On July 13, 2023, the U.S. District Court for the Southern District of New York issued its much-anticipated ruling on cross-motions for summary judgment in U.S. Securities and Exchange Commission (“SEC”) v. Ripple Labs Inc. (“Ripple”) and its two senior leaders, Bradley Garlinghouse (Ripple’s current CEO), and Christian A. Larsen (Ripple’s co-founder, former CEO, and current executive chairman). At issue was Ripple’s digital token “XRP” and whether it is a “security” under the Securities Act of 1933 (“Securities Act”), and if the underlying transactions conducted by Ripple involving XRP were securities transactions.
The Court found that whether or not XRP is a security depends in part on how it was distributed, drawing different conclusions based on whether XRP was distributed pursuant to Programmatic Sale, Institutional Sales or Other Distributions (as those terms are defined below). The Court concluded that Programmatic Sales of XRP did not constitute “investment contracts,” meaning that XRP sold in that manner is not a security, and therefore no violations of federal securities laws would have occurred in respect of Programmatic Sales.
The Court’s decisions represents a partial victory against the SEC for Ripple and the entire cryptocurrency industry after continuous efforts by the SEC to regulate the industry, and resistance by the industry on the basis that cryptocurrencies are distinct from securities and should be regulated accordingly.
Notwithstanding the Court’s decision, it would not be surprising if the SEC were to appeal, as the reasoning supporting the decision, including the distinctions drawn between the different types of sales, does not seem to align with how other asset classes are treated.
As we have previously written, on December 22, 2020, the SEC filed a complaint against Ripple, Garlinghouse and Larsen (together, the “Defendants”) alleging that they had engaged in an unlawful offer and sale of unregistered securities with a total value of US $1.38 billion. The SEC alleged that the Defendants violated Section 5 of the Securities Act with the sale of over 14.6 billion units of XRP to investors in the U.S. and worldwide for cash or other considerations since 2013.
XRP was distributed and sold in three main ways, specifically: 1) use of trading algorithms or digital asset exchanges (“Programmatic Sales”); (2) direct sale through written contracts to certain counterparties, including institute buyers, hedge funds and on-demand liquidity customers (“Institutional Sales”); and (3) as a form of payment for services or under written contracts to Ripple employees and third parties (“Other Distributions”).
In coming to its judgment, the Court was required to determine whether any of the three types of transaction in which XRP was sold is an “investment contract” and therefore a security. This analysis required the application of the 75-year old multipart test established by the U.S. Supreme Court in SEC v. W.J. Howey (“Howey Test”). The Howey Test involves analyzing the subject matter in four parts; 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.
Applying the Howey Test, the Court analyzed the economic reality and totality of circumstances surrounding the Defendants’ different transactions and concluded that XRP distributed through Programmatic sales are not securities, whereas XRP distributed through Institutional Sales or Other Distributions are securities.
Programmatic Sales were characterized in this case to be blind bid/ask transactions of which Ripple had no knowledge of who was buying the XRP and the purchasers had no knowledge of who was selling the XRP, such as transactions effected on a cryptocurrency exchange.
Judge Torres concluded that the Programmatic Sales did not satisfy the third prong of the Howey Test, which is expectation of profits based on efforts of others. The Court held that, given the blind bid/ask nature of the transaction, investors in the Programmatic Sales “could not have know if their payment of money went to Ripple or any other sellers of XRP”. The Court also considered the fact that Programmatic Sale represent less than 1% of the global trading volume of XRP and concluded that “individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all”. Because of this, the Court further held that, even though investors in Programmatic Sales bought XRP with a speculative motive and an expectation of profit, such motive and expectation “did not derive from entrepreneurial or managerial efforts” of Ripple.
To support its conclusion, the Court further cited a additional factors as to how Programmatic Sales were different from Institutional Sales (discussed below). For example, no contracts were entered between the individual investor and Ripple in the case of Programmatic Sales; Ripple’s marketing campaign was not distributed to purchasers on digital asset exchanges, and there was no evidence showing Ripple made any promise or offers to those investors.
The Court determined XRP sold through Institutional Sale constitutes as “investment contract”, thus securities, because each element of the Howey Test was met. First, institutional investors provided fiat or other currency in exchange for XRP, thereby satisfying the “investment of money” criteria. Second, the Court found that 1) investors’ asset were pooled together, with Ripple controlling and managing all of the accounts; and 2) the fortunes of each investor were tied to the fortunes of other investors, as well as the success of the overall enterprise. This established a “horizontal commonality” between Ripple and institutional investors and therefore proved to the Court the existence of the “common enterprise” aspect of the Howey Test. Third, the Court found Ripple’s communications, marketing campaign and the nature of the Institutional Sales would lead the investors involved to have a reasonable expectation of profits based on Ripple’s efforts. Therefore, the Court found that under the Howey Test, Ripple formed an investment contract when it sold XRP to Institutional Buyers, and had therefore engaged in the “unregistered offer and sale of a security in violation of Section 5 of the Securities Act.”
These XRP transactions encompass distributions to employees as compensation and to third parties as part of Ripple’s initiative to develop new applications for XRP and the XRP Ledger. Judge Torres quickly disposed of the SEC’s allegations, finding that the Other Distributions do not satisfy Howey’s first prong because the recipients of Other Distributions did not make a payment of money or “some tangible and definable considerations” to Ripple in exchange for the XRP. Therefore, the Court concluded that the Other Distributions did not constitute the offer and sale of investment contracts and therefore XRP is not a security in the context of Other Distributions.
Larsen’s and Garlinghouse’s Offers and Sales
Like Ripple’s Programmatic Sales, Larsen’s and Garlinghouse’s XRP sales were programmatic sales on various digital asset exchanges through blind bid/ask transactions. Larsen and Garlinghouse did not know to whom they sold XRP, and the buyers did not know the identity of the seller. On this basis, the Court concluded that the third Howey prong was not satisfied with respect to these transactions.
Implications and Impact
Judge Torres’s decision and application of the Howey Test attracted enormous interest both from the crypto industry, as well as legal community. Its conclusion that XRP is not a security under the Programmatic Sale was considered to be a first “win” of the crypto industry against the SEC in a decade of enforcement against the industry.
Despite that win, the future of XRP and the cryptocurrency industry remain far from certain. Given the SEC’s explicit and aggressive enforcement position on the basis that cryptocurrencies are securities, it seems unlikely the SEC will retreat. This was reinforced by SEC Chair Gary Gensler in his testimony before a Senate subcommittee calling crypto markets to be rife with noncompliance — potentially hinting at an appeal. Former SEC official John Reed Stark has re-echoed Gensler’s position, stating that the decision in XRP vs. SEC lies on “shaky ground” and will invariably be appealed.
As noted above, the Court’s conclusions and reasoning was surprising. In concluding that Programmatic Sales of XRP are not securities, the Court relied on the fact that purchasers under Programmatic Sales did not contract directly with Ripple and that Ripple did not receive any consideration from those trades. That scenario is no different from the trading of common shares and bonds in any secondary market and it is unclear why a distinction should be made between cryptocurrency and traditional securities in this context.
Furthermore, the Court believed that any profit or loss from an investment through a Programmatic Sale would come from market conditions rather than the actions of Ripple management. This ignores the reality that the actions of management are one of the central drivers of market conditions, and accordingly an investor’s expectation of profit would be inextricably linked to management’s actions.
In addition, the conclusion that XRP provided to employees as partial compensation would not be a security is confusing. The Court emphasized that such recipients did not provide consideration to Ripple in exchange for the XRP, but failed to consider the employees’ contributions to Ripple during the course of employment, and ignored that companies routinely offer securities-based compensation to employees.
The Ripple summary judgment decision is an important one at an critical time for the cryptocurrency industry and could have wide-ranging implications for the application of securities laws to cryptocurrencies and other digital assets. We will continue to monitor the development of the crypto space and encourage issuers and stakeholders to consult advisors and securities commissions for further guidance.
 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).