In a landmark decision on July 13, 2023, U.S. District Judge Analisa Torres of the U.S. District Court of the Southern District of New York brought a semblance of regulatory clarity for the blockchain industry.1 The case, initiated by the Securities and Exchange Commission ("SEC"), centers around Ripple's digital token, XRP, as a potential security.2 The decision offers four key takeaways, each of which will significantly influence the future of digital assets in the United States. Here, we delve into these pivotal points, exploring the Court's interpretation of the Howey Test in the context of digital assets, the differentiation between institutional and exchange sales of XRP, and the Court's assertion that XRP, as a digital token, is not in and of itself a security.3
- XRP Is Not in and of Itself an Investment Contract
The Court states, "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."3
First, this suggests the legal classification of digital assets should not be determined solely by inherent characteristics, but rather by the context and manner in which a digital asset is sold and distributed. This decision creates a degree of flexibility for blockchain projects to carefully consider the structure and method of their token sales. Prior to this decision, limited administrative guidance and inconsistent comments from the SEC created an uncertain regulatory environment for token issuers. Indeed, the head of the SEC, Gary Gensler, stated, "Of the nearly 10,000 tokens in the crypto market, I believe the vast majority are securities."5 Now, token issuers may have a path towards issuance without the fear of said asset being categorized as a security, a categorization that drastically limits who can purchase a token.
Second, this aspect of the decision could re-invigorate technological innovation within the blockchain industry in the U.S. By not categorically classifying all digital tokens as securities, the Court has left room for various token models to exist, including but not limited to, a model where tokens function as commodities rather than securities. This, in turn, could lead to the creation of new types of tokens, each with unique characteristics and uses, ultimately expanding how assets are created and issued within the U.S. market.
- Institutional Sales Constituted Investment Contracts
The Court found that Ripple's "Institutional Sales" of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act of 1933 and granted the SEC's motion for summary judgment with respect to sales of XRP to institutional investors..6 The SEC alleged that these sales were distributions of XRP into public markets through conduits ("Institutional Buyers"), essentially arguing that they were securities transactions.
The Court explains that Institutional Buyers invested money by providing fiat or other currency in exchange for XRP, satisfying the first prong of the Howey test. Additionally, the Court found evidence of a "common enterprise" between Ripple and the Institutional Buyers, satisfying the second prong of the Howey test. The Court was persuaded by evidence of "horizontal commonality," a legal concept meaning investors' assets are pooled together, and the fortunes of each investor are tied to the fortunes of other investors and the success of the overall enterprise.
The Court also found the third prong of Howey, the expectation of profits, was also met. It found that Institutional Buyers would have purchased XRP with the expectation that they would derive profits from Ripple's efforts. This conclusion is based on Ripple's communications, marketing campaign, and the nature of Institutional Sales.
A key takeaway from this portion of the Court's holding is digital asset transactions that mirror the Institutional Sales that Ripple made will likely be considered securities transactions under U.S. law. As such, issuers mimicking that approachmust register the offer and sale of tokens in the U.S. or utilize an exemption from registration.
- Programmatic Sales Were Not Securities
The SEC alleges that Ripple targeted "Programmatic Buyers" in "Programmatic Sales", aiming to increase speculative volume. However, the Court concludes that the Programmatic Sales did not meet the third prong of the Howey test because purchasers did nothave an expectation of profits from the efforts of others.7 The Court relied on various affidavits from XRP holders (e.g. app developers, stakers, investors) as evidence for its conclusion that "many Programmatic Buyers were entirely unaware of Ripple's existence."8 As a result, the Court granted Ripple Labs' motion for summary judgment with respect to programmatic sales of XRP to public buyers through digital asset exchanges.
The Court explains that while Institutional Buyers could reasonably expect Ripple to use capital from sales of XRP to improve the XRP ecosystem and increase the price of XRP, Programmatic Buyers did not. This is because "Ripple's Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP."9 Furthermore, the Court states, "[a]n Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money."10 In other words, Programmatic Buyers had no expectations of profits because they did not know if the money they paid for XRP was going to Ripple.
The Court further notes that since 2017, "Ripple's Programmatic Sales represented less than 1% of the global XRP trading volume."11 Meaning, the majority of individuals who purchased XRP did not invest their money in Ripple. This is a key fact, and token issuers should not expect to use exchanges to sell tokens as an end run around the current rules.
The Court also rejects the SEC's argument that Ripple's targeting of speculators or understanding that people were speculating on XRP as an investment is evidence of an investment contract. The Court stated "[i]t is not enough for the SEC to argue that Ripple "explicitly targeted speculators" or that "Ripple understood that people were speculating on XRP as an investment," because a speculative motive "on the part of the purchaser or seller does not evidence the existence of an 'investment contract' within the meaning of the [Securities Act]."12
The Court further explains that while some Programmatic Buyers may have purchased XRP with the expectation of profits derived from Ripple's efforts, "...Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it."13
The Court concludes in stating, "having considered the economic reality and totality of circumstances, the Court concludes that Ripple's Programmatic Sales of XRP did not constitute the offer and sale of investment contracts."14
This aspect of the decision, in turn, could set meaningful precedent for digital assets distributed similarly to XRP. As a result of the Court's decision, secondary marketplace sales of digital tokens may not be classified as investment contracts if they are conducted in a similar manner to Ripple's Programmatic Sales. This could potentially provide a degree of legal protection for certain types of token sales, particularly when buyers do not know who the seller is, and where the seller does not make specific promises or offers related to the token's potential profitability when they occur on secondary orderbooks.
- Other Distributions
The Court granted Ripple Labs motion for summary judgment with respect to "Other Distributions." These allocations went to employees as compensation and to third party developers. The Court found these distributions did not involve an investment of money and failed the first prong of the Howey test.
Specifically, the Court examined the first prong of the Howey test, which requires an "investment of money" to classify a transaction as an investment. The Court concluded that Other Distributions do not satisfy this prong because the recipients did not provide capital, money, or "some tangible and definable consideration" to Ripple.15 Instead, Ripple was the one providing XRP to recipients.
On the other hand, the SEC argued that these Other Distributions were an indirect public offering because the recipients could then transfer their XRP to another holder in exchange for currency, goods, or services.16 However, the Court rejected this argument because, as the Court notes, the SEC does not allege that these recipients were acting as Ripple's underwriters.17 Furthermore, the Court stated that the SEC does not develop the argument that these secondary market sales were offers or sales of investment contracts, particularly where the payment of money for these XRP sales never traced back to Ripple.18
In conclusion, the Court found Ripple's Other Distributions did not constitute the offer and sale of investment contracts, meaning certain third-party transactions such as charitable donations, developer grants, and transfers of XRP to executives of Ripple were not considered securities transactions.
It is important to note that the SEC has asserted the lack of monetary consideration does not mean there is not an offer and sale of securities.19 In its administrative order against Tomahawk, it asserted a "gift" of a security is a "sale" within the meaning of the Securities Act when the donor receives some real benefit.20
For digital tokens like XRP, the Court's analysis suggests that not all token distributions will necessarily be considered securities. Rather, the analysis depends on the specific circumstances of the digital asset distribution, including whether there is an investment of money and whether the money traces back to the company issuing the token.
Overall, the Court's decision provides meaningful precedent with far-reaching implications for the blockchain industry. Specifically, the decision could prove to be a foundational pillar for providing regulatory clarity for digital assets in the U.S. amid a cloud of regulatory uncertainty. However, while this decision provides judicial precedent, the Court's emphasis on the "totality of circumstances" reiterates the widely known fact that a particular Court's findings with respect to a specific token will not necessarily apply broadly to other digital assets. Token issuers should must continue to exercise caution and seek legal advice when planning their digital asset sales and distributions.
Footnotes
1 Securities and Exchange Commission v. Ripple Labs Inc., et al., No. 20-cv-10832 (S.D.N.Y. July 13, 2023)
2 Securities Act of 1933, 48 Stat. 74 (1933).
3 SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
4 Id. at 15
5 See: Kennedy and Crypto, September 8, 2022. Found at: https://www.sec.gov/news/speech/gensler-sec-speaks-090822#_ftn2
6 15 U.S.C. § 77e
7 Securities and Exch. Commn. v. Ripple Labs, Inc., 2023 WL 4507900 at 12.
8 Id. at 12.
9 Id. at 11.
10 Id.
11 Id.
12 Id.
13 Id. at 12.
14 Id. at 13.
15 Id.
16 Id. at 13.
17 Id.
18 Id.
19 See, e.g., In the Matter of Tomahawk Exploration LLC and David Thompson Laurance, S.E.C. Release No. 10530 (Aug. 14, 2018).
20 Id. (citing SEC v. Sierra Brokerage Servs., Inc., 608 F. Supp. 2d 923, 940–43 (S.D. Ohio 2009), aff'd, 712 F.3d 321 (6th Cir. 2013)).
Originally published 24 July 2023
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