But a federal judge giving the SEC a clear ruling on whether purchases of cryptocurrencies on the secondary market qualify as securities transactions could be key to determining the future of the U.S. crypto market. There is.
The SEC and the exchanges have different views on the important issue of when a virtual currency transaction becomes a securities transaction.
(Tingy Injury Law Firm, Unsplash)
Posted on March 24, 2024 at 5:58 PM ET.
As trial begins on Monday in a lawsuit brought by the U.S. Securities and Exchange Commission (“SEC”) against Terraform Labs and its former CEO Do Kwon for selling certain crypto tokens in violation of U.S. federal securities laws. We are pleased to announce that this case is important as the U.S. Securities and Exchange Commission (“SEC”) begins trial in a lawsuit accusing it of selling certain crypto tokens in violation of U.S. federal securities laws. It applies to the industry.
Perhaps most importantly, SEC v. Terraform Lab The case is not what happened in Judge Jed Rakoff's case in the US District Court for the Southern District of New York, but rather that a specific pretrial ruling that Judge Rakoff issued when he dismissed the Terraform Labs defendants was a secondary virtual currency transaction. This is the impact on the market. They argue that SEC regulations do not apply to the sale of virtual currencies. As discussed below, Judge Rakoff's ruling on this issue: SEC v. Terraform Lab That contradicts a ruling by Judge Annalisa Torres of the same court. SEC v. ripple lab, concerns an issue of great importance to the burgeoning crypto economy. Do federal securities laws enforced by the SEC apply when trading cryptocurrencies on secondary market exchanges? The answer could be key to determining the future of the U.S. crypto market.
basics
New crypto projects usually require startup funding. This is often raised by the company developing the project in the first place, either by selling stock or entering into a deal to provide tokens (if developed) in exchange for capital, or both. In this case, the Company will negotiate with the investors individually and directly sell tokens (or contract to receive tokens) (direct sale). Additionally, once the project is launched and the tokens are publicly traded, the company may continue with direct sales or engage in indirect blind bidding/offering sales (indirect sales) of the tokens on third-party cryptocurrency markets. . The SEC argues that these direct sales are “investment contracts,” a type of “securities” transaction that must be registered with the SEC or meet an exemption under the Securities Act of 1933. But what about indirect sales?This question was the driving force behind the SEC's landmark enforcement action against Ripple Labs and Terraform Labs..
In each of these cases, the SEC asserts that: both Direct and indirect sales of tokens may result in investment contracts subject to SEC regulation. Both judges agree that the direct sale of related tokens is (or at least may be) an investment contract security. However, opinions differ as to whether this also applies to indirect sales. How this conflict is resolved could have major implications for companies involved in token funding. But it will also impact countless market participants who trade in the multi-trillion dollar secondary cryptocurrency market.
ripple
in SEC v. Ripple Lab Co., Ltd., the SEC alleged that Ripple Labs illegally sold XRP tokens as unregistered investment contract securities to fund the growth of the Ripple ecosystem. According to the SEC, Ripple engaged in the following actions: both Direct sales of XRP tokens to institutional investors (which Judge Torres described as “institutional sales”) and indirect sales of XRP tokens through crypto asset markets where XRP is already actively traded (which Judge Torres described as “programmatic (expressed as “sale”). After years of litigation, Judge Torres agreed with the SEC's view that institutional sales are securities transactions. This is because “a rational investor would understand that Ripple would use the funds from its 'institutional sales' to improve the XRP market and develop uses for the XRP ledger.” However, Judge Torres reached a different conclusion with respect to programmatic sales, stating that because programmatic sales are indirect sales through blind bid/sell transactions, “programmatic purchasers must be aware that their payments were sent to Ripple. , or whether the payment was made to another seller.” XRP. ” In other words, “The economic reality is that programmatic buyers were in the same position as secondary market buyers who didn't know who or what they were paying for.”
To be sure, Judge Torres did not definitively rule that blind bid/ask indirect sales were possible. I never have Applies to securities transactions. Indeed, Judge Torres limited the scope of her opinion, noting that it applies only in the following cases: “XRP sales on the secondary market” rather than programmatic sales of XRP by Ripple [by third parties] Organize offers and sales of investment contracts. ” However, Judge Torres' opinion leads to the inescapable conclusion that other types of financing through the indirect sale of tokens may also not be securities transactions. Perhaps more importantly, the judge's reasoning suggests that absent extraordinary circumstances, secondary sales other than fundraising in the crypto market by a third party cannot constitute a securities transaction. be. That set the stage for Judge Rakoff's sharp disagreement. terraform.
terraform
in SEC v. Terraform Labs Pte., the SEC alleges that Terraform Labs sold the various tokens it helped develop (LUNA, MIR, and various “mAssets”) to consumers through direct sales and indirect sales in the cryptocurrency market as unregistered investment contract securities. He claimed that he sold it illegally. However, unlike Judge Torres, Judge Rakoff treated both the direct and indirect sales by Terraform Labs as securities transactions.At that time, Judge Rakoff clearly refused. rippleReasoning. Under Judge Rakoff's approach, the buyer's expectations remained the same for both direct and indirect sales. The fact that the indirect sale involved a “blind” purchaser made no difference to Judge Rakoff, who concluded that Terraform Labs was targeted. both Direct and indirect purchasers and their marketing.
Who is right?
Despite their disagreements, Judges Torres and Rakoff agreed on certain fundamental points. First, the justices agreed with the growing consensus among federal courts that a token alone is just a code and not an investment contract security itself. Second, both parties agreed that when selling tokens in a direct sale to raise funds, the tokens can be part of an investment contract transaction. However, when it came to indirect sales, the judges strongly disagreed. Judge Torres suggested that indirect sales clearly do not constitute investment contracts because the purchaser does not know whether they are buying from the token creation/funding company or a third party. However, Judge Rakoff rejected that distinction based on the facts set forth below. terraform.In Judge Lakoff's opinion, indirect sales can Even if the purchaser is “blind”, it could still be an investment contract, depending on the nature of the token and the prevalence of the token creator’s promotion.
So who has the upper hand in the indirect sales debate, Judge Torres or Judge Rakoff?
Simply put, it depends.
Imagine a hypothetical company creates a binding contract that promises token holders a 0.0001% share of the company's revenue for each token they own. The token will likely be a security similar to a stock certificate. This token would effectively transfer rights from one buyer to another under the contract, a right that a third party could consider before participating in an indirect sale. Regardless of how the tokens are acquired, each holder will benefit from this separate contract and the company's promise that the tokens convey legal rights. If the company breaks its promise, each shareholder can sue for the pledged shares.
For such tokens, Judge Lakoff's reasoning makes sense. Consumers in the secondary market acquire rights to identifiable legal entities. It makes no sense to distinguish between direct and indirect sales, given that both types of sales confer the same set of economic rights on the purchaser.
The problem with Judge Rakoff's ruling is that the vast majority of today's tokens do not convey such rights. If tokens that do not convey legal rights are sold for capital formation purposes, First time purchaser You may benefit from legally enforceable claims against the seller. That's because the initial purchaser provides capital with the understanding that the money will be used to increase the value of the token. Even if the exchange of tokens and capital is not a federal securities transaction, a company's failure to fulfill its promise may, in appropriate cases, give rise to legitimate claims for legal damages.
But what if someone buys the same token from a secondary market participant who is not affiliated with the company? Here, the buyer's funds never reach the company. The purchaser is no longer investing capital to participate in a general enterprise. And given that no promises have been made to secondary market purchasers, it will almost certainly be impossible for purchasers to bring a viable case against the company for contractual damages. be. Among other things, there is usually no “privilege” between the purchaser and the company, and no consideration is provided to the company. These are her two key requirements for enforcing the contract. In this scenario, Judge Torres' reasoning leads to the correct result. Blind buying and selling of tokens that conveys no legal rights is generally not an investment contract.
Take-out
While these examples will certainly inform how startups conduct token funding, the far more important implication of Torres and Rakoff's discussion of direct versus indirect funding sales is that It has to do with the question, non-funding or not. secondary Sales by third parties on crypto asset marketplaces are securities transactions. This issue is currently at the center of the SEC's recent enforcement actions against Binance, Coinbase, and Kraken. In all three cases, the SEC and the respective markets offered controversial interpretations of how Judges Torres and Rakoff's decisions should inform their conclusions regarding the secondary transactions at issue. Ultimately, these district court disagreements will need to be resolved by the Intermediate Circuit Court of Appeals and even the U.S. Supreme Court. Until then, major market participants will continue to face uncertainty and remain in the legal limbo that the crypto industry is accustomed to.
Samson A. Enzer is a partner and head of the cryptocurrency and fintech practice at Cahill Gordon & Reindel LLP, and Lewis R. Cohen is a founding partner of DLx Law. Nicholas Baril is Cahill's law clerk.
