Cryptocurrency tokens: should they be treated as a 'security' based on manner of sale?

The US District Court of New York, in Securities and Exchange Commission v Ripple Labs, on 13 July 2023, took the curious position that Ripple's cryptocurrency token, XRP, is a security when it is sold through to selected investors via private placements but it is not a security when sold to the public via crypto exchanges.

Just two weeks later, on 31 July 2023, that position was expressly rejected by another judge of the same district court in SEC v Terraform Labs. The judge found Terraform’s tokens UST and LUNA to be securities even if they were sold to the public via crypto exchanges.

What were the findings of SEC v Ripple and SEC v Terraform and how did their positions differ? What are their relevance to Singapore law and should the nature or arrangements surrounding the tokens (such as the manner of sale) matter for the characterisation of a token as a security?

The Howey test

Both the Ripple and Terraform cases applied the test in SEC v WJ Howey on whether the tokens were “investment contracts”, which is a type of security. However, they reached different positions.

Briefly, an “investment contract” is defined as any “contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promotor or a third party”.

The difference in both cases turned on the final element of the investment contract definition concerning the expectation of profits — whether the purchaser of the token may have “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”.

'Reasonable expectation'

In SEC v Ripple, the judge found the circumstances of the sale relevant as to whether the purchasers of the tokens may have had a “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”.

The judge found in SEC v Ripple that a purchaser in a private placement may have had a “reasonable expectation” but not a purchaser via a crypto exchange. Her rationale for the distinction was as follows:

1. The private placement purchasers were shown marketing materials giving a reasonable expectation that profits would be derived from Ripple’s efforts to build an ecosystem, such as Ripple’s explanation that its “business model is predicated on a belief that demand for XRP will increase… if the Ripple protocol becomes widely adopted”. However, for crypto exchange purchasers, “there is no evidence that these documents were distributed more broadly to the general public, such as XRP purchasers on [crypto] exchanges”. The judge acknowledged that marketing material was posted on Ripple’s website accessible to the public, but she did not consider the posting alone to be significant enough distribution.
2. The private placement purchasers were “sophisticated entities” which would reasonably be expected to form such a reasonable expectation by parsing through various public statements by Ripple’s founders connecting XRP’s price to Ripple’s efforts, posted on forums such as Reddit and in televised interviews. However, for crypto-exchange purchasers, “[t]here is no evidence that a reasonable [buyer on a crypto exchange], who was generally less sophisticated as an investor… could parse through the multiple documents and statements… which include statements (sometimes inconsistent) across many social media platforms and news sites from a variety of Ripple speakers (with different levels of authority) over an extended eight-year period.”
3. For private placement purchases, the purchase money was given to Ripple to develop the ecosystem. However, for the crypto exchange purchases, it was significant that in most cases, the purchase money was not given to Ripple, but given to a secondary seller. The judge found that “[s]ince 2017, Ripple’s [selling activity on crypto exchanges] represented less than 1% of the global XRP trading volume [...] Therefore, the vast majority of individuals who purchased XRP from [crypto] exchanges did not invest their money in Ripple at all.”
4. For crypto exchange purchases, the anonymous nature of the buyers and sellers negated a finding of such a reasonable expectation. The judge found that “the record establishes that with respect to [crypto exchange purchasers], Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it.”
5. Finally, crypto exchange purchasers could be expecting to profit by being “speculators” rather than “from the entrepreneurial or managerial efforts of others”.

Although the judge acknowledged that “some [crypto exchange purchasers] may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts”, the fact that some of these purchasers exist is not legally relevant given that “[t]he [legal] inquiry is an objective one focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant.”

Terraform rejects distinction

In SEC v Terraform, the position in SEC v. Ripple drawing a distinction between private placement purchasers and crypto exchange purchasers was rejected.

In Terraform, the judge had a very different view of what a crypto exchange purchaser would reasonably expect (and the information such a purchaser would consider). He criticised SEC v. Ripple on the basis that:

1. On an objective analysis, both a private placement purchaser and a crypto exchange purchaser would view the issuer’s statements in the same way. The judge’s view was “[t]hat [whether] a purchaser bought the coins directly from the defendants or, instead, in a secondary re-sale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on [the issuer’s] efforts.”
2. The issuer’s public statements must be relevant even for crypto exchange purchasers as “[The issuer (that is, Terraform)] embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting the profitability of the crypto- assets and the managerial and technical skills that would allow the [issuers] to maximize returns on the [purchaser’s] coins”.

Further, the judge was able to distinguish SEC v. Ripple (in particular, the argument that the purchase money on a secondary sale in a crypto exchange does not go to Ripple) on the basis that Terraform “said that sales from purchases of all crypto-assets -- no matter where the coins were purchased -- would be fed back into the Terraform blockchain and would generate additional profits for all crypto-asset holders” (emphasis added).

How might a future US case unfold?

In the face of two conflicting court rulings, how might a future US case unfold?

As may be seen, both SEC v Ripple and SEC v Terraform had different interpretations of what reasonable expectations a crypto exchange purchaser may have. This is a question that could potentially be resolved factually.

Crucially, in SEC v Terraform, the judge had to “resolve all factual doubts” in the SEC’s favour, given that it was a ruling on a motion to dismiss the SEC’s complaint (and the SEC will be given the benefit of the doubt on factual matters as the assessment is on the legal merits of the SEC’s case). Critically, the judge was able to “presum[e] that the public representations reached individuals who purchased their crypto-assets on secondary markets… and… motivated those purchases”.

In contrast, in SEC v. Ripple, where facts had to be proven, the SEC had to contend with the very real problem of proving that public statements and publicly available marketing materials were indeed relevant to the reasonable expectations of crypto exchange purchasers.

We may expect the SEC to adduce additional evidence in a future US matter.

The view from Singapore

Both SEC v Ripple and SEC v Terraform are not directly relevant to Singapore. The Monetary Authority of Singapore (MAS) has clarified that “The treatment of a token under the Howey Test is not a consideration for deciding whether a token is a product regulated under the SFA”.

Singapore’s Securities and Futures Act does not contain a reference to “investment contract” as securities. The closest potential candidate under Singapore definition of “securities” is “collective investment scheme”, but there is no case law on the Singapore element which is closest to the Howey element of “reasonable expectations", which is whether “the purpose, purported purpose or purported effect of the arrangement is to enable the [purchasers] to… receive… returns arising from the acquisition, holding… of, any right, interest, title or benefit in the property”.

Instead, based on current administrative guidance by the MAS, the focus is primarily on the nature of the token, and the following broad issues are considered:

• Whether the token contains characteristics similar to securities (such as voting or dividend rights or a representation of a debt).
• Whether the token may be utilised in itself (that is, what is commonly known as a utility token).
• Whether the token constitutes “e-money” or a “digital payment token” under the Payment Services Act. In a hypothetical case where a token constitutes both a “debenture” (that is, a security) and “e-money”, the MAS expressed that its “general regulatory stance is to not regulate [that token] as a debenture” but to regulate it under the Payment Services Act instead. It is unclear whether the MAS would choose to regulate under the Payment Services Act exclusively for all forms of securities which are also regulated under the Payment Services Act.

Osborne Clarke comment

We believe that a focus on the nature of the token has its merits, as seen from the difficulties of squaring both SEC v Ripple and SEC v Terraform. Focusing on the circumstances of the sale had created the curious outcome in SEC v Ripple.

That said, we suspect that if the cases were brought before the Singapore courts, the Singapore courts would adopt the same fact-finding exercise beyond the nature of the token.

We therefore make the following concluding observations on Singapore law where the circumstances of sale, or the wider arrangements surrounding the tokens may still cause legal problems of note to a token issuer:

1. The nature of a token may not be determinative of the issue of whether it is a security or not, and the activities surrounding the token may create a security.

In the US, this clearly is the case. In SEC v. WJ Howey, a sale of a land (with orange grove) bundled with a promise to share profits from cultivating the land was an “investment contract” and hence a security; in SEC v Ripple, for private placements, the sale of XRP (a utility token that may be used for transactions in the Ripple payment protocol) bundled with a promise to invest the purchase monies in the Ripple ecosystem was an “investment contract” and hence a security.

In Singapore, the MAS had already contemplated such a possibility. It contemplated for example that a token sold with a promise to buy back the token could constitute a debenture and hence a security.

1. The characteristics of a token may evolve over time and changes to its nature may render it a security.

In SEC v Terraform, this was already recognised with the judge stating that “[a]product that at one time is not a security may, as circumstances change, become an investment contract that is subject to SEC regulation”. The judge found that UST was originally merely a stablecoin. However, the subsequent promise to invest the collateral backing the stablecoin and share the profits of said investment transformed UST into a yield-bearing stablecoin which qualified as a security.

In Singapore, neither the courts nor the MAS had commented on this as no facts have arisen for this issue to be considered. However, we believe that a drastic change like this would be capable of rendering a token into a security that is regulated.

1. Marketing materials (stating that investors may expect a return from tokens arising from the efforts of the issuer) are clearly significant under US laws, and we may expect such marketing materials and whitepapers to be scrutinised by the MAS as well. It is of note that the MAS already prohibits digital payment token services providers from advertising digital payment token services to the Singapore public and there are various well-established restrictions on the advertising of securities to the public at large (under the framework of providing and referring to prospectuses).