Both Defendants And The Security And Exchange Commission … – Mondaq News Alerts

On July 13, 2023, the U.S. District Court for the Southern
District of New York granted partial summary judgment in favor of
Ripple Labs Inc. (Ripple), holding that the company did not violate
the Securities Act by selling its XRP token on public
exchanges.

Despite this partial win, the Court also held that Ripple’s
sale of the XRP tokens to sophisticated individuals and entities
including hedge funds and institutional investors did constitute an
unregistered securities offering.

Howey Test and Background

The Securities Act regulates the offer and sale of securities
and grants broad enforcement authority to the Security and Exchange
Commission (SEC). Under Section 5 of the Securities Act, it is
unlawful to sell, offer to buy or purchase a security, including
investment contracts, without a registration statement.

In 1947, the U.S. Supreme Court articulated a three-part test
for determining whether or not a transaction constitutes an
investment contract. In SEC v. W.J. Howey Co., the Supreme
Court held that an investment contract is “a contract,
transaction, or scheme whereby a person (1) invests his money (2)
in a common enterprise and (3) is led to expect profits solely from
the efforts of the promoter or a third party.”

In recent years, judges have used the Howey Test to
find that specific crypto assets are securities or investment
contracts. In these rulings, developer statements tying the value
of digital assets or profits depending on the “efforts of
others” or pooling funds was sufficient to find participation
in a “common enterprise” satisfying the Howey Test.

The SEC has brought more than 100 enforcement actions involving
crypto assets by asserting that tokens constitute securities. While
many actions result in settlements, experts in the crypto space
have been closing watching the Ripple litigation.

Filed in 2020, the SEC contended that Ripple violated the
Securities Act by selling XRP tokens to investors beginning in
2013. The court walked through the Howey Test but ultimately the
decision turned on the third prong, investor knowledge and
expectations.

Institutional Buyers

The court determined that the first prong of the Howey
Test was easily met because institutional buyers invested
money in exchange for XRP.

The second prong was also satisfied because Ripple pooled the
money and used it to fund its operations, and profits for XRP
investors were tied to Ripple and the investment of other
institutional buyers, establishing a common enterprise. Ripple used
the invested funds to promote XRP and the success of the token in
turn depended on and was tied to the success of other institutional
buyers.

In applying the third prong of the Howey Test, the
court examined whether similarly situated reasonable institutional
investors would have purchased XRP with an expectation of profiting
from Ripple’s business efforts. The court particularly focused
on marketing materials and statements aimed at institutional
investors, which pitched “speculate value” for XRP that
directly depended on Ripple’s efforts to develop its blockchain
for transactions involving its digital asset. Senior leaders made
statements in interviews and online posts highlighting Ripple’s
efforts and the speculative value of XRP.

With all three Howey factors satisfied, the court held
that the majority of Ripple’s sales to sophisticated
individuals and entities including hedge funds and institutional
investors were unregistered sales of securities.

Programmatic Sales

When turning to Ripple’s sale of XRP tokens on public crypto
exchanges, the court made clear that these circumstances
substantially differed from private sales to institutional
buyers.

Programmatic buyers did not or could not reasonably expect that
their money would profit Ripple or that Ripple’s efforts would
generate profits for them. These sales were blind bid or ask
transactions where the purchasers did not and could not have known
that their payments went to Ripple. These buyers were less
sophisticated and had less knowledge than the institutional buyers
and may not have been aware they were purchasing XRP from
Ripple.

Triable Issues

The court did find that there a genuine issue of material fact
existed regarding whether or not two of Ripple’s executives
aided and abetted a Securities Act violation. This analysis turns
on the scienter of the defendant. To prevail the SEC must prove
“general awareness”—either actual knowledge or
reckless disregard—of Ripple’s violation. Both executives
testified that they believed XRP did not constitute a security and
relied on legal analysis from prior counsel.

Takeaways

Given the stakes, it is likely that both sides will appeal the
decision. We will wait for the next round of decisions.
Structurally, absent registration, capital raises in connection to
crypto projects run the risk of securities violations. The crypto
markets believe that the Court essentially ruled that XRP tokens
are not securities per se, but rather commodities. We are
not convinced the Court of Appeals will agree.

Disclaimer: This Alert has been
prepared and published for informational purposes only and is not
offered, nor should be construed, as legal advice. For more
information, please see the firm’s
full disclaimer.