A federal judge dealt a significant blow Thursday to Security and Exchange Commission Chair Gary Gensler’s quest to bring the crypto industry to heel, but securities-law experts warn that the legal and political implications of the decision are difficult to predict and may not prove to be a lasting victory for investors in digital assets.
U.S. District Judge Analisa Torres ruled that Ripple Labs’ crypto token, XRP, is not a security when sold on digital-asset exchanges to the general public, but that Ripple’s sales to sophisticated institutional investors did qualify as an unregistered sale of investment contracts, in violation of federal law.
The decision rested on XRP’s XRPUSD, -4.72% status as an investment contract, which are regulated as securities by the SEC. Torres said that XRP only qualified as an investment contract when Ripple Labs sold them directly to institutional investors, but did not qualify as such when those tokens were resold on third-party platforms.
Read more: Ripple token not a security in retail sales, judge rules in partial win for crypto
Arthur Gabinet, a former SEC lawyer and a lecturer at Brown University, told MarketWatch that the ruling would prove to be controversial because it is uncommon for an asset to be considered a security in one context but then to lose that designation when resold in another context.
“If you’re distributing a token that’s a security because it’s an investment contract, it doesn’t matter if it’s a secondary-market transaction,” he said. “It seems to me that it’s still a security. I think the decision may be incorrect as matter of law.” He predicted that the SEC will ultimately appeal the decision.
Other experts, however, agreed with the reasoning that an asset could qualify as an investment contract in one context but not in another.
Federal courts follow the so-called Howey test to determine whether a transaction is an investment contract and therefore a security subject to SEC oversight. Under this test, an investment contract is a transaction whereby a person invests money in a common enterprise and is led to expect profits through the efforts of others.
Michael Selig, a lawyer at Willkie Farr & Gallagher who specializes in digital-asset regulation, said that the court “very reasonably took the view that the investment contract and the subject of the contract are separate things” and that just because XRP was distributed to institutional investors as part of an implied contract between them and Ripple, it doesn’t mean that every subsequent sale of XRP also constitutes an investment contract.
See also: Crypto bulls are thrilled by court ruling that XRP isn’t always a security
The decision, Selig argued, is most clearly a victory for digital-asset exchange Coinbase Global Inc. COIN, -0.73%, which the SEC sued last month for operating an unregistered security exchange. Following the logic of the Ripple decision, tokens offered on Coinbase are likely not securities in that context, even if they were security sales in other contexts.
Nevertheless, it is not a vindication of Ripple’s argument, also promoted by many other digital-asset issuers, that a token can only be a security if it confers rights on the holder of that security, in the way that a stock in a public company confers voting and ownership rights to shareholders.
Justin Slaughter, policy director at the crypto-investment firm Paradigm, wrote on Twitter that the decision leads to an ironic outcome — that sophisticated institutional investors are deriving more protection from securities laws than unsophisticated retail investors.
“That’s what happens when courts decide policy — wild outcomes,” Slaughter said, contrasting court-made policy with Congress’s ability to more thoughtfully craft new laws.
But this decision, even if it holds up on appeal, still leaves the SEC with the power to contest digital-asset sales on a case-by-case basis and does not give the industry the regulatory clarity it has long sought.
Slaughter argued the decision therefore makes it much more likely that there will be a legislative compromise on a new crypto regulatory framework, because Democrats will see that the status quo provides less protection for ordinary investors than they thought just 24 hours ago.
The timing of the decision is particularly interesting given that the House Financial Services Committee had been planning to consider a new bill to regulate crypto-market structure next Wednesday, just a few days following the reintroduction of a bipartisan, comprehensive crypto regulatory bill in the Senate this week.
“It’s about to be a very intense and exciting 96 hours in Washington, maybe the most consequential few days in crypto policy history,” he wrote. “Buckle up.”