” (Sinva v. Merrill, Lynch, Pierce, Fenner Smith) The Ninth Circuit Court in a gold case ruled that, “[The district court] found no common enterprise between the purchasers and CMC and noted that “the profits to the [gold] coin buyer depended upon the fluctuations of the gold market, not the managerial efforts of CMC… We [] agree with the district court.” (S.E.C. v. Belmont Reid Co., Inc.) The Ninth Circuit Court in a silver case, “… we hold that no investment contract was created. Once the purchase of silver bars was made, the profits to the investor depended upon the fluctuations of the silver market, not the managerial efforts of Key Futures… There is a national market for silver which is not dependent upon Key Futures. Thus, although the buy-back agreement here saved the customer a brokerage fee, it does not indicate that the plaintiffs were engaged in a common enterprise with any defendant.” (Noa v. Key Futures, Inc.)
The listed ordinary assets cannot be sold as securities under investment-instrument-capital-appreciation schemes (as crypto tokens are) because ordinary assets are not unique to any particular issuer. They cannot therefore embody the “promise” of a particular issuer, their value does not and cannot primarily reflect the efforts of any particular issuer. Notice that Ripple did not sell “ordinary assets” that are not unique to Ripple as securities. Why not? It could never work. The value of “ordinary assets” or even random tokens not issued by Ripple, do not primarily reflect Ripple’s efforts. Ripple thus issued a token, XRP, unique to Ripple, reflective primarily of Ripple’s efforts, by which it promised and delivered profits to Ripple/XRP investors.
This implication is seen when replacing XRP with sugar and Ripple with U.S. Sugar Corporation in Judge Torres’ holding. It would read this way, “Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased sugar with the expectation that they would derive profits from U.S. Sugar Corporation’s efforts. From U.S. Sugar Corporation’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that U.S. Sugar Corporation would use the capital received from its Institutional Sales to improve the market for sugar and develop uses for sugar, thereby increasing the value of sugar.”
If this was held by a court, as it was by Judge Torres, then U.S. Sugar Corporation would be obligated and liable in regard to efforts aimed at increasing the price of sugar for its institutional sugar purchasers. This is absurd and simply impossible because sugar is not unique to U.S. Sugar, thus the price of sugar cannot be primarily reflective of and dependent on U.S. Sugar’s efforts. Yet, judge Torres ruled this way in regard to Ripple’s institutional XRP sales.
Crucially, U.S. Sugar Corp. could devise an earnings-distribution securities scheme in which case sugar would then be the “subject”, but it cannot devise an investment-instrument-capital-appreciation scheme using sugar, as crypto issuers do with tokens.
Separation Impossible!
In a securities scheme utilizing the investment-instrument-capital-appreciation model, as crypto schemes do, it is frankly impossible to, as Judge Jackson asserts to “differentiate the alleged investment contracts from the tokens themselves”. (SEC v. Binance) Because in a crypto securities scheme, the “promise of profits” consists of the issuer’s impact on the market price of the token itself, the “promise” and its execution are inherently paired to the token itself. In short, tokens sold as securities, are securities themselves.
Joe Sho is an independent researcher focused on the intersection of public policy and the crypto asset markets.
