In 2008, as the global banking system melted down, a shadowy figure or figures in a dim room filled with empty Cheetos bags created Bitcoin.
In the following years, your younger brother talked excitedly about the blockchain at every Thanksgiving. Your dad quoted Charlie Munger and called your brother an idiot.
By 2021, Bitcoin was a household name, your barber wouldn’t stop mentioning DOGE, and your Great Aunt Ethel was going by the Twitter handle @ethel.eth. But, in early 2023, FTX’s meltdown and other frauds and market failures had skeptics predicting the imminent death of all things crypto.
Fast forward to today. Bitcoin has been packaged into easily digestible ETFs and is trading at all-time highs, and the broader cryptocurrency market is valued at more than $2 trillion.
Reasonable people can–and do–vigorously disagree about the underlying utility and inherent value of different digital assets and technologies. But skeptics and bulls would all agree that despite frequent predictions of demise, crypto has more than kept its feet.
Assuming the crypto industry is indeed here to stay (a safe bet), what elegant regulatory framework has the United States developed to protect investors and provide structure for industry participants? A 2,000-word legal opinion about orange groves, written in a time when the lobotomy was a common medical procedure by a judge who was born before women had the right to vote.
I’m referring, of course, to the U.S. Supreme Court’s 1946 Howey decision. Howey established the legal test–which endures to this day–for whether or not a financial asset is a “security” subject to the SEC’s jurisdiction.
Over the past few years, the SEC and the crypto industry have been engaged in a pitched battle over whether Howey is the appropriate framework for regulating digital assets.
According to SEC Chair Gary Gensler, “the vast majority of crypto tokens” are securities under Howey, issuers of digital assets need to register non-exempt offerings, and intermediaries–i.e., exchanges and broker-dealers–also need to register.
The industry has responded that Howey is not enough: The framework doesn’t provide sufficient guidance and the SEC has not created a meaningful path to registration or engaged in sorely-needed rulemaking.
In the past few years, the SEC has brought case after case against many of the most prominent players in crypto for allegedly transacting in unregistered securities under Howey. Many of these cases are still hotly contested in court, and it’s hard to keep up with the avalanche of news in this space.
Many observers think that it would be great for Congress to weigh in here, but that’s not going to happen this year. For the remainder of 2024 (and potentially beyond, depending on the outcome of the upcoming elections), these cases are the main crypto regulatory game in town.
This means that it’s a good time to check in on some recent Howey litigation developments. We’ll also take a look at the current state of the insurance markets for financial services companies with crypto exposure. Sorry (not sorry) for all the Howey puns.
Howey Got Here?
First, a refresher on Howey. The test is short and sweet. To qualify as an “investment contract” (and, accordingly, a security) subject to the SEC’s jurisdiction, a digital asset must involve:
- In a common enterprise
- With a reasonable expectation of profits to be derived from the efforts of others
During the SEC’s crypto crusades, there has been a lot of focus on the “common enterprise” and “efforts of others” elements of the test.
Crypto issuers have argued that truly decentralized platforms have no commonality and, because the community is mining/minting new coins and the founders have stepped away from the project, buyers don’t expect profits from the efforts of a managerial class.
The SEC has generally accepted that some digital assets–Bitcoin, maybe Ethereum (but maybe not!)–are sufficiently decentralized and divorced from any managerial efforts so that they cannot be securities.
In the recent raft of high-profile Howey cases, much of the action has focused on whether secondary market transactions–e.g., buying and selling between asset holders on exchanges, not direct sales from crypto issuers–satisfy the second and third elements of the test.
Ripple: Sometimes a Security, Sometimes Not a Security
The SEC’s litigation against Ripple Labs was one of the earliest–and has been one of the most closely followed and hotly contested–high profile Howey cases.
Ripple and its founders created the XRP token in 2013. They sold more than $1 billion of XRP to two types of buyers: 1. institutional investors who bought XRP directly from Ripple and 2. individual investors who bought XRP from Ripple on trading platforms.
In December 2020, the SEC sued Ripple, its CEO, and one of its founders for selling unregistered securities (XRP). After some preliminary skirmishes between the parties, in July 2023 Judge Annalisa Torres of the Southern District of New York (SDNY) finally jumped into the deep end of the Howey pool.
The SEC and the Ripple defendants filed cross-motions for summary judgment. This means that they each argued before trial that, based on discovery (documents + what witnesses said in depositions), “We win.”
When faced with controversial legal questions better suited for lawmakers than the courts, Solomonic judges love to split the baby. And this is what Judge Torres did in her decision on Ripple: She found that XRP was a security when sold to institutional investors but was not a security when sold to retail investors through trading platforms.
How can the same digital asset be a security sometimes but not other times? The decision focused on the third prong of the Howey test: Whether investors had “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”
According to the decision, while institutional investors probably understood “that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP,” retail investors on trading platforms “did not know who was selling” the XRP and so could not have had any reasonable expectation of profits specifically from “Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends).”
Even though Judge Torres found that Ripple had violated the law with the institutional sales, the partial victory was celebrated by the crypto community. After the decision, the SEC voluntarily dismissed the charges against the individual defendants.
Next up, the SEC and Ripple will fight over financial remedies for the institutional sales. Barring a sea change in SEC policy (which might come in 2025), the government may appeal the decision that XRP was not a security when retail purchasers bought it on trading platforms.
Terraform: Securities for Sure
In 2022, the Terraform network cratered, and its founder, Do Kwon, went on the run (although he claimed that he was not on the run). The SEC sued in February 2023, alleging that various digital assets sold by Terraform were unregistered securities and charging Kwon and the company with fraud.
In July 2023, SDNY Judge Jed Rakoff denied defendants’ motion to dismiss the SEC’s case, in the process finding that based on the SEC’s allegations the Terraform digital assets were unregistered securities.
Judge Rakoff pointedly threw shade on the Ripple decision and expressed doubt that a digital asset can morph from a security to a non-security based on the identity of the purchaser.
Then, in December 2023, Judge Rakoff slammed the door shut on the Terraform Howey analysis, finally concluding at summary judgment that the assets were unregistered securities. Some of this can be chalked up to evidentiary differences in the two cases. Still, a nice win for the SEC.
Wahi: “Empty Chair” Securities
In 2022, the SEC brought a first-of-its-kind crypto insider trading case against a former Coinbase product manager who used advance knowledge of digital asset listings to tip his brother and friend, who made over $1 million in profits.
After losing a motion to dismiss involving some riveting Howey analysis, the product manager and his brother ultimately pleaded guilty to criminal charges and settled the SEC case.
When it was initially filed, the Wahi case was a bit of a head-scratcher because the SEC didn’t also sue Coinbase for operating an unregistered securities exchange. But Coinbase knew that rough seas were ahead (see below).
When the SEC filed the insider trading charges, the company fired off a press release titled: “Coinbase does not list securities. End of story.” Coinbase also raised its voice in support of the brothers’ failed motion to dismiss the SEC charges (they ultimately settled).
Back to the Wahi case. Unlike the Coinbase employee and his brother, the friend flew the coop and is presumably living in some cryptopia with lax extradition laws.
When a defendant doesn’t appear in a civil case, the plaintiff (here, the SEC) will move for default judgment. In these scenarios, the court does some light analysis to show that it is not doing anything grossly unfair, but it generally will rule in the government’s favor when dealing with a miscreant who has fled the country.
To decide on the SEC’s motion for default judgment against the friend, Judge Tana Lin of the Western District of Washington needed to figure out if the government had a legal basis for its charges. Stop – Howey time!
Accepting the SEC’s allegations as true, Judge Lin easily concluded that each of the nine relevant crypto assets qualified as securities.
Most significantly, citing Judge Rakoff’s order in Terraform, Judge Lin found that this analysis held true even in the context of secondary market trading, ruling that “promotional statements and managerial promises…apply equally to tokens that an investor may have bought from the issuer directly or from another investor, including on a crypto asset trading platform.”
Along with Terraform, Wahi took a bit more wind out of the sails of the SEC’s crypto critics.
Coinbase responded that the Wahi decision “was procured against an empty chair [because there was no opposition to the SEC’s motion] and its reasoning reflects as much.” Super spicy language for a legal brief, and indicative of Coinbase’s bare-knuckles approach to the SEC fight (read on below).
Binance: Guilty Plea; Still Fighting the SEC
In June 2023, the SEC sued Binance. The SEC accused the company, among other things, of selling unregistered securities and operating an unregistered exchange. Binance’s founder and then-CEO, Changpeng Zhao (CZ), accused the agency of overreaching.
In December 2023, Binance and CZ pleaded guilty to a host of criminal charges centered on the exchange’s failure to do anything to prevent money laundering and other illegal activity on its platform. Binance paid more than $4 billion in financial remedies; CZ agreed to step down as CEO and is facing prison time.
Despite falling on its sword in front of the DOJ, Binance continues to fight the SEC’s civil case. Counterintuitively, while Binance could live with the (very high) cost of the criminal case, the SEC’s civil case presents an almost existential threat.
In a recent motion to dismiss, Binance relied heavily on the Ripple theory that secondary market transactions do not satisfy the Howey test.
A hearing on Binance’s motion to dismiss was held in January. Judge Amy Jackson Berman of the D.C. District Court appeared skeptical of Binance’s arguments, but some observers detected a possible affinity for Judge Torres’ opinion in Ripple. We’ll know her views soon enough.
Coinbase: “Absolutely Committed to Defending Itself in Court”
Remember how the SEC sued a few guys for insider trading in supposed crypto securities on Coinbase but didn’t sue the exchange itself for listing those unregistered supposed securities?
In July 2023, the SEC got around to suing Coinbase. In response, Coinbase said that the SEC was not being fair and promised to fight to the bitter end.
True to its word, Coinbase asked the court to throw out the SEC’s case. Like Binance, one of Coinbase’s central arguments is that secondary market trading of crypto assets cannot create an investment contract because “the purchaser gets no share in business income, profits, or assets.”
Last week, SDNY Judge Katherine Polk Failla mostly denied Coinbase’s motion to throw out the SEC’s case. While the judge was required to accept the SEC’s allegations as true at the pleading stage, the legal analysis is not good for Coinbase. Following Terraform and Wahi, Judge Polk Failla rejected the Ripple approach to secondary market transactions, finding “little logic” in Coinbase’s attempt to draw a distinction “between the reasonable expectations of investors who buy directly from an issuer and those who buy on the secondary market.”
This, of course, is far from the end of the Coinbase story. The company has again vowed to fight on, in the SEC case and through lobbying efforts. Coinbase is also pursuing affirmative litigation against the SEC, challenging the agency’s failure to make rules for the crypto industry. Reflecting the upside-down world that is crypto regulation in 2024, after Judge Polk Failla found that the company’s core business model likely violates the law, Coinbase’s stock price dipped slightly but has recovered as of the date of this writing.
Kraken: Last but not Least
Going for the trifecta, the SEC rounded out 2023 by suing Kraken in November for operating an unregistered exchange.
Not to be outdone by its bigger brothers in the crypto industry, Kraken sprinkled its own motion to dismiss into the 2024 crypto regulatory gumbo. A hearing is scheduled for June.
The Future of Crypto Regulation
If I’m a crypto titan locked in an existential struggle with the SEC right now, I am probably thinking that time is my best friend.
Setting aside the defense’s wizardry in Ripple, the SEC has done a good job of convincing courts that it has the authority to regulate a variety of crypto assets. If the Binance and Kraken judges follow suit, the SEC will have clearly achieved the upper hand in district court. Future appellate decisions could change this story, but as more and more district judges endorse the SEC’s theory of the case, it becomes less and less likely that the industry will find relief in the federal court system.
In the best-case scenario, judges will continue to say different and possibly contradictory things, appeals will grind their way through the courts, and legal uncertainty will prevail.
What to do? Keep the court battles alive, continue to lobby for a new regulatory framework, and cross your fingers for favorable government intervention in 2025.
Stay tuned for more fireworks.
Crypto and the Commercial Insurance Market
Some believe that crypto risks are difficult – if not impossible – to underwrite given the lack of a new regulatory framework dedicated to the industry. This is not true.
In fact, because crypto is governed by old preexisting frameworks, sophisticated insurance underwriters already have expertise in the core legal and regulatory risks (securities, regulatory, AML/KYC) to the industry. Sufficient knowledge of and comfort with different crypto business models, however, has been slower to evolve.
It is true that insurance for crypto firms is tricky. Carriers manage risk very carefully (including by typically requiring approvals from senior personnel), and premiums, terms and conditions are often more restrictive than in other industries. Some of this complexity is a function of the genuinely high regulatory and litigation risks for crypto firms. But further education about lower-risk segments of the industry also helps to bridge the gap between crypto companies and insurers.
Crypto companies should take a proactive approach to educating their carrier partners and leverage the underwriting process as a competitive advantage. Carriers are open for business. If you want to get the best possible coverage terms in this environment, it’s important to work with an insurance advisor who deeply understands this industry and can help you to translate (and differentiate) your business model, products, regulatory posture, and compliance infrastructure for underwriters.
