By Nate Kelly:
Seven years after Ripple Labs, Inc. first began to sell its digital asset XRP, the Securities and Exchange Commission (SEC) filed a Complaint against Ripple Labs, Inc. and its CEOs, accusing them of engaging in an unregistered securities offering through the sale of their digital asset, XRP.[1] The SEC alleged that Ripple had been selling XRP as a security without proper registration, violating Section 5 of the Securities Act of 1933.[2] The SEC sought injunctive relief, disgorgement with prejudgment interest, and civil penalties in its enforcement action, which did not involve fraud.[3] On July 13, 2023, District Judge Analisa Torres delivered a decision on the parties’ cross summary judgment motions.[4]
The SEC’s legal analysis in the Ripple case followed an approach similar to that used in other enforcement actions against issuers of digital assets, such as Kik and Telegram.[5] However, what sets Ripple apart is that it is a high profile example of a securities regulator targeting an initial coin offering (ICO), which many see as the SEC’s long term goal.[6]
Background and Howey Test
The determinative question of classifying XRP as a security was whether or not it was an investment contract.[7] To understand the legal classification of investment contracts as securities, we turn to the Howey test, established by the Supreme Court in 1946 in the case of S.E.C. v. W.J. Howey Co.[8] The Howey test established a standard for determining what qualifies as an investment contract.[9] The Court deliberately created a broad scope to prevent promoters from designing instruments that evade regulation. In defining what constitutes a security, Congress painted with a broad brush recognizing “the virtually limitless scope of human ingenuity, especially in the creation of ‘countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.’”[10] The breadth was accomplished by defining “the term security in sufficiently broad and general terms so as to include within that definition the many types of instruments that in our commercial world fall within the ordinary concept of a security.” [11] Accordingly, the Howey test established four criteria for investment contracts: (1) a contract, transaction, or scheme involving the investment of money, (2) in a common enterprise, (3) with the expectation of profit, (4) to be derived from the efforts of others.[12] When these elements are established the sale is an investment contract. Therefore, unless context otherwise indicates the sales are of securities and the offer and sale have to be registered in compliance with section 5.[13]
Application to Ripple
Applying the Howey test to XRP, it was determined that “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.”[14] Consequently, the court examined the totality of the circumstances surrounding different sales of XRP.[15] The court then divided the sales of XRP into four distinct categories.[16] These categories are: (1) Sales of XRP directly to institutional investors (Institutional Sales); (2) Algorithmic sales of XRP on digital asset trading platforms (Programmatic Sales); (3) XRP distributions to Ripple employees and third parties (Other Distributions) and; (4) Sales of XRP by chief operating officer and chief executive officer on various digital asset trading platforms.[17] The Court’s determination of whether XRP is a security hinged on the third and fourth elements of the Howey test, as applied to each category of sales .
As to the sales to institutional investors, the Court found that all of the Howey elements were satisfied. Specifically, the Court found “[f]rom Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital it received from its Institutional Sales to improve the market for XRP and develop uses of the XRP ledger, thereby increasing the value of XRP.”[18] This conclusion focuses on the conduct of Ripple surrounding the sales.
In contrast, for programmatic sales, the Court emphasized the knowledge of the buyer rather than the conduct of Ripple.[19] The court found, unlike institutional investors, buyers in the impersonal market did not possess a contractual relationship with Ripple. Buyers in the impersonal market were unaware whether they were purchasing from the defendants. Thus, they did not expect their payments to benefit Ripple’s business.[20] As a result, the Court concluded that these buyers did not invest with an expectation of profit from Ripple’s efforts. This decision seemed to imply that a direct relationship with Ripple and knowledge of where the money was going were crucial factors.
The Court then determined that XRP distributions to employees and others did not satisfy Howey based on the lack of “investment of money.”[21] “In every case [finding an investment contract] the purchaser gave up some tangible and definable consideration in return for an interest that had substantially the characteristics of a security.”[22] Lastly, the sales made by the COO and CEO fell within an exemption of the securities act. [23]
Implications
In the context of crypto, a pressing question is how the SEC will treat sales in secondary markets such as coinbase or other similar trading platforms. Although Judge Torres did not directly rule on whether secondary market sales were investment contracts, the ruling on programmatic sales indirectly addresses this question.[24] This question is addressed tangentially through the reasoning that because buyers did not know if the money was going to Ripple or to another third party, they were not investment contracts.[25] If this precedent is followed in subsequent cases, it would stand to reason that purchases of cryptocurrencies on the secondary market are not securities. However, nothing in the definition of a security or in the Howey case specifies that a direct relationship or that the identity of the seller is relevant.[26] imposing the additional requirement of a direct relationship with the issuer would represent a significant change in the way securities laws have been applied.
Moreover, it is likely some courts may not adopt the reasoning of Ripple based on its failure to address the Supreme Court’s definition of “financial instrument profits” from United Hous. Found., Inc. v. Forman.[27] In Forman, financial instrument profits are defined as among other things “the ability to resell at a price that exceeds the cost of purchase.”[28] Because, at least at the moment, crypto currencies are not widely used as currency. Purchasers may be motivated to acquire crypto to hold and sell at a profit. If a court adopts this line of reasoning it may determine that purchasers on a secondary market have an expectation of profits.
While this ruling is favorable to the crypto holders, future crypto cases will likely vary since each case presents different facts. Courts may consider ongoing obligations between the issuer and token holders, as well as the impact of public statements promoting the token on the expectation of profit for purchasers in the open market. Some courts may distinguish the Ripple analysis without explicitly rejecting it, allowing for nuanced interpretations based on the specifics of each case. It is important to note that since this opinion has been issued, one court has already declined “to draw a distinction between … coins based on their manner of sale.”[29] This holding directly rejects the approach taken by Judge Torres in the Ripple case.
The overall impacts that this decision will have on both the crypto and securities industries are unclear. It would seem that under this case, crypto companies will be required to comply with Section 5 requirements for some sales but not others. One potential impact could be that crypto companies will have to go through this analysis on their own to determine which sales constitute investment contracts. In an area where clarity is lacking, and regulators and courts struggle to navigate the fast-changing tides of crypto and blockchain technology, this could impose a substantial burden on crypto companies. Alternatively, this ruling could lead to the government enacting concrete regulations surrounding the sale of cryptocurrencies. Only as other courts chose to adopt or decline Judge Torres’ reasoning from the Ripple case will we understand its true impact.
[1] Sec. & Exch. Comm’n v. Ripple Labs, Inc., 2023 WL 4507900 (S.D.N.Y. July 13, 2023).
[2] Id.
[3] Id.
[4] Id.
[5] SEC v.Kik Interactive Inc., 492 F. Supp. 3d 169, 175–80 (S.D.N.Y. 2020); See also SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352 (S.D.N.Y. 2020)
[6] SEC Director, Division of Corporation Finance, William Hinman, Digital Asset Transactions: When Howey Met Gary (Plastic), Remarks at the Yahoo Finance All Markets Summit: Crypto (June 14, 2018) https://www.sec.gov/news/speech/speech-hinman-061418.
[7] Supra note 1 at 5.
[8] S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946).
[9] Id.
[10] Reves v. Ernst & Young, 494 U.S. 56, 60 (1990) (quoting Howey, at 299)
[11] H.R.Rep. No. 85, 73d Cong., 1st Sess., 11 (1933)
[12] Mendelson, Michael “From Initial Coin Offerings to Security Tokens: A U.S. Federal Securities Law Analysis.” Stanford Technology Law Review, vol. 22, no. 1, Winter 2019, pp. 66.
[13] Id.
[14] Supra note 1 at 18. (quoting S.E.C. v. W.J. Howey Co., 328 U.S. 293, 66 S. Ct. 1100 (1946)).
[15] Id.
[16] Id. at 10.
[17] Id. at 11.
[18] Id.
[19] Id.
[20] Id.
[21] Id. at 13
[22] Id. (quoting Int’l Bhd. of Teamsters v. Daniel, 439 U.S. 551, 560, (1979)).
[23] Id. at 14.
[24] Id.
[25] Id.
[26] Securities Act of 1933, 15 U.S.C. §§ 77a-77aa (2018).; Supra note 7.
[27] Joan Heminway, Ripple and Forman, BUSINESS LAW PROF BLOG (July 2023), https://lawprofessors.typepad.com/business_law/2023/07/ripple-and-forman.html (last visited Sept. 24, 2023).
[28] Id. ; See also United Hous. Found., Inc. v. Forman, 421 U.S. 837, 854 (1975).
[29] Sec. & Exch. Comm’n v. Terraform Labs Pte. Ltd., 2023 WL 4858299 (S.D.N.Y. July 31, 2023).
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