Another federal court recently weighed in on whether cryptocurrency trading platforms should be regulated by the SEC for facilitating the exchange of “securities”. In SEC v. Payward, Inc., Case No. 23-cv-06003-WHO (N.D. Cal.), the SEC alleges that Payward, Inc. (d/b/a “Kraken”) – an unregistered entity – operates a digital asset exchange through which users buy and sell securities. Kraken moved to dismiss the complaint, arguing that the transactions fall outside of the SEC’s regulatory purview because those sales do not involve securities. Judge William Orrick denied the motion.
In its ruling, the Court first summarizes the current state of SEC cryptocurrency enforcement. Then, in applying the test set out in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (the “Howey test”), it leans on recent decisions by other courts that have applied it in the digital asset context. The Court does not adopt a new or novel approach to the issue but, in framing its decision, helps to further elucidate the contours of the law (as it currently stands).
Before walking through and applying the Howey test’s three elements, the Court addressed three other issues:
- First, it rejected Kraken’s argument that an “investment contract” requires a written or formal post-contract obligation by the issuer. The Court instead reiterated (citing Hocking v. DuBois, 885 F.2d 1449, 1456 (9th Cir. 1989)) that the relevant “inquiry is not limited to the contract or other written instrument” but “leav[es] open the possibility that the security is not formed of one neat, tidy, certificate but a general ‘scheme’ of profit-seeking activities.” In short, the “principle is well-settled … investment contracts are not limited to actual contracts.”
- Second, the Court found that the distinction between primary market and secondary market transactions may be relevant but is not dispositive. Kraken argued that the transactions on its platform are not “investment contracts” because a secondary market purchaser does not reasonably rely on the statements or representations made by the primary market issuer. But binding Ninth Circuit precedent imposes no such blanket rule with respect to secondary market transactions; each transaction must be evaluated on its own merits with a focus on the “reasonable expectations of the investor” in each specific case. In this case, Judge Orrick found that the SEC had sufficiently alleged that the primary market representations carried over to the secondary purchases on Kraken.
- Third, the Court clarified the distinction between the crypto assets themselves and the offers to sell those crypto assets. The tokens are not, in a vacuum, securities any more than other commodities such as gold, silver, or sugar. But those commodities may be offered or sold as “investment contracts” depending on the circumstances. The Court referred back to Howey, which dealt with the sale of shares in a citrus grove. Orange groves “are no more securities than cryptocurrency tokens are … [b]ut the contracts and expectations surrounding the sale of both may form an investment contract, bringing them within the purview of the [Securities] Act.” This echoes the court’s reasoning in SEC v. Ripple Labs, Inc., 682 F.Supp.3d 308 (S.D.N.Y. 2023).
The Court then determined that the SEC had sufficiently pled all three elements of the Howey test: (1) an investment of money; (2) a common enterprise; and (3) an expectation of profits due to the efforts of others.
Investment of Money
Kraken argued that while primary market purchases constitute an investment of money, secondary market purchases do not. The Court disagreed, declining to read any privity requirement into this prong of the Howey test. Kraken users purchasing the tokens through the platform invested money in an enterprise.
Common Enterprise
The “closest question” for the Court was the issue of vertical commonality between the token issuers and secondary market purchasers. Kraken tried to minimize any connection between the two groups. But the Court held that the SEC had “plausibly alleged vertical commonality between the investors using Kraken to purchase crypto assets and the promoters whose job it is to promote those assets and grow their associated networks.”
Expectation of Profits Due to the Efforts of Others
Lastly, the Court addressed whether the Kraken users purchased tokens with the requisite “expectation of profits.” Kraken relied on SEC v. Ripple Labs, wherein Judge Hamilton found that XRP purchasers on digital asset trading platforms did not have a reasonable expectation of profits. But Judge Orrick distinguished that case on the facts, noting that this determination depends on “the totality of circumstances and the economic reality of that specific contract, transaction, or scheme.” In this case, the SEC had plausibly alleged that the Kraken users were purchasing SOL and ALGO tokens with an expectation of profit “derived from the promoters’ representations that Kraken republished and reasserted on its platform.”
For more information on digital assets, please contact Benjamin Kussman, Esq. at [email protected].
