“Imagine trying to explain what an iPhone is in language your great-grandfather would have understood just after World War II,” said Joseph Hall, an attorney at the white shoe firm of Davis Polk & Wardwell who represents cryptocurrency-focused Grayscale Investments.
“That’s how easy it is to predict which digital assets are securities under the post-war Howey test,” he said, referring to the 1946 case about investments in a Florida orange grove that the Supreme Court used to define what is and is not a security.
In a Jan. 25 editorial for Law 360, Hall—who worked for the SEC from 2003 to 2005, ending up as managing executive for policy—took aim at the agency’s lack of clarity in defining whether and why digital assets are securities.
Specifically, he took aim at the agency’s Dec. 22 lawsuit against Ripple Labs over its sales of XRP, the fifth-largest cryptocurrency by market capitalization, which the SEC has now formally alleged is an unregistered security. As a result, it claims Ripple’s sales of XRP over the past seven years were illegal, and is seeking to recoup $1.3 billion from the company and its top two executives.
Calling the suit indicative of what was wrong with the agency’s treatment of cryptocurrencies under now-departed Chairman Jay Clayton, Hall called on Gary Gensler, the recently nominated SEC chairman who is currently a professor teaching digital assets and blockchain at MIT, to use the suit to “chart a different course” in its treatment of cryptocurrencies.
“It’s difficult to overstate the impact this uncertainty has on the development of blockchain technology in the U.S.,” he said. “Outside the venture capital community, corporations, major investors and banks are understandably skittish about risking serious sums of money on technologies their lawyers can’t assure them comply with law.
There’s a fairly good reason for that skittishness. As Hall noted, news of the SEC’s lawsuit dropped XRP’s market cap from $25 billion to $30 billion down to around $13 billion.
That resulted in heavy investor losses, he said. Among the losers is the Grayscale XRP Trust, which Hall’s client liquidated shortly after the suit was launched—and at far from the cryptocurrency’s pre-lawsuit high—citing concerns about liquidity.
New strategy needed
Aside from sticking it to investors, Hall cited several problems with the suit.
First is the timing. It was filed a day before Clayton resigned. That “suggests the possibility of a rift among the commissioners as opposed to a case everyone agreed had to be brought immediately in order to avert looming investor harm,” Hall argued.
Second, Hall argued that even if the SEC plans to stick with its view that few cryptocurrencies are not securities—and he notes that the agency has not formally declared that bitcoin and ether are in the clear—XRP was a poor choice for the test case.
Noting that Ripple uses XRP “to simplify cross-border payments,” Hall argued that there are “plenty of digital assets with more tenuous use cases than XRP, any one of which might have better helped the SEC etch its views into federal caselaw before taking on a leviathan like Ripple Labs. A loss on the merits in the XRP litigation could epically damage the SEC’s regulatory project when it comes to digital assets.”
Ripple CEO Brad Garlinghouse has been very clear that the company intends to fight the SEC tooth and nail.
A better approach, Hall said, would be to recognize that shoehorning digital assets like bitcoin and XRP into a yes-or-no securities definition based on a 75-year-old precedent about shares in an orange grove is not the best way to go.
For one thing, digital assets are used in many commercial and peer-to-peer transactions that are often designed to eliminate middleman. That doesn’t work with the current securities law framework, which is largely based on channeling securities sales through heavily regulated intermediaries, he said.
Trying to shoehorn cryptocurrencies into that framework, Hall argued, “would increase their cost and complexity to the point of being useless, or at the very least, uncompetitive with existing alternatives.”
Instead of continuing with its “hardline” regulate-by-enforcement strategy, the SEC would be better off focusing on the notice-and-comment rulemaking that is the standard tool of regulators, Hall said.
That is something Gensler is admirably suited to do Hall said:
“In his earlier tenure as CFTC chair, Gensler led that agency through a notably robust rulemaking agenda, and in the years since leaving government service he has developed deep crypto expertise through his work with the MIT Media Lab’s Digital Currency Initiative.”