07/13/23 -> SEC v. Ripple:

On July 13^th, Judge Analisa Torres of the United States District Court for the Southern District of New York ruled on cross-motions for summary judgment filed by the SEC and Ripple Labs (the company closely associated with XRP) in relation to litigation that dates back to December 2020. Specifically, Judge Torres ruled 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.”

Rewind -> Applicable Case Law:

Under the law, the Howey test consists of four elements for a transaction to be classified as a security. SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey“). Herein, the elements are as follows: (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit, (4) to be derived from the efforts of others. If all four prongs are met, the transaction—including some digital assets—may be a security and, if so, subject to U.S. federal securities laws. This so-called “investment contract” analysis is used to determine whether unique or novel instruments or arrangements, such as digital assets, are securities subject to the federal securities laws. Notably, the “Howey test” applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.

Howey Prong One: An Investment of Money.

The first prong of the Howey test is typically satisfied in an offer and sale of a digital asset because the digital asset is purchased or otherwise acquired in exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other type of consideration. See In re Tomahawk Exploration LLC, Securities Act Rel. 10530 (Aug. 14, 2018) (issuance of tokens under a so-called “bounty program” constituted an offer and sale of securities because the issuer provided tokens to investors in exchange for services designed to advance the issuer’s economic interests and foster a trading market for its securities). Further, the lack of monetary consideration for digital assets, such as those distributed via “air drop,” does not mean that the investment of money prong is not satisfied; therefore, an airdrop may constitute a sale or distribution of securities in that a digital asset is distributed to holders of another digital asset, typically to promote its circulation.   

Howey Prong Two: Common Enterprise.  

Generally speaking, investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts. See SEC v. Int’l Loan Network, Inc., 968 F.2d 1304, 1307 (D.C. Cir. 1992).

Howey Prong Three & Four: Expectation of Profit, From the Efforts of Others.

In general, this prong is satisfied when a promoter, sponsor, or other third party provides essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts; this is an objective analysis focused on the transaction itself and the way the digital asset is offered and sold. Relevant to this inquiry is the “economic reality” of the transaction and “what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.” Howey, 328 U.S. at 298. See also Tcherepnin, 389 U.S. at 336 (“in searching for the meaning and scope of the word ‘security’ in the [Acts], form should be disregarded for substance and the emphasis should be on economic reality.”).

Fast Forward Back to 07/13/23 -> SEC v. Ripple:

As a general note, Judge Torres reinforces that a determination of an unlawful offer and sale of should hinge on the facts and circumstances by which the sale was made. Judge Torres states that under “the plain words of Howey” . . . “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.” Judge Torres then goes on to assess three categories of alleged unregistered XRP offer and sales: (1) Institutional Sales under written contracts for which it received $728 million; (2) Programmatic Sales on digital asset exchanges for which it received $757 million; and (3) Other Distributions under written contracts for which it recorded $609 million in “consideration other than cash.”

Importantly, Judge Torres notes that only the “Institutional Sales” constituted the unregistered offer and sale of an investment contract. Unlike “Institutional Sales,” Judge Torres ruled that “Programmatic Sales,” whereby Ripple sold XRP through various exchanges, did not meet the third prong of Howey—buyers were not aware they were buying XRP from Ripple given that Ripple “did not make any promises or offers because Ripple did not know who was buying the XRP.”

Further, Judge Torres states that “Institutional Buyers, would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts” and “[t]here is no evidence that a reasonable Programmatic Buyer, who was generally less sophisticated as an investor, shared similar ‘understandings and expectations’ [and] could parse through the multiple documents and statements that the SEC highlights, which include statements (sometimes inconsistent) across many social media platforms and news sites from a variety of Ripple speakers (with different levels of authority) over an extended eight-year period.”

What This Means / The Ambiguity That Remains / SEC Appeals:

Given that most secondary trading on crypto exchanges does not involve the token issuer, Judge Torres would likely find that crypto exchanges are not listing investment contracts (like the ruling on Ripple’s “Programmatic Sales”).

Notably, Programmatic Buyers purchased XRP because they thought it would increase in value. However, if these buyers were not relying on information from Ripple, why did they think XRP’s price would increase? This question seems imperative to a determination on this issue.

In typical footnote fashion, footnote 16 reads “The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court. Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme,” leaving secondary markets subject to inadequate conception.

On August 9^th, the SEC announced its intention to appeal the recent XRP ruling. The SEC’s appeal centers around the interpretation of whether Ripple’s Programmatic offers and sales to XRP buyers, as well as its “Other Distributions” in exchange for labor and services, constitute the sale of securities. The SEC seeks interlocutory review (a review of a decision before the conclusion of the full trial), though the appeal process could take months or even years.

Ultimately, there is a good chance that the Second Circuit will in fact reverse Judge Torres’ decision. However, until then, Judge Torres’ ruling opens the door for crypto developers to raise funds from the public without having to comply with any meaningful regulation (notwithstanding general prohibitions against fraud and manipulation in commodity spot markets.) 

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SEC v. Ripple (07/13/23): https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf.

https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.

SEC’s Decision to Appeal: https://coingape.com/breaking-us-sec-to-appeal-judge-torres-xrp-ruling/.

Featured Photo Copyright: https://www.bloomberg.com/news/articles/2023-08-09/sec-seeks-to-appeal-ripple-labs-ruling-xrp-isn-t-a-security.