Are Digital Assets Securities?
Tyler White, University of Mississippi School of Law, Class of 2024
In July, a federal magistrate rejected the Security Exchange Commission’s (“SEC’s”) third attempt to withhold internal documents relating to a speech given by an SEC official in 2018. The decision is part of a case in which the SEC claims Ripple Labs, Inc. (“Ripple”) conducted an unregistered sale of digital asset securities. The release of the internal documents could affect not only the outcome of this case but the authority of administrative agencies.
The term “security” includes an “investment contract” and other instruments such as stocks, bonds, and transferable shares. The Supreme Court’s Howey case found that 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 SEC has made clear that it believes some digital assets are securities and has brought charges against companies for selling unregistered securities.
In 2013, the SEC sued a crypto company for selling unregistered digital asset securities for the first time. In April 2022, the SEC again brought suit against the founders of a blockchain platform for misleading investors about the company’s growth prospects and for selling digital tokens that are unregistered securities. Typically these suits are civil; however, the Department of Justice (“DOJ”) has brought criminal actions as well. For example, in U.S. v. Zaslavskiy, the DOJ criminally charged Zaslavskiy for securities fraud for fraudulently inducing purchases of a digital asset scam.
SEC statements have generally reflected the position taken in these cases. However, many now argue that the speech by the former director of the SEC’s Division of Corporation Finance, William Hinman, reasonably led them to believe that digital assets such as Ripple’s XRP are not securities. Hinman stated that the agency did not consider the virtual currencies Bitcoin or Ether to be securities and would “put aside the fundraising that accompanied the creation of [e]ther” and look instead at the “present state of [e]ther.” Yet, this statement conflicts with then SEC Chairman Jay Clayton’s statement on CNBC, where he said, “a token, a digital asset, where I give you my money, and you go off and make a venture… and in return for me giving you my money, you say you know what I’m going to give you a return…that is a security and we regulate that.”
For years the crypto industry has aggressively challenged the SEC, and Ripple’s seemingly aggressive stance toward its regulator reflects this approach. For example, Terraform Labs sued the SEC contesting subpoenas served as part of an investigation regarding the unregistered sale of securities. In July, Grayscale sued the SEC the same day its application for a Bitcoin ETF was rejected. Additionally, Empower Oversight sued the SEC for access to FOIA documents regarding potential conflicts of interests of senior SEC officials and their role in regulating crypto. The crypto industry has aggressively challenged any regulator that stands in its way. This stance may reflect judicial trends toward constraining the exercise of regulatory power.
Now, lawmakers are taking things into their own hands, and the issue of whether digital assets are securities may be mooted by legislation. Two bi-partisan bills have been introduced to provide regulatory certainty – (1) the Lummis-Gillibrand Responsible Financial Innovation Act and (2) the Digital Commodities Consumer Protection Act of 2022. Both bills would treat the majority of digital assets as commodities, rather than securities. However, without the passage of a bill, the question of how digital assets should be regulated remains. Likely, the Court will decide in SEC v. Ripple if digital assets are securities.
Until digital asset legislation arrives, the Ripple decision could lay the framework for regulating digital assets. In December 2020, the SEC filed a Complaint against Ripple for selling unregistered securities. The SEC alleges that Ripple was objectively reckless in believing that XRP was not a security, and that Ripple was on “fair notice” that XRP was a security. In January 2021, Ripple filed an Answer stating that the Complaint “advances an unprecedented and ill-conceived legal theory — with neither statutory mandate nor congressional authorization.” Ripple had made clear they do not believe XRP is a security. In an attempt to challenge the allegations, Ripple sought certain documents from the SEC including internal documents relating to the Hinman speech. However, the SEC argues that attorney-client privilege protects such documents.
On July 12, 2022, a federal magistrate rejected the SEC’s attorney-client privilege argument and ordered the SEC to produce the documents. The judge reasoned that “the predominant purpose of the communications was not to provide legal advice to aid the SEC in conducting public’s business.” Now that the decision has been rendered, the SEC must hand over the documents.
Ripple hopes these documents will confirm that Hinman’s comments were agency policy. In the speech, Hinman explains when “a digital asset transaction may no longer represent a security offering.” He goes on to say that “[o]ver time, there may be other sufficiently decentralized networks and systems where regulating the tokens or coins that function on them as securities may not be required.” And that for Ethereum, it was agency policy to “put aside the fundraising that accompanied the creation of [e]ther” and look instead at the “present state of [e]ther.” Ripple relies on this language for their reasoning of why XRP is not a security and hopes that the documents will reveal this truly was the agency’s position.
Under the Howey Test, 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.” The issue in applying Howey to XRP ultimately turns on whether there is an “expectation of profit to be derived from the efforts of others.” The key question for a court in assessing whether a transaction satisfies the third prong of Howey is to determine whether profits are derived from the activities of the promoter or rather, the operation of external market forces beyond the control of the promoter. Hinman said that the way a digital asset is “sold – as part of an investment; to non-users; by promoters to develop the enterprise – can be, and, in that context, most often is, a security…” However, this creates many ambiguities, and Ripple argues that it lacked “fair notice that its conduct was in violation of law, in contravention of Ripple’s due process rights.”
Additionally, Ripple points to several other sources of ambiguity. First, Ripple points to a 2019 meeting where SEC staff met with a digital asset platform considering to list XRP. During the meeting, the platform sought guidance on whether the SEC considered XRP a security, upon which the SEC did not say it was. Next, Ripple points to the fact that “XRP was listed on over 200 exchanges, billions of dollars in XRP was bought and sold each month, numerous market makers engaged in daily XRP transactions, Ripple’s ODL product was used by many customers, and XRP was used in third-party products, many of which were developed independently of Ripple.” Finally, Ripple contends that the U.S. Department of Justice (“DOJ”) and U.S. Department of the Treasury’s Financial Crimes Enforcement Network (“FinCEN”) determined that XRP is lawfully used and traded in the marketplace as a virtual currency in 2015 and 2020.
The Potential Ripple Effect to Come
Ripple argues that its investors did not rely on its efforts after the initial issuance of XRP. Currently, courts are split on whether post-sale efforts satisfy Howey’s “effort of others” prong. The 11th Circuit held that post-sale efforts are not necessary to satisfy Howey’s efforts of others prong; however, the DC Circuit held that post-sale efforts of others are necessary to satisfy the prong. This issue could be resolved if Ripple goes to the Supreme Court.
As this uncertainty plays out in Court, the crypto industry continues to aggressively challenge any regulator standing in its way. In one instance, a Ripple enthusiast went so far as to make death threats toward an SEC expert witness. This incident highlights issues with the aggressive stance and tone toward regulators and may be viewed as instigating the actions of their supporters. Ultimately, only time will tell if this aggressive stance pays off for Ripple and the crypto industry; however, the approach appears promising so far.
Here, the Court adamantly pushed back on all defenses the SEC raised regarding production of the documents. The Court even went as far to say that the question of whether speech reflected the agency’s policy has been “unnecessarily complicated by the SEC’s litigation tactics.” Further, the Court said, “[t]he hypocrisy in arguing to the Court… suggests that the SEC is adopting its litigation positions to further its desired goal, and not out of a faithful allegiance to the law.” The Court’s stern language towards the SEC could reflect the judicial trend toward skepticism about the exercise of regulatory power and bode poorly for the SEC in Ripple.
Ultimately, a lack of regulatory clarity leads to issues such as these and often forces Congress to act. The two bi-partisan bills mentioned above hope to resolve this issue and provide much-needed regulatory clarity. However, for now, the question remains – are digital assets securities?
SEC Documents Could Lead to Determination of Who Regulates Digital Assets
The production of internal documents relating to the Hinman speech could ultimately lead to a framework for regulating digital assets. Regardless, legislators are attempting to take matters into their own hands by introducing bills that provide regulatory clarity. The Ripple decision could also lead to a resolution regarding whether post-sale efforts satisfy Howey’s “effort of others” prong. Bigger than the crypto industry; however, Ripple could reflect the judicial trend toward skepticism about the exercise of regulatory power.
 SEC v. Shavers, No. 4:13-CV-416, 2013 U.S. Dist. LEXIS 110018 (E.D. Tex. Aug. 6, 2013).
 See https://www.sec.gov/litigation/litreleases/2022/lr25377.htm.
 United States v. Zaslavskiy, No. 17CR647(RJD), 2018 U.S. Dist. LEXIS 156574 (E.D.N.Y. Sep. 11, 2018).
 United States SEC v. Terraform Labs Pte Ltd., No. 22-368, 2022 U.S. App. LEXIS 15722 (2d Cir. June 8, 2022).
 Grayscale Investments LLC v. SEC (Petition for Review filled in the US Court of Appeals for the District of Columbia)
 Empower v. SEC, No. 1:21-cv-01370, 2022 U.S. Dist. Ct. E. Dist. Of Virg. (Dec. 8, 2021).
 See NFIB v. Department of Labor (Supreme Court of the United States limited the power of OSHA to implement a vaccine mandate for much of the nation’s workforce. W. Virigina v. EPA (Supreme Court struck down the EPA’s Clean Power Plan and essentially limits the EPA’s authority to regulate the carbon emissions from coal and gas power plants.).
 Director William Hinman, Division of Corporation Finance, Remarks at the Yahoo Finance All Markets Summit:
Crypto, Digital Asset Transactions: When Howey Met Gary (Plastic), (June 14, 2018), https://www.sec.gov/news/
 S.E.C. v. Mutual Benefits Corp., 323 F. Supp. 2d 1337, 1342 (2004).
 See Hinman Speech
MEET THE AUTHOR
Tyler White is from Flora, MS, and is a current 2L at The University of Mississippi School of Law. White is a Staff Editor for the Mississippi Law Journal, a Business Law Fellow, Vice President of the Intellectual Property Law Society, Vice Magister of Phi Delta Phi, and Social Chair for the Business Law Network. Additionally, White is a member of the Christian Legal Society and the Entertainment and Sports Law Society.
White attended Southwest Mississippi Community College, where he played baseball, served as Student Body President, and was inducted into the Academic Hall of Fame. Following his time at Southwest, White transferred to The University of Mississippi, where he graduated in 2021 and was named a Taylor Medalist, the highest academic honor the University bestows.
This past summer, White worked as a Summer Associate at Butler Snow LLP in Ridgeland, MS. White also received a summer placement from his Business Law Fellowship and worked with in-house counsel at C Spire in Ridgeland, MS. This summer, White will return to Butler Snow LLP for his first half, and then work with Baker Donelson in Jackson, MS.