CoinList has a standing meeting every Wednesday called “Crypto Weekly” where the company comes together to talk as a group about all things crypto. At our last session, which came off the heels of the SEC’s complaint against Ripple, someone posed the question: why does the SEC regulate crypto?
The answer without a bunch of legalese is something to the effect of this — the SEC’s mission mandates that the agency facilitate (and therefore regulate) fair securities offerings and securities markets and, generally, the SEC views crypto offerings and trading to fall within these two areas.
In the most basic of terms, the SEC case singled out XRP for being offered initially and continuously into the market without providing disclosure. Still, we’ve all had marketing directed at us that offer investments without any substantive disclosures and, honestly, no one reads the miles-long disclosure documents anyway. Inevitably, the next question then becomes: why does the SEC pursue Enforcement actions so aggressively for things that seem very much like technical violations? The answer to that second question is grounded in the SEC’s final prong to its mission — protecting investors.
Crypto Weekly quickly turned back to less mundane topics, but the unasked question remained: If the SEC’s mission is to protect investors, facilitate capital formation, and ensure fair markets, does the XRP action actually accomplish this mission?
Let’s take a look.
SEC vs. Ripple
If you are reading this, then you likely know that the day before then-SEC Chairman Jay Clayton left office, on December 22, 2020, the SEC filed its long-threatened suit against Ripple Labs Inc. and two of its executives alleging that they raised over $1.3 billion through an illegal ongoing digital asset securities offering of XRP. The SEC alleges that beginning in 2013, Ripple raised funds and also distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services. In addition to structuring and promoting the XRP sales used to finance the company's business, the SEC alleges that the charged executives effected personal sales of XRP totaling approximately $600 million.
Quotes by the Enforcement Division folks at the agency commenting on the case indicate the suit was largely brought under the “investor protection” prong of its mission. Namely, the failure to comply with the registration provisions of the securities laws for the XRP offering deprived purchasers of required disclosures designed to protect investors. Though the complaint reads as if the SEC is pursuing a fraud claim, ultimately, the discussion pivots to “use” to support XRP’s classification as a security; their argument is bolstered by a few low-hanging-fruit arguments such as attorney memos stating (as attorney memos always do in this space) that XRP may be considered to be a security.
Ripple Community vs. SEC
Before the SEC action became public, XRP was traded on numerous US venues and had significant US participation. With this news, XRP has been delisted by a number of platforms in the US and its price plunged. In response to this downturn, on January 1, 2021, certain holders of XRP filed a petition to compel the SEC Acting Chairman to amend the SEC's complaint against Ripple so that their XRP holdings would not be considered securities. In contrast to the SEC’s complaint and statements, and rather ironically, the petition alleges in broad strokes that the SEC action hurt the very investors that the action intended to protect.
This brings us to the crux of the issue facing the crypto community: Right now, there is no clear mechanism to correct an illegal offering in the digital asset space or to otherwise ensure that investors in markets will not be significantly harmed if a digital asset is deemed to be a security. US participants have no choice but to stop supporting the asset or find themselves in a potential suit with the agency.
The SEC offers a glimpse of a roadmap that they would find acceptable to remedy securities violations as laid out in the Airfox and Paragon actions. In those cases, the issuers agreed to offer purchasers the opportunity to recover what they paid minus the amount of income received or damages, if the asset was no longer held. They also agreed to register the tokens.
Such a roadmap is based on the standard remedy for an illegal offering of a security wherein the issuer (Ripple and the executives in the XRP case) provide the purchasers with the opportunity to rescind and then re-offer the asset in a legal way. However, the magnitude of the XRP market eclipses the cases before it so, we can only ask questions around how applying a similar mechanism would work:
- Should the rescission offer be extended to the many, many hands that have exchanged it thus far? Or considering the size of the market should there be limits to the offer to the original purchasers (who may not now hold any XRP) or to the holders now?
- Assuming that we could identify the correct population, at what price would the rescission be made?
- Would the issuer return the number of bitcoins or other crypto received per XRP or the USD exchange rate at the time of purchase be applied?
- What damages could a purchaser of XRP claim? Would damages be inclusive or exclusive of price impacts of the SEC action?
- Would the Defendants remain solvent enough to make good on those offers?
- Are the many, many institutions that have served as intermediaries in facilitating or advising buys and sales of XRP automatically broker-dealers or investment advisers?
- If Ripple and the executives register XRP, could it be traded in a meaningful way considering the limited abilities of broker-dealers to offer digital asset trading?
- If Ripple and the executives do not control the whole of XRP, are limitations in disclosures acceptable? When would Ripple and the executives NOT be considered issuers with reporting responsibilities?
Enforcement Actions vs. Rulemaking
The SEC’s Division of Enforcement upholds the SEC’s mission of investor protection with particular vigor in the crypto space. The Division brought nearly 60 actions and halted another 18 allegedly fraudulent schemes involving blockchain and digital assets during Chairman Clayton’s tenure.
The SEC’s rulemaking divisions, though, seem to be behind their Enforcement colleagues in addressing how to handle the outcome of the Enforcement actions.
This lag necessarily means that the other two parts of the SEC’s mandate — to maintain fair, orderly, and efficient markets and to facilitate capital formation — have gaps. These gaps could create unmanageable circumstances if a court decides that XRP is a security. Ramifications could include:
- The XRP market would likely become depressed, as anyone holding or trading in XRP did not intentionally purchase a security instrument, and therefore might not be able to comply with the obligations associated with such an instrument, and would likely seek to sell (the XRP market witnessed a sharp price decline just with the news of the SEC action).
- Any platform still supporting the asset may delist it in the United States as intermediaries would not want potential exposure for operating an unregistered securities exchange and/or unregistered broker-dealer.
- Cryptocurrency funds would also potentially face pressure to expunge the asset from their books. As a result, liquidity would then dry up so that no XRP participant could get out what they put in or continue to use XRP in the way that it was intended.
- Any project using a similar model as XRP would likely leave the United States to mitigate liability.
- Uncertainty as to the next action the SEC may take and against which digital asset without a clear remedy could cause many projects, intermediaries, and participants to exit the space altogether.
In short, a lack of a regulatory “fix” would cause harm to all participants and the markets in which they trade, particularly US users who will suffer from both price declines and the likely loss of access to this technology for the reasons set forth above.
At present, the SEC rulemaking divisions are concentrating on interpretations and guidance about how to offer and trade newly issued digital assets in a compliant way, and these efforts are extremely welcome.
More pressing, though, is addressing the questions above in finding solutions for assets that have already been issued, which the SEC has concluded to be securities, but that also have devoted markets and scores of investors and intermediaries supporting them, if not thousands of US retail users to boot.
Regardless of whether XRP is deemed to be a security (and we hope it will not be), the future of financial markets will undoubtedly be digital, and regulatory clarity is needed to protect those assisting in its growth. Policies tailored to promote digital assets by facilitating crypto capital formation and maintaining fair, orderly, and efficient digital markets are must-haves for the future of our financial markets.
To summarize, fully realizing the SEC’s mission in the digital asset space whether by Congressional action, court order, or cooperation across each of the SEC divisions under a strong, new SEC Chair leading the charge is the only “action” needed for investors to be protected.
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