On July 13, Judge Analisa Torres, district judge for the United
States District Court for the Southern District of New York, issued
a substantial order (the Order) on cross motions for summary
judgment in the U.S. Securities and Exchange Commission v.
Ripple Labs case (SEC v. Ripple), which breathed new
life into the cryptocurrency ecosystem.
Buried within the legal and procedural language of the Order,
Torres declared 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.”
Translation–XRP is not a security.
While the Order addressed a number of issues, the key takeaway
is that a digital asset like XRP may be a commodity on its own,
especially when traded on centralized or decentralized exchanges.
However, the same digital asset may be deemed a security depending
on how and to whom it is sold or distributed.
In its motion for summary judgment, the SEC alleged three
categories of unregistered sales of XRP:
- Sales to institutional investors using purchase agreements that
included lockup periods, resale restrictions, and indemnification
clauses; - Programmatic sales (i.e., digital asset exchange sales) that
involved blind bid/ask transactions where neither the buyer nor the
seller knew of the other’s identity; and - Other distributions–distributions to employees and third
parties as compensation for services rendered
The court’s Order addressed each of the SEC’s
categorical allegations in turn, and it ruled whether each method
of distribution or sale constituted the unregistered offer or sale
of investment contracts in violation of Section 5 of the Securities
Act of 1933. In ruling on the allegations, the Order applied the
facts and circumstances of each method of distribution or sale to
the Howey test factors, the long-standing test defining
what constitutes an investment contract. In Howey, an
investment contract is a contract, transaction, or scheme whereby a
person (1) invests their money (2) in a common enterprise and (3)
is led to reasonably expect profits solely from the efforts of a
promoter or a third party.
Institutional Sales:
Ripple’s institutional sales were sales of XRP to
“sophisticated individuals and entities.” The Order found
that the institutional sales constituted the unregistered offer and
sale of investment contracts in violation of Section 5 of the
Securities Act. The Order found that the first two prongs of the
Howey test were rather easily met. However, the Order
focused heavily on the third prong, i.e., whether the institutional
buyers of XRP were led to expect profits solely from the efforts of
a third party, in this case, Ripple. In finding the third prong
met, the Order cited various marketing materials and other
advertisements from Ripple to institutional investors, which
created the expectation that an investment in XRP was an investment
in Ripple.1 Therefore, the court found that
institutional buyers “would have purchased XRP with the
expectation that they would derive profits from Ripple’s
efforts.”2 Based on the economic reality of the
sales and the totality of circumstances surrounding the sales, the
court found that the institutional sales of XRP constituted the
unregistered sale of investment contracts.
Programmatic Sales:
The programmatic sales of XRP differed from the institutional
sales in that the programmatic sales occurred on digital asset
exchanges with public buyers. The court focused almost exclusively
on the third prong of Howey and found that the
programmatic sales did not constitute unregistered offers
and sales of investment contracts. In reaching its conclusion, the
court reasoned that the public, exchange purchasers of XRP, did not
expect profits based on the efforts of Ripple, particularly because
they did not know they were buying XRP from Ripple.
Instead, because the programmatic sales of XRP were facilitated
using a blind bid/ask order book, the programmatic purchasers were
not aware whether they were “investing” in Ripple.
Importantly though, the court noted that the programmatic
purchasers could have and may have expected profits from their
purchase of XRP; however, “they did not derive the expectation
of profits from Ripple’s efforts” because they were
not aware they were purchasing XRP from Ripple, and thus,
they were not investing in Ripple with an expectation of profits
from Ripple’s efforts. Thus, the court was able to conclude
that the programmatic sales, or blind bid/ask sales of XRP on
exchanges, did not constitute the offer and sale of investment
contracts.
Other Distributions:
The other distributions alleged by the SEC included
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. The court concluded that the other
distributions did not constitute unregistered offers and sales of
investment contracts. The court noted that the other distributions
failed to satisfy Howey‘s first prong–the
investment of money. Under Howey, courts have held that in
order for there to be an “investment of money,” investors
must “provide the capital, put up their money,” or
“provide cash.” The employees and companies that received
XRP did not “pay money,” and Ripple did not receive
payment from these XRP distributions.3
Takeaway:
While acknowledging the Order will likely be appealed to the
Second Circuit by both parties, it is nonetheless a win for the
entire crypto economy, injecting a powerful and much-needed element
of rationality and restraint into the crypto regulatory
landscape.
Footnotes
1. The Order noted that certain marketing materials
explicitly linked the success of XRP to the success or
Ripple.
2. Further supporting the court’s position was the
nature of the sales and the use of purchase agreements (which
included typical private placement language, including lockup
periods, indemnification clauses, and representations that the
purchaser was not buying XRP for purposes of reselling or
distribution).
3. Note: this is a deviation from the SEC’s
“Framework for ‘Investment Contract’ Analysis of
Digital Assets” which states that “the lack of monetary
consideration . . . does not mean that the investment of money
prong is not satisfied.” The court here did not consider
whether other consideration (e.g., services) can satisfy the
“investment of money” prong of the Howey
test.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
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