U.S. court sends ripple through murky waters of crypto regulation

Author(s): Matthew T. Burgoyne

Sep 7, 2023

An imperative question in the cryptocurrency industry is when exactly does a token become a security? A recent decision from a U.S. court on the SEC Ripple dispute could potentially impact how we answer that question in Canada, especially with regards to the “investment contract” test. The absence of a globally adopted approach to crypto asset creation and distribution continues to muddy the waters in the ever-evolving digital asset space.

In the video below, Osler partner and Co-Chair of the Digital Assets and Blockchain practice, Matt Burgoyne outlines the District Court’s decision and what it could mean for Canadian businesses.

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Video transcript

MATTHEW BURGOYNE: Hello, I’m Matthew Burgoyne, Co-Chair of the Digital Assets and Blockchain Group at Osler in Calgary.

An imperative question in the cryptocurrency industry is when exactly does a token become a security? This is relevant for Canadian token issuers, the Canadian Securities Administrators, the SEC in the U.S. and of course Binance and Coinbase, who were both recently sued by the SEC on the basis that they engaged in, among other things, unregistered offerings of security tokens. The recent decision from a U.S. court on the SEC Ripple dispute could potentially impact how we answer that question, especially with regards to the “investment contract” test.

The investment contract test is a crucial tool in determining whether the manner in which a token is sold constitutes a distribution of a security. In Canada, the Supreme Court decided in the “Pacific Coin” case that an investment contract arises when all of the following have been met: There has been:

1. an investment of money, 
2. in a common enterprise, 
3. with the expectation of profit 
4. to come significantly from the efforts of others. 

July 13, 2023, saw a landmark ruling by the United States District Court. It declared that Ripple Labs’s XRP token constituted a security when sold to institutional investors, thereby falling under SEC oversight. However, when sold on a digital exchange or via a trading algorithm to the general public, the token was not deemed to be a security.

The court held that the facts surrounding the sale of the token are critical to understanding whether the token is an investment contract, since the token “is not in and of itself a 'contract, or scheme or transaction' that embodies the requirements of an investment contract.”

Institutional buyers would have reasonably expected that Ripple would use the proceeds for the XRP ecosystem, which would likely result in an increase in the token's value, according to the court.

But those who purchased the tokens on crypto exchanges didn't necessarily know if their payments for XRP went to Ripple or any other seller since the crypto exchanges used trading algorithms that matched buyers and sellers in blind transactions. Therefore, there wouldn’t necessarily have been any expectation of profit coming significantly from Ripple’s efforts. 

So, what does this mean for Canadians?

The Ripple verdict offers Canadian regulators and market participants food for thought. If similar principles were applied in Canada, certain tokens sold on digital exchanges to the public via trading algorithms could evade being classified as securities. Conversely, if sold to institutional investors with the promise that sale proceeds will be used to further develop the token ecosystem, they may be regarded as securities. This might pave the way for a more nuanced approach in crypto asset classification.

The absence of a coherent, globally applied approach to crypto asset creation and distribution, forces regulators to fit crypto asset regulations into the traditional capital markets regime on a case-by-case basis. 

Here is the bottom line:

1. Canadian token distributors should be cautious and seek legal advice before initiating any token distribution event, even if the distribution takes place offshore.
2. Be prepared to defend against the argument that your project is distributing an investment contract. If there is an identifiable group or person whose efforts are essential for the success or failure of the project, it is best to obtain legal advice. Canadian securities regulators are monitoring the industry closely, and the penalties and sanctions for noncompliance can be costly. 

Osler’s Digital Asset and Blockchain Group can help guide you through this novel regulatory landscape. Please reach out if you have any questions about securities laws and how they may impact your business in the ever-evolving digital asset space.