The question of ‘offering’ in the securities law

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This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

Ripple CEO Brad Garlinghouse (@bgarlinghouse) tweeted:

The most important part of this ruling:

“XRP, as a digital token, is not in and of itself a “contract, transaction[,] or scheme” that embodies the Howey requirements of an investment contract.”

This is a now a matter of law (not up for trial.)

— Brad Garlinghouse (@bgarlinghouse) July 13, 2023

Mr. Garlinghouse misconstrued the statement in the ruling. Although the judge in the XRP case clearly misapplied the law, the statement quoted from the summary judgment is actually a good statement, if not misconstrued.

Note that the statement is true for any asset, not just XRP.

In the securities law, the focus is on the ”offering” not the ”asset in and of itself’.’ It is a particular manner of an offering that may constitute an investment contract (thus a security), not the thing being offered in and of itself.

Whether or not a crypto asset is a security according to the securities law is discussed in detail in Even BTC Has Become a Security.

At the same time, the entire discussion about whether crypto assets are securities, broad or narrow, supporters of the Securities and Exchange Commission (SEC) or promoters of crypto, is fundamentally misguided and misplaced.

Specifically, everyone is focusing on the asset itself, when the real focus should be on the offering instead.

This is not an argument for or against any crypto asset. This is really what the essence and purpose of the securities law are. There is no first principle-based law to define a certain ”thing” (asset) as a security, but rather an ”investment contract” which offers the thing as a securities offering. When such an offering exists, the thing that is being offered is then called a “security.”

That is, the basis of the entire legal theory is the offering, namely a securities offering, on which a thing called ”security” sits and through which an investment contract is formed.

With this view, the thing itself may not be a security to start with but may become a security if it’s offered in a securities offering.

For this reason, the analysis must look at the entire history to identify distinctive ”offerings” and determine if any of the offerings constitute a securities offering. For that, the Howey test is the standard. But the test is against each underlying offering, not the asset itself.

For example, every crypto asset has an initial offering by the issuer. That is a distinct offering. Some of the initial offerings were clearly a securities offering used for a capital raise (e.g., every ICO that had pre-mining and thus the selling of the asset from the issuer to investors to raise capital); some were not a securities offering (e.g., the original bitcoin offered by Satoshi to miners in a unilateral mining contract in which Satoshi as the issuer did not do any pre-mining and did not receive any proceeds of the offering).

Most crypto assets then had a subsequent secondary offering on an exchange. The crypto exchanges that are centrally operated off-chain are really making securities offerings when they facilitate crypto trading. This converts the asset being offered into a security even if the asset is not security already. See Crypto exchanges convert crypto assets into securities.

Further, some crypto assets made new offerings by changing the original initial offering contract. This happens when the underlying base protocol changes. These are different from secondary offerings made on exchanges. But likewise, these new offerings could transform an asset into a security even if the asset was not already a security to start with (considered in the context of the initial offering and the second offering). This is what happened with BTC, Ethereum, and many other core-developer-controlled protocols.

The above is the only right way to interpret and apply the securities law; otherwise, not only can an analysis be easily confused and misguided, but it also fails to accomplish the purpose of the securities law.

Focusing on the offerings also makes sense because this really is the purpose of the securities law. It explains why the securities law and regulations are almost always related to capital raise, because capital raise and investment contract are always tied together through an offering. That’s also how the four prongs of the Howey test are tied together. They are not separate independent elements. They are tied to a securities offering. Not the thing offered but the offering itself.

The article Why Cryptoassets Are Not Securities published on Harvard Law School Forum, somewhat touched upon the points I make. I don’t fully agree with the analysis in the article, but it’s the only one I have seen on the matter of crypto assets that has the right focus.

The above is about the initial offering. The subsequent selling, especially the selling of bitcoin on exchanges, invokes a second offering which may constitute a securities offering. See Crypto exchanges convert crypto assets into securities.

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