Judge Analisa Torres’ greatly anticipated Orderin the
SEC’s lawsuit against Ripple is a split decision. The Order
basically finds that Ripple’s digital token XRP is a security
when sold privately to individuals and institutional investors
pursuant to purchase agreements, but is not a security when sold on
a digital asset exchange where sellers don’t know who’s
buying and buyers don’t know who’s selling.1
Although the Order should be perceived as at least a partial
victory for crypto, it perversely upends a fundamental tenet of the
securities laws which is that the laws are designed to protect
those who cannot fend for themselves. Moreover, the finding that
digital tokens sold anonymously on digital asset exchanges is not a
security also seems to contradict the “fraud on the
market” theory of securities liability.
Background
The SEC brought this lawsuit against Ripple and two of its
executives in December 2020, arguing the defendants offered and
sold over $1.5 billion of XRP without registration or exemption in
violation of Section 5 of the Securities Act of 1933. You can read
more in my blog post
here from two years ago about Ripple and about the SEC’s complaint. In
September of 2022, both sides filed motions for summary judgment.
On July 13, Judge Torres granted the SEC’s motion for summary
judgment as to private “institutional sales”, and granted
Ripple’s motion for summary judgment as to “programmatic
sales” on digital asset exchanges.
At the heart of this case was the issue that’s been central
to just about every other enforcement action brought by the SEC in
the digital asset space: whether XRP is an “investment
contract” and thus a type of security as defined by the
Securities Act of 1933. Under the standard set forth in the seminal
1946 Howey case, an investment contract requires (i) an
investment of money, (ii) in a common enterprise, (iii) with a
reasonable expectation of earning a profit through the efforts of
others.
Ripple engaged in two distinct types of XRP sales: private
“institutional sales” under written contracts for which
it received $728 million, and “programmatic sales” on
digital asset exchanges for which it received $757 million. Judge
Torres analyzed the two transaction types through the lens of
Howey, and both turned on Howey’s third prong: whether
or not the investors had a reasonable expectation of earning a
profit through the efforts of others.
Institutional Sales
Ripple sold $728 million of XRP to sophisticated individuals and
entities (the “institutional buyers”) pursuant to written
contracts.
The court cited precedent showing that “profit”
includes increased value of the Investment. Further,
“reasonable expectation of profit from the efforts of
others” need not be the sole reason a purchaser buys an
investment, as an asset can be sold for both consumptive and
speculative uses. The inquiry is an objective one, focusing on the
promises and offers made to investors; it is not a search for the
precise motivation of each individual participant.
Based on the totality of the circumstances, the Court found that
reasonable investors in the position of the institutional buyers
would have purchased XRP with the expectation that they would
derive profits from Ripple’s efforts. Based on Ripple’s
communications and marketing campaign and the nature of the
institutional sales, the Court determined that reasonable investors
would have understood that Ripple would use the capital to improve
the market for XRP and develop uses for the XRP network, thereby
increasing the value of XRP.
Programmatic Sales
The Court reached the opposite conclusion as to the $757 million
of “programmatic sales” to public buyers on digital asset
exchanges. Whereas the institutional buyers reasonably expected
that Ripple would use the capital it received from them to improve
the XRP network and increase the price of XRP, programmatic buyers
on digital asset exchanges could not reasonably expect the
same.
Ripple’s programmatic sales were blind bid/ask transactions,
and buyers could not have known if their payments of money went to
Ripple, or any other seller of XRP. Also, Ripple’s programmatic
sales represented less than 1% of the global XRP trading volume,
meaning that the vast majority of XRP buyers on digital asset
exchanges did not invest their money in Ripple at all. Unlike
institutional buyers who purchased XRP directly from Ripple
pursuant to a contract, programmatic buyers stood in the same shoes
as secondary market purchasers who don’t know to whom they were
paying their money.
While some programmatic buyers may have purchased XRP with the
expectation of profits to be derived from Ripple’s efforts, a
proper inquiry focuses objectively on the promises and offers made
to investors, and is not a search for the precise motivation of
each individual participant. Ripple didn’t make any promises or
offers to these buyers because Ripple didn’t know who was
buying the XRP, and the purchasers didn’t know who was selling.
There was also no evidence that any of the promotional materials
that Ripple provided to the institutional buyers were distributed
to the general public.
Closing Thoughts
The Court’s split decision provides helpful guidance to the
crypto industry as to circumstances under which a digital token
would be deemed a security and when it wouldn’t.
But the ruling that a digital token is a security when it’s
sold to sophisticated investors but not when it’s sold to
retail investors would lead to perverse results as a matter of
policy in that those who have the wherewithal to defend themselves
and have the leverage to negotiate for contractual safeguards will
nevertheless receive the protections of the securities laws, yet
retail investors will not. That seems to upend a fundamental tenet
of the securities laws which is that they are intended to protect
those who cannot fend for themselves.
Also, the ruling seems to contradict the “fraud on the
market” theory of the securities laws. In a securities fraud
case, a plaintiff does not need to prove that he relied on a
company’s fraudulent misstatements or omissions. A plaintiff
need only show that the company’s misrepresentations were
material and publicly known, that the stock traded in an efficient
market and that the plaintiff traded in the company’s stock
during that time. The rationale here is that an investor who trades
in a public market stock relies on the integrity of the price of
that stock, and because most publicly available information is
reflected in the market price, an investor’s reliance on any
public material misrepresentations is presumed for purposes of a
securities fraud action.
In his July 14 Money
Stuff column, the ever creative Bloomberg columnist Matt
Levine analogizes this to a company like Meta, which once upon a
time sold an aggregate of approximately $11 billion in its IPO and
one follow-on offering, but hasn’t sold any shares to the
public in many years. People buy and sell approximately that much
of Meta stock to each other – on any given day! – yet very few of
those people ever look at Meta’s SEC filings. Nevertheless, if
it turned out that Meta had made a material misstatement or
omission in one of those filings, it would not be able to argue
that the case should be dismissed because most of the retail
traders in the stock didn’t even read the disclosures in the
filings. Yet that is the implication of the Court’s ruling in
Ripple.
Footnote
1. The Order also found that XRP is not an investment
contract and thus not a security when offered and sold by Ripple to
employees as compensation (because it failed the “investment
of money” prong inasmuch as no consideration was paid for the
Tokens) and when insiders sold XRP on digital asset exchanges (for
the same reason that XRP sold by Ripple on exchanges were not
deemed investment contracts, i.e., seller and buyer
anonymity).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
