One of the cutting-edge legal issues – one that is raised in a number of pending securities class action lawsuits – is the question of whether cryptocurrencies are “securities” and therefore required to be registered with the SEC before they can be traded. Within this larger question are a host of related issues, perhaps the most interesting of which is the question whether digital currencies that act as “mediums of exchange” are securities, or rather are more like traditional currencies, which are exempt from the definition of securities. The answer to this question could have an enormous impact on the marketplace for digital currencies and could have significant liability implications in a number of pending actions and enforcement actions.
The distinction between “currencies” and “securities” and its potential application to digital currencies has in fact been acknowledged publicly by, among others, SEC Chair Jay Clayton. In April 26, 2018 testimony before the House Appropriations Committee, Clayton divided cryptocurrencies into “two areas.” In the first group are coins that function as a “pure medium of exchange” and as “a replacement for currency.” This group includes bitcoin, which Clayton says “has been determined by most people to not be a security.” The second group includes “tokens which are used to finance a project.” This latter group includes the typical ICO token, about which Clayton has said, “there’s none that I’ve seen … that aren’t securities.”
While Clayton may have acknowledged this distinction, the question is how we tell the difference. At this point we have to assume the regulatory agencies will address these issues and their implications – eventually. As discussed in an interesting June 11, 2018 Law 360 article by Cohen & Gresser attorney Christian Everdell entitled “Ripple Labs Case Will Address Key Cryptocurrency Question” (here), many of the legal questions these issues present could be addressed by a court before the regulatory agencies have a chance to stake out their positions. In particular, Everdell suggests that a recently filed action involving Ripple Labs may address many of the key issues about cryptocurrencies used as mediums of exchange.
Ripple Labs is the issuer and distributer of a cryptocurrency called XRP. According to Everdell, XRP, along with, for example, bitcoin and ether, is one of several cryptocurrencies that serve as “the primary medium of exchange to purchase ICO tokens and other, less ubiquitous cryptocurrencies.”
On May 3, 2018, a holder of XRP cryptocurrency filed a lawsuit in California (San Francisco County) Superior Court against Ripple Labs and its CEO, Bradley Garlinghouse. In his complaint (here), the plaintiff alleged that XRP is a security and Ripple’s sale of XRP constituted an unregistered securities offering in violation of Sections 5 and 12 of the federal securities laws. The plaintiff raised similar allegations under the California securities laws as well. On June 4, 2018, the defendants removed the plaintiff’s complaint to the federal court in the Northern District of California. (The removal petition can be found here.)
Like many cases that have been filed in recent months against ICO companies, the plaintiff’s complaint in the Ripple Labs case argues that the cryptocurrency at issue represents a security within the meaning of the federal securities laws. In his complaint against Ripple Labs, the plaintiff expressly confronts the four-part Howey test that courts have developed to examine whether or not a financial instrument is a security. Indeed, in paragraphs 100 through 118 of the complaint, the plaintiff provide factual assertions to try to show that each part of the four-part test have been met.
The question whether or not XRP represents a security as to be established by the four-part Howey rubric is interesting. But as Everdell points out in his article, the Ripple Labs lawsuit raises a further, even more interesting question, which is whether cryptocurrencies that function as true currencies should be regulated as securities even if they meet the requirements of the four-part Howey test. Everdell contends that if a cryptocurrency like XRP, which functions as a medium of exchange, is deemed to be a security, “it would have a profound and potentially destructive effect on the U.S. cryptocurrency market, as everyone who bought these coins would be holding unregistered securities that could not be transferred without violating the law.”
Everydell acknowledges that for a court to interpret XRP as a currency “would represent an entirely novel interpretation of that term.” On the other hand, as Everdell notes, if not exempt as a currency, it will be an uphill battle for the company under the Howey test. Everdell notes in particular that if the work to create, maintain, and promote the digital ledger within the blockchain is considered sufficient “entrepreneurial or management activity” to satisfy the fourth component of the four-part Howey test, “then almost all cryptocurrencies will be swept into the definition of a securities and will be regulated as such, even if they function exclusively as a currency.”
It would be far better, Everdell concludes, for the regulatory agencies to clarify the rules for different type of cryptocurrencies; but in the absence of regulatory agency action, the courts will proceed to confront and address these issues.
I thought Everdell’s article was quite interesting because of the distinction he draws between cryptocurrencies used as mediums of exchange and other types of digital currencies. As his article explains, the securities laws draw important distinctions between traditional currencies and other types of financial instruments. The challenge for the courts will be trying to figure out how this distinction applies in the context of these new digital currencies. In talking about these issues, Everdell frequently uses the phrase “traditional currencies.” Court may well have a hard time seeing the new digital currencies as “traditional currencies,” even if they are as Everdell suggests, being used as mediums of exchange.
When and if the court (or a court) gets around to considering the questions about whether or not XRP is a currency and is or is not exempt from the securities laws, there is a critical imbedded factual issue. That is, whether or not XRP really is functioning as a medium of exchange. Everdell presents this circumstance as a statement of fact. However, it is not self-evident from reading the complaint that XRP is in fact functioning as a medium of exchange. To my mind, this question is a factual issue that requires the kind of finding of fact that courts will not consider at the motion to dismiss stage. To the contrary, courts are instead required to take all well-pleaded facts as true for purposes of determining motions to dismiss. This seems to present the possibility that the distinctions that Everdell suggests this case involves may not even come up at the motion to dismiss stage.
Of course, all of this is very interesting, and in fact the reason I read Everdell’s article and wanted to write about it here is simply because it illustrates the kinds of very interesting issues that the recent wave of litigation against cryptocurrency companies could present. There could be a host of very interesting and arguably novel legal issues that courts will be required to address. The growing wave of litigation involving these transactions could prove very interesting to watch.
Finally, one procedural issue that Everdell does not discuss and that could present itself as an intervening issue before the court is called upon to address these interesting legal issues is the question of whether or not this case will stay in federal court. As noted above, the plaintiff originally filed his complaint in state court, and the defendants removed the case to federal court. One question is my mind is whether or not the plaintiff may seek to have the case remanded back to state court, in reliance on the U.S. Supreme Court’s recent decision in the Cyan case. (The Supreme Court’s March 2018 decision in Cyan is discussed at length here.) The plaintiff might argue that that because, as the Supreme Court decided in Cyan, state courts retain concurrent jurisdiction over liability actions under the ’33 Act, that this case was not properly removed and therefore should be remanded to state court. (Readers may have more insight into this issue, and encourage them to jump in on this issue using the blog’s comment feature.) Of course, even if the case is remanded, the state court will eventually have to address these issues, but the eventual consideration could be postponed by the wrangling over the procedural and jurisdictional issues.