How SEC vs. Ripple Stems from an Age-Old Philosophical Debate
essentialism vs. functionalism, redux
Super Phun SEC vs. Ripple Thymes
I must admit, the SEC vs. Ripple litigation has been a lot more interesting than I would’ve predicted: Ripple’s and the #XRParmy’s lawyers are keeping the SEC on its toes by mounting creative, laugh-test-passing defenses not tried by Telegram, Kik and other ‘token issuers’ that have been felled by the SEC in the paper-wizard magic duels known as securities litigation.
The main theme of Ripple’s and the #XRParmy’s defense is that a good offense is better—thus, they are arguing over and over again, in so many words, that the SEC’s overall pattern of guidance and enforcement regarding how securities laws apply to tokens marks a pernicious hat-trick of regulatory overreach by being: (1) logically inconsistent, (2) practically arbitrary and (3) incorrect as a matter of law.
The latest skirmish in this amusing bread & circus is the #XRParmy’s motion to intervene as defendants in the SEC’s lawsuit against Ripple, Ripple’s ensuing response supporting that motion and the SEC’s ensuing opposition to that motion. You can get a brief summary of these developments here and here but I recommend skimming through the ‘Argument’ sections of each of the court-filed memos linked in the prior sentence.
SEC Reveals More of its Token Philosophy
Even though it was just filing a motion to intervene, the #XRParmy used the opportunity to also raise substantive arguments regarding the SEC’s case against Ripple. Of course, the gravamen of the SEC’s case against Ripple is that Ripple violated the registration requirements of the Securities Act (aka ‘Section 5 of the Securities Act’) when Ripple sold or caused to be XRP to the public under circumstances where there would be a reasonable expectation of profits from XRP’s future increase in value due to the continuing essential managerial efforts of Ripple in a common enterprise with the XRP buyers/holders.
The #XRParmy’s motion to intervene argues that this so-called ‘Section 5 claim’ cannot be isolated from other potential securities law claims against XRP holders, such as the claim that any cryptocurrency exchange that allows trading in XRP is violating the requirement that securities exchanges must be run by authorized securities broker-dealers. In doing so, the #XRParmy equates the SEC’s Section 5 claim against Ripple to the SEC “asking the Court to conclude that all XRP, including those owned by XRP Holders are securities.” [emphasis added] If so, then XRP holders should be allowed to intervene, since they might suffer adverse effects from their XRP being deemed to be securities.
In its enforcement strategy to date, the SEC has generally refrained from directly advancing the theory that tokens are (intrinsically) securities when traded on secondary markets. That is because the legal precedents on investment contracts generally do not involve hyper-liquid transferable investment contracts trading actively on secondary markets. Instead, the Howey case law is replete with investment contracts arising from transactions between rube investors and a ‘securities issuer’ (usually a hybrid seller / servicer company, like the WJ Howey Co. was with respect to sales and cultivation of orange groves). So, in arguing that tokens trades not involving the issuer are securities transactions, the SEC would be arguing an issue of first impression and would run a greater risk of losing the case. Furthermore, this argument would be risky because, if Cryptolaw Twitter debates are any reasonable indicator, it tends to quickly give rise to rather preposterous philosophical debates.
In the Ripple case, like in the SEC’s other token cases, the SEC is focusing its arguments on the fact that Ripple sold XRP to raise risk capital under circumstances satisfying the Howey test. That conduct violates Section 5, whether or not XRP are securities when traded among third parties, just like the Howey Co.’s sale of land/service contracts violated Section 5, whether or not those contracts would be securities if subsequently traded among third parties. The #XRParmy’s motion to intervene strategically links this cleaner Section 5 claim to a host of potential secondary market claims and thus places the trickier issues front-and-center. The motion does this in two steps: (1) by first equating the SEC’s Section 5 claim against Ripple to the SEC “[c]laiming that [XRP] itself is the security” and then (2) equating the SEC’s supposed position that XRP is a security to “calling the ‘oranges’ produced by the orange groves in Howey securities.”
All in all, Ripple’s arguments that XRP should not be subject to the securities laws are basically a reductio ad absurdum of the SEC’s arguments that XRP should be subject to the securities laws—-with the punchline being that if the SEC’s theories are accepted, not only are XRP securities, but so are the oranges in the Howey case. Since it is supposed to be patently absurd for oranges to be securities, then the SEC’s arguments about XRP must also be patently absurd.
To rebut this aggressive reductio, the SEC has finally had to tip its hand a bit more and explain how it views the differences between primary transactions involving XRP and secondary transactions involving XRP as well as how it views the relationship of XRP to the alleged investment contract that constitutes a security. To wit, in its opposition to the #XRParmy’s motion, the SEC writes as follows.
Movants claim they must intervene to convince the Court that XRP is not “per se” a security. But this case presents no such question. “While helpful as a shorthand reference, the security in this case is not simply the [XRP], which is little more than alphanumeric cryptographic sequence,” [but rather] it is all the facts and circumstances surrounding the digital asset and the manner in which it is offered and sold (including the entirety of the representations Ripple made and purchasers’ resulting expectations) that made the offers and sales of XRP the offers and sales of an investment contract. The XRP traded, even in the secondary market, is the embodiment of those facts, circumstances, promises, and expectations, and today represents that investment contract. And, incorrectly reframing the inquiry from the legally correct view of what the investment contract is (the XRP’s offer and sale in the particular context) to Movants’ narrower view (the XRP itself) makes no difference to what Movants really care about—digital asset trading platforms’ listing of XRP
This reasoning will be no surprise to those who have been following my writing for a while, since it’s the reasoning I thought the SEC was using all along. I have long argued that analogies likening open network tokens to consumable goods, software licenses or natural commodities are fundamentally flawed, and that open network tokens should instead be viewed first and foremost as shares of network equity.
In any event, the SEC’s rejoinder to Ripple and the #XRParmy has raised a bit of a hue and cry among critics of the SEC’s position on tokens, presumably including those who sponsored the hopelessly confused, confusing and ironically named “Securities Clarity Act “,—an Act which proposed to amend the definition of securities in the Securities Act to exclude any “investment contract asset”—meaning almost all tokens. Likewise, fans of Lewis Cohen’s law review article “Ain’t Misbehavin’: An Examination of Broadway Tickets and Blockchain Tokens” view the SEC’s interpretations as erroneous. They believe that investment contracts can only exist between people who have also entered into a legal contract with one another. On this view of the securities laws (which I will later argue is an essentialist view), it would be impossible for secondary market transactions in XRP to fall under the securities laws, since the average XRP buyer does not have a legal contract with Ripple. Thus, the SEC’s statement that “XRP traded…in the secondary market…[can] represent an investment contract” is considered to be dead wrong under this school of thought.
My concern here is not to argue which approach is wrong or right—at this point I would be fine with either side winning if it resulted in a stable, navigable status quo for token creators. I just don’t really care about theory—I care about results. But, I do find it interesting to diagnose theory quagmires. Thus, my goal here is to go meta and show how silly the token debate has become—because it is really ultimately just a sophistical philosophical debate in which the two sides are constantly talking past each other about unprovable propositions that don’t really matter.
Essentialism vs. Functionalism
This basic distinction should be familiar to those with a passing interest in philosophy. The famous original essentialist is Plato (or, I guess, his mentor Socrates). Trusty Wikipedia summarizes essentialism thusly:
In law, an example of essentialism would be the view that whether or not a given ‘thing’ is regulated as a security must be determined by its intrinsic features. There are certain essential attributes of a security—such as it being a contract or instrument representing a contract—without which the securities laws must not apply, because the requisite essence of security-ness is lacking. Legal essentialism may largely overlap with legal formalism (most famously advocated by Antonin Scallia):
By contrast, legal functionalism can be summarized thus:
Legal functionalism overlaps in large part with legal realism and legal instrumentalism:
It seems to me that, ultimately, the reason this discussion is so tricky is because it's covertly a legal philosophy debate between legal functionalists (the SEC) and legal essentialists (#XRParmy, Ripple). Thus, each side misunderstands the other’s positions, their views are essentially irreconcilable and yet still have to all try to get along. Let’s explore this a bit more—it’s full of delicious ironies.
Token Functionalism, AKA the Duck Test
The functionalist or realist position is epitomized by William Hinman’s speech, “When Howey Met Gary (Plastics)”.
Basically, Hinman argues that there are situations in which a token has all of the important functions of a security: For the issuer of the token, it functions to raise capital and fund future development efforts, just like selling a security does. For the buyer of the token, it functions as an investment, which will perform very well if the token issuer is smart, talented, loyal and disciplined and perform very poorly otherwise— just like buying a share of stock in a company. On the other hand, there are times when token transactions just aren’t functioning that much like a security—for example, the Bitcoin and Ethereum ecosystems are funded and worked on by a very wide array of otherwise unaffiliated and uncoordinated persons. There is no one to hold accountable for bad price performance; conversely, there is no one who can ‘make or break’ the price performance either. A “sufficiently decentralized” cryptocurrency is just not functioning like a security.
You get the idea. Legal functionalism is sometimes referred to as the “duck test”: if it functions like a duck (looks, walks, swims, quacks like a duck, etc.), then it’s a duck. There is no metaphysical essential “duckness” that is missing in something that functions exactly like a duck—rather, if the functional match is sufficiently exact, that thing just is a duck.
A good example of legal functionalist reasoning can be found in Grundfest’s early comments on whether Bitcoin is a security—basically, he argued it sometimes is and sometimes isn’t, depending on what functions it has to the people using it. If it has similar functions to securities, then it is a security. (I suspect he no longer specifically thinks Bitcoin is a security—but this clip remains a good illustration of functionalist legal reasoning).
The functionalist approach has also been tacitly embodied in how Blockstack handled its qualification of STACKS tokens as securities under Regulation A+ and subsequent determination that STACKs ceased being securities. In their correspondence with the SEC about STACKs, Blockstack’s lawyers were asked many questions by the Staff, such as whether Blockstack holding lots of STACKs could make Blockstack an investment company needing to be registered under the Investment Company Act. Blockstack’s counsel provided very functionalistic answers to these types of questions, which ultimately were accepted by the SEC—for example, Blockstack’s counsel wrote to the SEC as follows:
Token LLC does not meet the definition of an investment company for purposes of the Investment Company Act of 1940 (“Investment Company Act”), despite its holdings in Stacks tokens, because...it is reasonable to treat Stacks tokens held by Token LLC as non-securities for purposes of the Investment Company Act...
This is a very functionalist and anti-essentialist take: the STACKs tokens are securities when held by an investor, because the investor has investment purposes, but not when held by the token issuer, because the token issuer is holding them for use with the technology or grants to community members pursuant to ‘App Mining”. By contrast, on the essentialist view, STACKS tokens cannot be securities, because they lack the essential contract rights for securities. a specific kind of thing is intrinsically a security, and nothing else is a security—Lewis Cohen’s article cited above takes an essentialist view, because he requires that there be a particular kind of contract between the parties in order to agree that there’s a security, no matter how similar the functions of something else, like a token, may be to the functions of a security.
On the functionalist view, we don’t care whether a thing is a security—that is almost an incoherent question or topic. A category mistake. Rather, we ask what the function of the relevant law or legal classification is, and we just do the duck test—when, for example, tokens have many of the same functions as a more traditional security like shares of capital corporate stock—such as being able to sell them to use capital, being able to use them to vote on governance, etc.—then a broad remedial statute like the Securities Act obviously must apply to them.
SEC vs. Ripple :: Functionalism vs. Essentialism
In SEC vs. Ripple, the lines are pretty clear—the SEC thinks the U.S. federal securities laws embody the duck test. In transactions that have functions similar to securities transactions—the classic example being that of an ICO which raises significant risk capital) for the token issuer—the securities laws apply, and the SEC is not too worried about the metaphysics. Meanwhile, Ripple continues pointing out ways in which XRP lack the alleged intrinsic features of a security and emphasizes how this leaves parties confused and with insufficient notice of how to comply with securities laws. These two camps are completely talking past each other and may just have a very different view of the law and its purposes and opportunities.
Perhaps ironically, the pattern I see is that the essentialists (e.g., Ripple) argue that the functionalists are asserting untrue essentialist propositions. Simultaneously, the functionalists (e.g., the SEC) argue that that essentialists are asserting untrue functionalist propositions.
Basically, current token securities debates are going like this:
Your honor, the SEC is saying XRP transactions are securities transactions. (Tacit premise: because essentialism is the correct interpretive framework) this would mean that XRP are securities (a thing either is a security, or it isn’t). But that is absurd, because a database entry on a ledger cannot be a security. The SEC is overreaching by arguing tokens are securities, your honor—send them home and dismiss their case!
Your honor, the defendants are saying XRP transactions can be conducted for all the same reasons and purposes as a securities transaction (raising capital, appreciating in value, etc.) but still not be subject to the securities laws. (Tacit premise: because functionalism is the correct interpretive framework), this would mean that XRP transactions can have all or most of the functions of securities transactions without being subject to the securities laws.
But that is absurd! A transaction that has the purposes and risks of a securities transaction should be subject to the securities laws. Congress's intent in using a broad principles-based approach under the Securities Act was clearly to capture every type of transaction that predominantly has securities-like purposes and risks. If we don’t regulate XRP transactions as securities transactions, more and more market players will spawn tokens instead of traditional securities, and all the protections of the securities laws will be lost through the creation of an essentially arbitrary loophole. Your honor, please reject this argument!
This is an anti-pattern, and I am not sure much progress can be made while it is perpetuated.
A Conclusion, You Say?
I don’t really have one. This article grew spontaneously of a discussion with some other cryptolawyers. I guess I would say that it’s time people be able to navigate tokens with more legal confidence—it is clear cryptocurrency and DeFi are here to stay. Thus, it would benefit everyone if we identified our theory-based biases, discarded them and focused on developing pragmatic, repeatable and efficient solutions that are fair to everyone.
Well thought out piece and really gets to reconciling the different legal frameworks for the case. Oddly, in 2018, when prospective ICO clients were coming to me with their own essentialist interpretations of the Howey Test as to why they could issue tokens in the U.S. (and were relying on me to represent that position), I would literally respond over and over again that I no longer exclusively relied on the Howey Test...that the test I put more weight on was the Duck Test and thus the functional test. So this article kind of blew me away since this was a conversation that I had multiple times in 2018. While the XRP cheerleaders make the clever essentialist argument, I don't know how Congress could allow the SEC to be castrated by forcing the essentialist argument....with that said, its not Congress here but the courts and Congress may or may not have the appetite to specifically go down this road....likely it will be left to Gary Gensler to figure out. The challenge is that the functional test continues to create a lot of grey area and Hester Pearce's safe harbor would probably go a long way to resolving.....or at least kicking the can down the road for three years!