Ripple CTO Explains Investment Contract and Why SEC Is Wrong About XRP

David Schwartz, Ripple’s Chief Technology Officer, recently highlighted significant distinctions between contracts and “reasonable reliance,” emphasizing the implications of these distinctions for current U.S. securities regulation.

Schwartz’s post points to the SEC’s approach in classifying certain actions as contracts or securities when, in fact, they lack essential contractual elements.

His explanation illustrates how the SEC’s interpretation could misclassify actions or investments, creating regulatory challenges, particularly in the digital asset sector.

Reasonable Reliance vs. Contracts

Schwartz opens by contrasting “reasonable reliance” and contractual obligations, noting they are often mistakenly seen as similar. He suggests that “reasonable reliance” occurs when one can expect another party to act in its interests, and such expectations do not require formal contracts. In contrast, a contract typically obligates one party to prioritize another’s interests, creating an enforceable commitment.

To illustrate this, Schwartz uses the example of a restaurant: a restaurant owner can reasonably rely on customers to dine there if they offer quality food at a fair price. This scenario involves no formal contract obligating people to patronize the restaurant.

However, if there were an agreement compelling people to dine there regardless of the quality, then it would become a contractual arrangement. Thus, Schwartz asserts that a contract is necessary when relying on another to act in their interests.

Schwartz says this distinction is essential in securities law. He said investment contracts are regulated to ensure that parties’ interests are protected by enforceable commitments.

Investment Contracts and Securities Regulation

Schwartz then explores the idea of investment contracts as defined under U.S. law, where the obligation to act in another party’s interest forms the basis for regulation.

He explains that an investment contract should involve one party obligating itself to act on behalf of another, even if it conflicts with their interests. This is a key aspect of securities, where shareholders rely on company management to prioritize their interests.

For example, Schwartz explains that when someone buys stock in a company, they rely on the company to act ethically, ensuring fair profit distribution and upholding fiduciary responsibilities. This reliance, supported by contractual obligations, qualifies stocks as securities, differentiating them from non-security investments.

Applying This Concept to Art Purchases

To further clarify the distinction, Schwartz uses the example of purchasing art from an emerging artist. A buyer may hope the artist’s future work will increase in value, thus enhancing the value of early pieces, but there is no guarantee.

The artist is under no contractual obligation to continue producing art, let alone ensure the appreciation of previously sold pieces. The artist’s actions may influence the value, but there is no enforceable contract to make them act in the buyer’s interest.

This absence of a contractual obligation to act on behalf of the investor’s interests differentiates art sales from securities and highlights why art purchases, despite investment potential, do not fall under securities regulation.

Schwartz extends this line of reasoning to cryptocurrencies and digital assets. He implies that the SEC’s current regulatory approach could misclassify digital assets as securities by interpreting reasonable reliance as an investment contract, despite the absence of contractual obligations to prioritize investor interests.

According to Schwartz, the distinction should be based on whether the investment relies on enforceable contractual obligations or merely on reasonable reliance.

Potential Legal Reforms and Future Considerations

Concluding his post, Schwartz expresses cautious optimism that the Supreme Court might bring “common sense” to bear on the law in ways that clarify these distinctions. He hints at the possibility of legislative reforms that could address the SEC’s interpretation of the Howey Test, which has been the standard for determining securities.

Schwartz suggests that any change should codify Howey’s application in a way that distinguishes reasonable reliance on others acting in their interests from actual investment contracts requiring enforceable obligations.

In his view, this would allow digital assets to be correctly classified, avoiding broad interpretations that may stifle innovation or misclassify assets based on incidental investment potential rather than contractual obligations.

Schwartz’s perspective challenges the current regulatory approach and presents an argument for a nuanced, precise application of securities law that adapts to new financial instruments and investment models.

Disclaimer: This content is meant to inform and should not be considered financial advice. The views expressed in this article may include the author’s personal opinions and do not represent Times Tabloid’s opinion. Readers are urged to do in-depth research before making any investment decisions. Any action taken by the reader is strictly at their own risk. Times Tabloid is not responsible for any financial losses.

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