Public Key Podcast

Everything You Need To Know About the SEC vs. Ripple Lawsuit: Podcast Ep. 68

August 8, 2023 | by Chainalysis Team

Episode 68 of the Public Key podcast is here! The cryptocurrency industry got good news when Judge Analisa Torres ruled that Ripple Labs Inc. did not violate securities law in selling its token (XRP) via public exchanges. But securities law and cryptocurrency specialist, Lewis Cohen (Co-Founder, DLx Law), explains why the industry shouldn’t start the celebrations just yet. 

You can listen or subscribe now on Spotify, Apple, or Audible. Keep reading for a full preview of episode 68.

 

Public Key Episode 68: Analyzing the SEC vs. Ripple lawsuit and recent judge ruling 

The SEC vs Ripple has been a landmark case for the crypto industry and recently the Judge presiding over the case ruled that Ripple in the sales of XRP token via public exchanges.

In this episode, Ian Andrews, brings on securities law and blockchain expert, Lewis Cohen, co-founder of DLX Law, who explains  this case is far from over and still has serious implications for the crypto industry. 

Lewis provides a background on securities laws and how they may apply to cryptocurrency, ICOs and NFTs and how decentralization is not the sole determining factor in whether a token is a security or not. 

He analyzes the judge’s ruling in the Ripple case, highlighting the distinction between institutional sales, programmatic sales, and other distributions, while explaining the impact on exchanges and the ongoing litigation of other major crypto trading  platforms.

Quote of the episode

“The fact that you can sell something in a fundraising scheme does not make that thing itself a security.”
– Lewis Cohen (Co-Founder, DLx Law)

Minute-by-minute episode breakdown

  • (2:35) – Introduction and background of Lewis Cohen and explanation asset backed securities 
  • (6:04) – The ICO boom and their similarity to traditional securities transactions 
  • (10:25) – Explanation of securities laws and the Howey test
  • (17:06) – Clarification on the relationship between decentralization and securities laws 
  • (27:12) – Overview of the U.S. Securities and Exchange Commission’s (SEC) complaint against Ripple
  • (33:02) – Analysis of Judge Torres’ court ruling on the Ripple case and explanation of institutional sales, programmatic sales and other distributions
  • (36:05) – Impact of the ruling on exchanges and future SEC lawsuits
  • (41:37) – Explanation of the ongoing process and potential outcomes of the case

Related resources

Check out more resources provided by Chainalysis that perfectly complement this episode of the Public Key.

Speakers on today’s episode

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Transcript

Ian:

Hey everyone. Welcome back to another episode of Public Key. This is your host, Ian Andrews, very excited to be joined today by Lewis Cohen, who is the co-founder of DLX Law. Lewis, welcome to the podcast.

Lewis:

Hey, man, thanks for having me.

Ian:

Now, as people who are regular listeners to the show are well aware, I am the furthest thing from a securities lawyer, but I’ve been reading nonstop lately about the Ripple case, as I think probably everyone who’s in the orbit of the crypto ecosystem has. And I am mystified as to what the judge has actually ruled on. So I think today we’re going to spend the bulk of the time really trying to dig into that and see if we can get me to a feeling like I’m slightly competent on the topic. That would be a big win. But you’ve been in the space for a long, long time. I’d love to start with a little bit of your background and how you came to focus on this area of cryptocurrency, blockchain, and the impacts to securities laws.

Lewis:

Sure. Thanks. Yeah, I started my career in another offbeat area some years ago. Years ago. And that was in the world of asset-backed securities. And asset asset-backed securities at the time, especially as a young lawyer, I got involved, were very different from anything else that had come before, and a whole new set of rules, regulations, and ways of dealing had to address them because with asset-backed securities, you take basically a pile of mortgages, or credit card obligations, or things like that, you put them into a legal entity that really does not do anything, it just sits there. Some people call it a brain-dead entity, and then it sells some sort of interest in that.

And if you think about it, it looks a lot like a DAI, a multi-collateral vault, because in many ways that’s exactly what it is. And so we had to develop new sorts of rules, disclosures, and ways of dealing with this. And I worked extensively with the SEC during that period to figure out how to do that. There was a period of probably about the better part of 10 years before the SEC came up with disclosure rules, which ultimately became called regulation AEB, asset-backed.

So despite the fact that we see the chair of the SEC saying today, “Come in, and register, and everything works fine.” The reality is that in the past and other circumstances, the SEC have modified the rules to address different and unusual circumstances. There’s nothing wrong with that. Some things were made more tight, some things that didn’t apply were ignored. For example, when you had a securitization transaction, nobody said, “We need financial statements.” Because it wasn’t particularly relevant. Instead, they provided statistical data about the performance of the mortgages or other things. And I think that’s the direction we see and we’ll, I’m sure, talk a little bit more about in some of the legislation on both the House side and the Senate side, going, “Hey, let’s rethink what disclosures are needed. Let’s make sure the right disclosures are provided, but not set up rules that are sort of functionally impossible to comply with.”

So based on that background, when I first learned about this idea of, and sometimes we say blockchain and it gets a little bit of a skew look, “It’s crypto, man, it’s crypto. Don’t you know?” And I agree with that. But when I first learned about this, I said, “This feels a lot like what I’ve been doing for much of my career.” And I got very interested. And I was at a large law firm. And I said, “Hey, let’s dive right in. Let’s make this happen.” And it became clear to me, though, that large law firms didn’t really understand what was going on under the hood. I had the real privilege and honor to work with Consensus, the company, in some of their earliest projects. And so you’re there at the beating heart of really what’s going on in the Ethereum community and a lot of the different things, and learning, and understanding.

And I said, “Hm. This is different than things I’ve done before.” And ultimately we decided if we wanted to do this the right way, we need to start our own law firm, which my co-founder, Angela Angelovska-Wilson and I did in May of 2018. So our firm is about five years old now. And we help people almost exclusively working with crypto assets in one way or another. Some of those may be very large organizations that are traditional organizations, many that you guys at Chainalysis serve, but also others as well, much smaller startups, and others. And really what we believe is critical for anyone as a lawyer working in the space is you got to understand what’s going on under the hood. And that’s what we seek to do.

Ian:

Yeah. That’s really exciting. So I would imagine at the timeframe you’re coming into it, one of the hot topics must have been ICOs, initial coin offerings.

Lewis:

Yep.

Ian:

And my experience, and I’ve only been in the space about two and a half years, so I only lived that period, 2017, 2018, through headlines that I wasn’t really following. But my sense of it is that in some ways the challenges we’re having between the industry and the SEC are a little bit reflecting back on that period of the ICO boom. When I look at an ICO, I have a hard time not seeing it as being equivalent to a private tech company doing an initial private investor round, where, in that case you create documents often called a safe, and you have a bunch of accredited investors who put some money into that initial seed, startup capital pool, to help a group of folks with a good idea get off the ground. ICO, to me, functionally looks the same. Would you agree with that?

Lewis:

100%.

Lewis:

Yeah, 100%.

Ian:

Okay.

Lewis:

This is really, it’s a great, it’s a very insightful question, because it’s really where a lot of our confusion stems from. The prior chair of the SEC, Jay Clayton made a statement that, “Every ICO I’ve seen looks like a securities transaction.” I’d broadly agree with that. It sounds like you would as well.

Ian:

Absolutely.

Lewis:

If we can take just a slight step back, and talk about our securities laws and what the principles are, because I think it’s when you know what the principles are, it’s a lot easier to fit things into the framework. Obviously, prior to the stock market crash in 1929, and the depression that followed, we didn’t have federal regulation of securities. So like many other things, including barbershops, and money transmission, and a whole range of things, they were regulated at the state level. Each state could make its own securities laws and it regulated activity in the state in its own way. And those are commonly referred to as blue sky laws. You could sell anything but the blue sky, kind of thing.

Obviously, after the market crash, and people looked around and said, “Well, these are national markets, and they’re really important to our entire economy in the United States. We need federal regulation.” Fair enough. So Congress went ahead and drafted federal regulation. But if you’re going to regulate securities activity, what’s a security? … “Well, what are we regulating here?” So some things were obvious. Well, if you’re selling shares of stock in a company or corporation, that’s the security. That’s what we’re thinking of. Good to go. If you’re selling notes, or bonds, or debentures that are widely traded as an investment, those are securities. And so what Congress did is they enumerated various things. “Okay, we would all agree, here. That’s a security. Check. That’s a security. Check.”

And they went through about, give or take 10 or 12 different categories. But Congress back then, they’re just as smart as we are today. Maybe not smarter, maybe not less smart. I said, “People are people and they’re always going to find workarounds. So if we just define securities as things with certain types of names or categories, stock, bond, note, debenture, things like that, people are going to just, ‘Well, you know, Ian, I’m not going to sell you a stock, I’m going to sell you schmuck.’ Different, totally different. So we’re good to go, here.”

So Congress borrowed from state law this idea that there were arrangements called investment contracts, which didn’t necessarily fit into any of the other categories. But it’s a you know it when you see it. That’s what we’re driving at, here. That should be regulated. And so they stuck in that term. And rather unfortunately or maybe fortunately, they didn’t define the term investment contract because it was used commonly in state law, they incorporated into federal law. It didn’t define it. And so nobody quite knew what it meant. And so it took about another, give or take 10 years, for the Supreme Court to get around to saying, “Okay, here’s what we think you, Congress, meant when you use that term. We think it means an investment of money in a common enterprise with a reasonable expectation of profit primarily from the efforts of others.”

They originally said solely, but people realized solely, that’s not quite right, primarily, for our purposes primarily. So when those factors are present, and here’s really the important part again, a transaction will be considered a securities transaction. When we relate to each other in some way, and those factors are present, the law will … Even though you’re not calling it a securities transaction, I’m not calling it a securities transaction, if I’m investing in money in you, we have a common enterprise in some way. We’re both in it together. You’re not walking away and I never see you again. I have an expectation of profit. I’m not just buying some piece of art from you. I’m doing this to make money. And I’m expecting you to drive that forward. When those factors are present, we’re going to say, “That’s a securities transaction.”

That may be fine, and this really ties back into where your question started, if we are both sophisticated people who, I can make an investment in you, I’m what’s considered an accredited investor, you give me whatever information I need, and then we make that decision. You haven’t done a public offering of that. You’ve just talked to me. It’s a securities transaction, but it’s one that’s exempt, no registration is required.

The problem we saw in the ICO period is people were doing exactly that, but they were not doing it on a private basis. They’re putting it up on a website, you probably remember this, with a countdown clock and every bad thing you can pretty much do, “Hurry up and buy,” not a lot of information, what information is inaccurate? Sometimes they had pictures of God knows who on the website as you probably remember. And the whole thing was just absurd and ridiculous. So they were absolutely fundraising transactions because the people buying the tokens in those ICO transactions, they didn’t really want to use the token for whatever, a sensible purpose. In many cases, the protocol wasn’t even built. There was nothing you could use them for. What they wanted was to experience a profit based on whoever was the team, “Oh, look at this guy. It’s Prince Charles or whatever,” some absurd things they put up, and they wanted to make a profit. And so those were securities transactions. There were no exemptions. They were done publicly. There were no exemptions, and they were in violation of the law.

And so we saw the SEC appropriately come down on those like a ton of bricks, and mostly that got stopped, but I’m going to pause for breath, here, but that is where our problems kind of started, because you’re 100% right. Those fundraising transactions do, I think quite clearly fall within the scope of our federal securities laws, and are regulated, and either need to be exempt, appropriately exempt or registered with the SEC.

Ian:

And I think I want to pick up on something that you said, there, where you’re using the term the transaction, is a securities transaction. It doesn’t necessarily mean that the business is now a securities business or that something that the entity has created, the token in this case, is in and of itself a security. Am I thinking about that-

Lewis:

You’re thinking about-

 

Ian:

… reading too much into your commentary?

Lewis:

Yeah, no, you’re thinking about that 100% correct. And the judge really zeroes in on that, in that she focuses on the fact that the fact that you can sell something in a fundraising scheme does not make that thing itself a security. And it could be the most basic of commodities. The fact that there’s a commodity involved does not mean that the asset being sold, or what she refers to as the subject … Here, I was looking for a quote to give you. So she says, “But the subject of a contract transaction or scheme is not necessarily a security on its face. Could be, but it’s not necessarily.” She goes on to say that, “This Howey case and the cases that followed have held that a variety of tangible and intangible assets can serve as the subject of an investment contract.” And she gives some various examples. In each of these cases, the subject, which is the term you use, basically, of the investment contract was a standalone commodity, which is not in itself inherently an investment contract.

And so that’s really the key thing you have to examine, “So is there a scheme in which case that is substituting, it’s a disguise? I could have pitched it as an investment scheme where we were selling securities, but I obfuscated, I tried to trick you into thinking, ‘Nah, you’re not really that kind of thing.’ And I’m giving you something that you don’t want or need on its own. You just want to resell it later.” That should be covered by the securities laws, but the judge in the XRP case says, “When the transaction doesn’t meet the four prongs of Howey, you could sell the exact same thing.” And then this, I think, goes to what a lot of people is like, “Hang on, you’re protecting the institutional investors. You’re not protecting the retail investors.” We’ll talk about that. But that’s not her point. Her point is simply this, that you have to look at a particular transaction, not at the asset, unless the asset itself is a security.

Ian:

Well, and this is where I think a lot of people on Twitter suddenly start talking about oranges.

Lewis:

Exactly.

Ian:

And they’re like, “Oranges aren’t securities, even though you could invest in an orange grove and that could be a securities transaction.” I’m finally understanding why everyone’s been talking about oranges for the last few months.

Lewis:

Well, the catch I’d say, Ian, and this a little bit gets up my nose. People use this as a simplistic way of explaining it, and that’s fine, “Oranges are not securities.”

Ian:

Yeah.

Lewis:

But tokens are also not oranges. So I think it sells us short by underselling the argument in the other direction. You know, oranges are made-

Ian:

Yeah.

Lewis:

… by the good Lord upstairs. They’re in unlimited supply, and they’ve always been around, and you can find them in a lot of places. Tokens are made by, typically, one person deploying a smart contract on a network like Ethereum, and they’re in finite supply, and they’re specifically designed that when you apply demand, the price goes up. That’s not how oranges work. So they have very, very, very different characteristics. So I think in fairness, I wish people would stop saying, “Oranges are not securities.” Not because it’s not true, but it doesn’t get at the core issue. That doesn’t make tokens themselves securities, but it misleads, I think, the honest listener.

Ian:

That’s a great point. And I would actually like to chase that a little bit because then I think ICOs, clearly securities transactions, but I felt like you were going to lead us down the path of saying, “Even though you can have these security transactions, it doesn’t in any way influence a later decision about are any given crypto tokens, whether there was an ICO or not, a security?” But I feel like your last comment there is saying, “Well, in some cases it is a security and it’s not.” Can you give us maybe a framework that’s a little more sophisticated than the oranges that we can use to just reasonably apply as we’re navigating through the ecosystem?

Lewis:

Of course. Well, if we start with the base case. And for better or for worse, XRP is pretty good as a base case. But for the most part, Ether is not too far away. You have to look at the asset itself and the arrangement that it represents. So things that, particularly, in the early days, were characterized as utility tokens, which is not a term at all that I like, and you may have heard that term, but things that we’re … First and foremost, let’s just recall, the token itself is really just a number. What does it mean when you own, whether it’s Bitcoin, Ether, XRP, or anything else, is that you have knowledge of a private key which allows you to give an instruction to a network of computers and tells it to do something. So that’s first and foremost.

So is there anything that’s associated with that number that gives you rights or benefits against some identifiable group? And for most tokens, if you look at the CoinMarketCap, 50, or maybe even 100, or CoinGecko, we’re appropriate these days to say, when you look at that group, most of the tokens, holding aside stablecoins or Memecoins, do not provide any particular rights or benefits. But other coins do. Other coins have economics baked into them. For example, they may have a fee switch turned on. There may be a sharing, there may be a DAO that’s created in that if you own the token, the DAO periodically does a buy and burn on those tokens.

Now you have a very different sort of arrangement. If the DAO is seeking to run a business that would otherwise just look like a normal business except it’s completely decentralized, then you say to yourself, “Well, what’s going on here?” That doesn’t mean that it’s necessarily a security, but you have to look at it. Where the danger zone, I would say for folks predicting the DAO community are, is, is this really something managed by the community at large? And we can use the word decentralization. Interestingly, that word does not come up but once in the Ripple decision, that’s a very interesting thing, because people have been obsessed around this. But we can come back to that.

But when you think about DAOs, is it something where everybody’s really collectively deciding? And there are communities that are like that, where there’s really meaningful community engagement, but there are plenty of communities where it’s really a small number of folks who are driving the bus, and everybody else is along for the ride. Those are communities. If you’ve got real economics, you’re running a business, and there’s a small number of people or companies that are functionally making all the decisions and everyone’s relying on, now you have a different sort of arrangement.

So as a framework, ask yourself, “What is the token doing? And am I in part of an actively managed business?” XRP is not an actively … It’s just like you use it, you send it to somebody, they send it back to you, like Bitcoin. Doesn’t really do a lot. Even the Ether token itself is not, in and of itself a business or a venture, but other things are. So you think of more sophisticated products like Curve and Yearn or other things like that, that do, those are rate setting, that people are actively sitting there and managing the process. That’s a different thing. And so I would absolutely urge caution to your listeners again to make sure, I wouldn’t extrapolate from Judge Torres’ decision in Ripple Labs that any token you do, you’re good to go.

Ian:

Yeah, that seemed to be the internet’s reaction as soon as the ruling came out was, “Okay, everything now, not a security. Great. We’re in the clear, let’s go wild.” Decentralization has always been to me a bit of a red herring. I appreciate the idea of community driven action in the same way that I’m fascinated by things that happen on Kickstarter, but it doesn’t seem like decentralization in and of itself really has anything to do with securities law, but it’s been built up in the ecosystem as a shield, almost, that says, “Well, no, we’re decentralized, therefore securities laws don’t apply.” And I’ve never understood that logic. Could you maybe strawman the case on both sides of this argument for us?

Lewis:

Absolutely, and it’s a great question. It’s really a fundamental question. And look, decentralization is critically important, as you say, for a lot of different reasons, just for the ethos of the crypto ecosystem and many other things. So it’s certainly a very important concept. I think in fairness to community members, this really got its start when someone at the SEC, this gentleman, Bill Hinman, who was at the time in a very senior staff role as the director of the division of corporation finance, gave a speech, and this has now become a famous speech when Howey met Gary (Plastic), which was a case. And in that, Director Hinman was seeking to address a challenging issue in the community back in, I think that was in 2018 or ’19, I can’t even recall at this point. He was, “Well, what is the status of Ether?”

And Director Hinman didn’t want to say, “There’s nothing to see, here, nothing to worry about,” because basically Ether was sold and functionally in a crowd sale. So he didn’t want to say that, but he didn’t want to also get people all alarmed that the Ether token was a security. And so he came up with this term, “Right now, I see the Ether ecosystem as sufficiently decentralized.” And so people extrapolated from that. “Oh, I get it. If you’re sufficiently decentralized, then you’re okay. If you’re not sufficiently decentralized, might have a problem.”

And I think they took the wrong lesson away. The lesson is less about whether the ecosystem is decentralized, it’s what is the nature of the transaction? And I think in the article, which you may have in your show notes, Ineluctable Modality of Securities Law, we say, “Look, you have to ask yourself what is the nature of the token itself?” So if you are fundraising with the token, whether that’s because you’re the Ethereum Foundation or an initial person who received a big boatload of Ether tokens, if you are fundraising for a business and saying to people, “Hey, I’m going to drive this thing.” That’s going to be problematic.

The overlap with sufficient decentralization is it’s like the inverse of reliance on the efforts of others. The idea would be, “Well, if the community is so sufficiently decentralized that you’re not relying on anyone, then you can’t rely on a given seller, because by definition you’re not relying on anyone.” So it’s more like you’re looking at the same thing from the other side and say, “Hey, if no one is driving the bus, then I could buy from anyone and not think that I’m relying upon them.” But the key question, it’s not the inverse part, it’s the form of it. It’s like, “Is it reasonable to expect that you’re relying on someone?” And so for example, even with Bitcoin, we’ve seen investment contract transactions where people said, “Somehow or another they convinced them, like BitConnect, you’re going to do some crazy scheme with Bitcoin.” It’s not that Bitcoin isn’t decentralized, it’s people pitched the purchase based on something they’re going to do. So the key thing from a legal point of view is not so much the decentralization. That’s the absence, it’s the way cold is the absence of heat. It’s the same kind of concept, there.

Ian:

One of the things that I’ve had explained to me related to decentralization is that you could have something start as a centralized project, which I think almost everything I’ve observed in crypto actually does.

Lewis:

Yeah.

Ian:

Right?

Lewis:

Absolutely.

Ian:

It’s you and I get together and we say, “You know what would be awesome? If we applied an automated market maker, lending pools, we come up in and lose Crypto Emporium, and we launch. And then over time … ” So at the beginning, clearly, there’s an enterprise, “We’re going to go seek people to invest in our efforts. We’ll build this up.” But it’s some point in the future we could say, “You know what? There’s now a huge community of enthusiasts who are participating. There’s lots of great people with good ideas. We’ve written the technical architecture in such a way that other people can build on it regardless of what you and I think.” And at that point, it crosses into this realm of decentralization. And so at some point it definitely was a common enterprise and then it is no longer, and that somehow has an impact on the securities treatment of both transactions and the enterprise itself. Is that realistic or practical in-

Lewis:

I’d say-

Ian:

… any way?

Lewis:

… it a little differently. And I think again, Judge Torres did a amazing job in her opinion. The transactions between third parties who might be, you and me, our friend Jane starts a protocol with six of her buddies and she’s in the process of trying to decentralize. And each month that goes by Jane and her colleagues are a little bit less relevant, but it’s hard to say, “Have they really decentralized?” Hard to know, right?

Ian:

Yeah.

Lewis:

But then somewhere along the way, maybe she airdrops some tokens and they’re trading around. And you and I, who have nothing to do with Jane, we’ve never met her, don’t know her, never had any conversations with her, vaguest idea. Is she even living? I don’t know, maybe something terrible happened. We don’t know. You and I trade that token that Jane was the developer of and the centralized party, we don’t know the status of her scheme.

Between the two of us, we are not engaged in a securities transaction whether or not Jane is still driving the bus on that project, because between the two of us, we’re just trading something with each other. The critical thing that the SEC has tried to argue is that if Jane is driving the bus, then when we trade with each other, we are engaged in a securities transaction. The importance of that is that let’s say you are in the business, you’ve got a couple of different things going on over there, Ian, besides an amazing podcast. You’ve got a whole sneaker business. And you would, just like early on in Kicks, and you got all kinds of vintage … And you’re a dealer in sneakers. You make a market, you’ll buy them, you’ll sell them. You have a big inventory of sneakers in the back behind the nice artwork you got, there. So you’re a dealer in sneakers.

And then, also, somewhere along the way you became a dealer in tokens, same deal. You buy them, you sell them, and you have an inventory of them. When you deal in sneakers, you’re not engaging in securities transactions. The SEC wants to say, “Wow, hang on a second there, fella. When you’re dealing in tokens, you need to figure out if Jane’s scheme is ongoing and it’s relying on her or not.” You’re like, “I don’t know Jane. I don’t know what you’re talking about. Maybe she went and she’s on a long vacation. Maybe she just stopped. She got bored. I don’t know. Maybe she’s really actively involved. I do not know, and I cannot assess that. I cannot know whether, when I sell a token to Lewis as a dealer, I need to register as a broker dealer. I can’t make that assessment in the same way that I’m selling sneakers here.”

Now, this is different. Let’s say Jane comes to you with some of her tokens. “Ian, you seem to know a lot of people. How about I give you a bunch of my tokens, you sell them for me.” Very different set of facts. You are now distributing them. So are you an independent third party, unaffiliated? You’re just buying and selling tokens. Judge Torres recognizes that. And so she says, “It’s not relevant whether Jane’s scheme is decentralized or not decentralized when you and I trade in that token with each other, because you have strict liability. If you were dealing in securities, you would need to register with the SEC as a broker dealer and comply with a whole raft of regulations.” And they’re appropriate regulations. Nobody’s beefing about the regulations. But you need to know. So if you’re dealing in shares of stock, oh, you better talk to a lawyer because, man, you need to register.

Ian:

Yeah.

Lewis:

How do you know which tokens require you to register with the SEC and which do not? How do you make that assessment? That is the beef, really, that we’ve heard from the crypto community from day one, not about Jane. When Jane sells those tokens she would need to register those fundraising transactions until people do not rely on Jane. And that day might come. She’s got a big community and she happens to still be holding some tokens, but when people buy from her, they’re no longer relying on her or her company. At that point. Decentralization matters a lot, because they’re buying from her.

The question isn’t about the decentralization. It’s the, “Is it reasonable to rely on her?” If there’s a big community and a lot of people are doing a lot of stuff, then you might say, “It’s not reasonable to rely on what Jane is doing.” The question isn’t decentralization. The question is reliance on the efforts of others. That’s the Howey question. Decentralization is a way of saying, “Well, you don’t have to rely on Jane anymore because you don’t have to rely on anybody.” But when you and I trade, when coins are on a marketplace, Bittrex, Gemini, Binance, you name it, nobody knows whether that project is sufficiently decentralized, nor can they determine that. That’s the critical difference. Hopefully that …

Ian:

This is super helpful groundwork. So let’s jump into Ripple. This lawsuit’s been ongoing. I think SEC initially filed against Ripple way back in 2020 before the world shut down for the pandemic. Maybe start with a quick summary of what the SEC’s complaint against Ripple was, and then we can jump into the recent ruling from the judge.

Lewis:

Ripple had already had a brush with the law four years earlier or something around being a money transmitter. And so they went through this whole thing about whether, through their use of the XRP token, they needed to register, and they did. They eventually settled and they became a money transmitter, and they did all of that. Fine. They kept, because they generated this large amount of XRP tokens, and because a lot of people thought that it was a good product, and it would become successful, they bought it on a speculative basis. And so they said, “I got a feeling that people are going to use, this is going to be a great solution.” And maybe they’re right, maybe they’re wrong, not our point. People started buying it speculatively, that’s fine. People buy a lot of things speculatively.

And then Ripple. So then they said, “Well, a lot of people buying this speculatively. I thought I could raise money to keep driving forward my business by selling these tokens.” And so they sold quite a mod. I think it’s well over one and a half billion dollars worth of Ripple, I think is alleged, about 700 and 700 give or take between the institutional sales and the programmatic sales, give or take. And so the SEC looks at this, “Well, hold on a second, here, guys. Aren’t you the prime candidate of what we’re trying to stop, here? People are funding your business. And they’re doing so in a way that either is not exempt from the registration requirements in these transactions or providing the adequate disclosures. You are the poster child of what’s going wrong with this whole thing.”

And so the SEC, after presuming a long time of discussion and engagement decides, “We’re going to sue you and we’re going to allege that when you fundraised by selling your tokens, you violated the law. So that gave rise to this thing. Ironically enough, the lawsuit was, I think, on the next last day of Jay Clayton’s term as chair. And the Gensler, SEC inherited that and continue to move forward. But I think we can all readily understand where the beef was with Ripple Labs, and said, “Look, you’re raising a lot of money, here. Feels like,” just like you said, Ian, “that this feels like a tech company raising money, and yet you’re not making sure that you’re exempt, nor are you registering with the SEC. You got to pick one channel, guys, and you didn’t pick either. And so that’s our beef with you.”

Now, clearly, I think part of it was also thinking that this was going to be an easy case to win, and therefore having won that case, they were going to go on and then knock over some more bowling pins down the line. But that was the gist of the beef. And I think for many people we thought, “Yeah, there’s a beef there, there’s a beef to be had.”

Ian:

Yeah. And why did Ripple, and obviously you’re not representing Ripple, so speculation, here, not insider advice, but what is your assessment of why Ripple chose to argue against that case? Because that seems incredibly straightforward and something that I would say, “Well, gosh, we should probably settle and not do that again.” That would be my layperson’s assessment of the situation. But they clearly didn’t do that. They’ve been fighting this to great expense for now over three years and it’s ongoing.

Lewis:

Absolutely, and I’m glad you just reminded me because it should be either at the top or the bottom of the show. But as with every podcast I do, there’s no legal advice here. I’m not your lawyer. Get your own. So just to be very clear, no legal advice for anybody, here. These are just my own opinions and not those of anyone else’s. In terms of why Ripple apps choose to sue, there’s a lot at stake for them. The potential liability, it was quite large, and I think they felt genuinely that they had arguments to be made, and they wanted to assert those arguments.

And I think just as the SEC as an enforcement authority is every right to bring claims and actions that they, let’s assume in good faith feel are violating the law, people who are accused of violating the law have every right to defend themselves. And in this case, and I can’t, and I don’t want to speculate exactly why they didn’t settle, but this is very large situation, and they felt they had good grounds to win. They retained some amazing law firms to represent them, and they said, “Look, let’s just go at it.” And sometimes you got to just throw it down and see what happens.

Ian:

Well, and it seems like the strategy has paid off in their favor, at least to some degree. So unpack for us what Judge Torres’ ruling said, because I personally found it very confusing. She made two big statements, but walk us through what that was.

Lewis:

Sure. I think it really confused a lot of people. You’re far from being alone. And I think it was confusing both in terms of what she just practically said and then also confusing what the policy was. I think both of those flummoxed a lot of people. And you see a lot of internet chatter, “She got it exactly backwards,” a lot of different things. So let’s first talk about what she actually said. She broke down the transactions as the SEC put them forward into these, broadly speaking, three categories, the institutional sales, the programmatic sales, and what she refers as the other distributions. There were also some sales by the individual defendants, Garlinghouse and Larsen, we can talk about those at the very end.

So for the institutional sales, they fit, and the judge analyzed each of those separately as transactions. She’d never analyzed the XRP token after having concluded that it did not in and of itself embody a contract transaction or scheme for purposes of Howey. She says, “The token’s not the thing. We need to look at the transactions.” And so with the institutional transactions, people came in the front door, negotiated with Ripple Labs, Ripple Labs made direct undertakings to those persons, and said, “Hey, if you give me money, look at all the different things we’re going to do. This is really going to work out.” They commingled the monies that various purchasers had, so there’s a common enterprise through commingling what, in technical terms we call horizontal commonality.

And she said, “Clearly, the people buying the tokens, were not buying them like sneakers because they’re going to wear them, they were buying them in bulk so that they could resell them later at a profit.” So all of those elements were present. She does, “It’s really down the middle. Howey, boom. Did you register? Oh, you didn’t? Sorry, that’s a violation of the law. So you offered securities in the form of these transactions. You did not register with the SEC. Game over. You’re responsible.” However, that’s the less interesting part of her decision.

The second part obviously relates to the programmatic sales. And when it comes to programmatic sales, what XRP was doing was dribbling out small amounts of XRP in various marketplaces, and that there’s a critical thing, and I think this, as you said, Ian, earlier, was something that the internet had missed. She focused on the fact that there was a vibrant and active secondary market for XRP. At the time that this was going on, XRP was more or less the fourth largest traded token in the marketplace. There were a lot, a lot of people just trading with each other for whatever reason. We might think, “Man, what are you thinking over there, XRP trading people?” Fair enough. That’s not the point. They’re trading with each other. There’s a vibrant market for that. People are selling their supreme Kicks and doing all whatever, good idea, bad idea, not the point. They’re trading with each other.

What the judge concludes is, “Well, let’s look at the transactions in which XRP is selling them. They’re on a blind bid-ask basis. They’re just mixed into the flow of the other transactions that are already occurring.” When people bought or sold, but particularly here, bought the XRP tokens, they don’t know are they buying from Ian Andrews? Are they buying from Lewis Cohen? Are they buying from Ripple Labs the company? They don’t know, nor do they care. Nobody’s making representations to them. They’re not coming in, sitting down, engaging. There are none of the elements that are present in a Howey scheme, and therefore those transactions are not non-investment contract transactions.

So that’s what she says. As to the other distributions, that’s the area where I think many of us feel that she perhaps overshot the mark a little bit. So in the other distributions and your, I’m sure, community of viewers are aware, many, many projects use their tokens to remunerate their employees, sometimes contractors. And she says, “Well, they’re not putting capital into the business, so therefore no investment of money, therefore no investment contract transaction.” That’s a little … I don’t know about that. I think most of us would say, “We don’t know about that.”

Ian:

That’s a head scratch to me because-

Lewis:

That’s a head-

Ian:

… because-

Lewis:

I think that’s-

Ian:

As an employee of tech companies my entire career, my labor in exchange for equity via stock options in the business, again, just like-

Lewis:

You don’t have to be a fancy lawyer.

Ian:

… my ICO comment earlier.

Lewis:

Yeah, you don’t have to be a fancy lawyer. And again, of course when you get stock options, you’re getting a security, right, because the stock is a security.

Ian:

Yeah.

Lewis:

The problem with the XRP token, it’s not a security, but you’re bartering. Her argument is that, “You’re not making an investment of money, but you’re bartering,” right? So for example-

Ian:

Yeah.

Lewis:

You could imagine that you might have said, let’s just be optimistic, here, and said, “Well, I would’ve gotten $300,000 a year in cash, but if you give me tokens, I’ll do a $100,000 a year. Or just give me the money. Boom, fine.”

Ian:

Yeah.

Lewis:

You’re bartering $200,000 of value for tokens. That’s really no different than you’re getting $300,000 of cash and then using $200,000 to buy the tokens. There’s no economic difference in that whatsoever. So I don’t know. I’m right there with you, Ian. I’m not sure I got anything to say about that.

Ian:

The second piece that you talked about there, these programmatic sales, it seems like the industry impact on that ruling is going to be most directly felt by exchanges and one of the charges against them, I believe, is operating as an unregistered broker dealer for facilitating securities transactions via all these tokens. Does the ruling in the Ripple case ultimately cited as some precedent law in that case?

Lewis:

Well, I’m going to take the question just a little bit more broadly and say there are three allegations that are core allegations in three different lawsuits all filed around the same time. And all three are basically the same. Number one, exactly as you said, you’re acting as an unregistered broker dealer. So as we talked about before with the sneaker example, you’re acting as a market as a national securities exchange, which is different. So the broker dealer, you’re just offering to buy and sell in a exchange. You’re creating prices and creating a marketplace for bids, and asks, and prices. So that’s the second type of violation. And then there’s third, you’re acting as a clearing agent, meaning you’re settling trades. So you’re taking the cash from one buyer, the securities of another buyer, and crossing them to effect that all of those are three different but regulated activities.

And the SEC accuses all three of those entities of all three of those violations. All of those violations turn on what they are actually trading in, not being securities, excuse me, not being sneakers, but being securities. And so Judge Torres’ analysis here is absolutely central, just like you said, for all three of those cases. And also, potentially for Uniswap, for example, which effectively facilitates very similar activity. And she says, “Look, it’s not so much when two third parties are buying and selling, absent other facts. Those are not securities transactions. They’re securities transactions when someone … “

And again, for example, in my case of the tokens and Jane, I think, our heroine in our story, if she comes to you and asks you to distribute the tokens for her, that could well put you in the position of acting as her agent, in effect, on her behalf and selling those securities. And in the absence of there being a vibrant market, if the purchasers, for example, in a initial DEX offering or an initial exchange offering like a launchpad type situation, where there is no vibrant market, and basically everybody’s buying the token based on the only thing you have out there is not a market of buyers and sellers, but simply a project that’s saying, “Hey, buy this because its numbers going to go up.” I think you get a very different result.

So her decision really helps as to tokens that are already out there in trading. You had asked earlier about, “Well, how do you on ramp?” And that is, in many ways, the big question. And one of the bills in Congress, the House Market Structure Bill, attempts to address that by creating a on ramp way of allowing people to distribute tokens without necessarily violating the law, but in a practical way of doing that.

Ian:

Interesting. We won’t use the three that are actually in lawsuits, maybe, so we’re a little freer to speculate, here, but theoretical exchange collaborates with a new project. They want to distribute a token. The exchange has a bunch of existing customers who like to buy tokens for whatever reason, and they say, “We’re going to onboard token X, the new token of the day.” And they put out an email to all their customers, they advertise over Twitter, and draw a bunch of people in who buy token X. That’s going to get you in trouble.

Lewis:

Yeah, it is potentially going to get you into trouble, potentially. Right?

Ian:

Yeah. Okay.

Lewis:

And that’s where, and I have to say, I hadn’t used the whole cold as the absence of heat thing, but now I’m liking it. That’s why I love doing podcasts. You always come up with something new and different. That’s where decentralizations really becomes important. Right?

Ian:

Okay.

Lewis:

It’s not so much is the project, when you do that to decentralized? It’s is it reasonable to expect that the people buying on your exchange are relying on the efforts of that project? So if you’re not decentralized, then there’s a good chance that it is reasonable for them if you’re the main distributor of the token, and it’s not decentralized, that is, Jane’s really driving the bus, man, is she brilliant. MIT, that girl’s crazy. People are going to be relying on that. It’s not so much per se that you’re distributing the tokens, is, is it reasonable to rely on the efforts of others?

And again, in the case of Ripple, Judge Torres is looking at this and there’s a lot of people trading this stuff, they don’t know or care where it’s coming from. In the DEX offering or the exchange offering that you hypothesize, it’s probably quite likely, and in fact, in many cases, the exchange is actually disseminating the white paper and various things, and really facilitating that reliance. If you are facilitating the reliance on Jane, and Jane Labs, and that sort of thing, then you really are running a real risk, there, yes. So it really depends on what that relationship is, what are you trading, and where does it stand?

Ian:

Yeah, that’s very helpful. And it seems like there’s a slightly different scenario where there’s a token that’s already popular by its own right. It’s in the market. There’s lots of people that hold the token, they trade it frequently. And my theoretical exchange says, “Well, gosh, we want to facilitate some of these transactions, because we collect a fee on every one, and that’ll make us some money.” And we do the same marketing. We send out an email to all our customers and we advertise on Twitter and we say, “Token X is now available for trading on our platform.” That seems like it keeps me out of trouble.

Lewis:

Well, again, Judge Torres specifically doesn’t rule on that, right? She has a footnote-

Ian:

Okay.

Lewis:

… 16, and she’s not getting into the direct secondary sales. I think that’s an area where, if you’re running an exchange, you need to think long and hard about it. Do you feel comfortable that you are really sufficiently distant from anything going on, that you’re not promoting the scheme, you’re just facilitating third party transactions. If you’re comfortable that you’re facilitating third party transactions, then that’s a different set of circumstances. So decentralization is in the background, but really the question is, “How are you?” So if you’re going out there, and again, you could take the XRP as one end of the scale and maybe the launchpad as the other end of the scale. With the XRP token, she said, “Look, it doesn’t appear that people are relying in any way on the person selling. In the launchpad there is no market. You’re facilitating distribution. It’s not on your website. It’s on the exchanges website. But it’s the same thing. You probably have a lot of problems.”

Ian:

Yeah.

Lewis:

“Where in that thing that needs to be, everybody needs to … ” But it’s not that the token, the core thing here, it’s not that the token is a security. You’ve got to ask yourself, “Am I facilitating the distribution of an investment scheme?” And that is a different kind of question.

Ian:

Yeah, it’s very different than what I think most people are focused on right now, so I’m glad we got into that discussion. The important thing in the Ripple case is it’s not over. So this ruling is not the end of the case. Talk to us a little bit about, just from a process standpoint, what we should expect going forward now that this ruling’s been issued.

Lewis:

Well, that’s absolutely right. We said there are these three categories of sales, the institutional sales, she rules on, the programmatic sales, she rules on, the other distributions, she rules on. And then the individual sales by Garlinghouse and Larsen are functionally the same as the programmatic sales, so she rules on. So that leaves just one little thing, and that is did Garlinghouse and Larsen aid and abet in their individual capacity, the company in their illegal sales? So we know that the institutional sales violated a law. Her question is, “Garlinghouse and Larsen as executives, did they aid and abet that?” That’s a factual question. That’s held back. And that needs a trial. So we don’t have a final judgment because she hasn’t resolved all the questions.

Without a final judgment. Neither Ripple nor the SEC can appeal this decision as a matter of right. They don’t get to, like, “Okay, I’m going to appeal it and I’m out of here.” Because there’s no final judgment. That requires, and you’ve probably heard this term already, what’s called interlocutory appeal. That is, “Hey, hold on a second, pause the game because I’m going to go to the replay booth and try and figure out what’s going on over there. And then we’ll come back and keep playing, because it’s so important to the outcome of the game, we can’t wait until the game’s over to do the appeal. I got to figure it out now because that’s going to affect everything.” An interlocutory repeal depends on both the trial court judge, Judge Torres, granting that, and also the appellate court, in our case the second circuit, accepting it. So the SEC would have to ask, Judge Torres would have to grant, and the second circuit would have to grant.

As far as I’m aware, the SEC have not asked yet. So it’s a moot point. They could ask. If they do, Judge Torres would have to agree, “Yes, this is so important, I’m going to certify this for appeal.” The second circuit would have to agree, and then we would pause the trial, and move on to the appeal. If they don’t ask, or they’re denied by either the two courts that could deny it, “So sorry.” And then you’ll continue with the trial. But of course, there’s one more possibility. Mathematically they could settle with the two defendants.

At that point, all the issues are done and you don’t need a trial because you’ve settled, and then you have a final judgment. And then either side or both sides could appeal because Ripple lost, too. So they have an ability to appeal, or the SEC could appeal, or they both could appeal. So then in either way, the earliest I think anybody could see this getting resolved is probably about a year from now. And it could even be longer, depending on the trial and every which other thing. So it’s going to be a while any way you slice it.

Ian:

Yeah. Well, I’m going to get my popcorn, and keep watching, and I’m going to follow you on Twitter because you get deep into all these topics as they’re unfolding. Give us your Twitter handle-

Lewis:

Sure. It’s-

Ian:

… so that we can-

Lewis:

It’s NY crypto lawyer. So N-Y, I won’t spell crypto lawyer. You can hopefully figure it out. If you can’t spell crypto lawyer, probably just best let it be.

Ian:

That’s right. You don’t need to follow.

Lewis:

You don’t need to follow.

Ian:

That’s okay.

Lewis:

Because I’m following myself, man. I can’t spell that stuff. So in any event, Ian, it’s been so nice chatting with you. I’m so psyched. You have got a great show. And I hope everybody’s watching, not just this episode, but many more of the great episodes that you’ve done.

Ian:

Lewis, thanks so much. I feel incredibly more informed than where I was this morning when we started. It’s been terrific. Hope to have you back again soon as this and other cases progress, to unpack the- 

Lewis:

Be a pleasure.

PolicyRegulation