On July 13, 2023, US District Judge Analisa Torres of the US
District Court for the Southern District of New York ruled that
Ripple Labs’ token, XRP, was a security when sold to
institutional investors and not a security when sold to retail
investors using digital asset exchanges or when used for service
providers.
Judge Torres’s analysis in Securities and Exchange Commission v. Ripple Labs,
Inc. relied on the Supreme Court’s Howey
test, which outlines the standard for an investment contract and,
therefore, a security under federal securities laws. Judge Torres
rejected many of the novel arguments made by Ripple but ultimately
decided in its favor, except for one category of token sales. This
alert looks solely at the court’s analysis of XRP as an
investment contract.
In SEC v. W.J. Howey Co., the Supreme Court
stated that “an investment contract for purposes of the
Securities Act [of 1933] means a contract, transaction or
scheme.” In analyzing whether XRP, a digital asset, was an
investment contract, Judge Torres looked at the economic reality
and totality of circumstances surrounding each offer and sale of
the underlying asset. The subject itself is not necessarily a
security, but how it is used in the circumstances determines
whether it meets the Howey requirements.
The Howey test consists of three criteria that must be
met for an investment contract to be considered a security:
- It must be an investment of money.
- The investment must be in a common enterprise.
- There must be an expectation of profits derived primarily from
the efforts of others.
Background
The SEC commenced its action against Ripple on December 22,
2020, alleging that the company engaged in various sales and
distributions of XRP in violation of Section 5 of the Securities
Act. The sale and distribution of XRP by Ripple fit into three
categories between 2013 and 2020:
- “Institutional Sales,” which were primarily to
institutional buyers, hedge funds and on-demand liquidity
customers, pursuant to written contracts for which Ripple received
$728 million in proceeds. - “Programmatic Sales,” which were blind bid/ask
transactions on digital asset exchanges for which Ripple received
$757 million in proceeds. - “Other Distributions,” which were a form of payment
for services under written contracts for which Ripple recorded $609
million in “consideration other than cash.”
The offers and sales of XRP by two of Ripple’s executives
– Christian Larsen (former CEO and current executive
chairman) and Bradley Garlinghouse (current CEO) – were
categorized as “Programmatic Sales,” which totaled $450
million and $150 million, respectively.
The decision
Before the court were the parties’ cross-motions for summary
judgment. We’ve outlined the court’s conclusions below.
1. Ripple’s ‘Institutional Sales’ of XRP
constituted unregistered offer and sale of investment contracts in
violation of Securities Act Section 5
First, the court rejected the defendant’s argument that
“all investment contracts must contain three ‘essential
ingredients’: (1) ‘a contract between a promoter and an
investor that establishe[s] the investor’s rights as to an
investment,’ which contract (2) ‘impose[s] post-sale
obligations on the promoter to take specific actions for the
investor’s benefit’ and (3) ‘grant[s] the investor a
right to share in profits from the promoter’s efforts to
generate a return on the use of investor
funds.’ ”
The court looked at the economic reality and totality of
circumstances surrounding the offers and sales of XRP to
institutional buyers and concluded that they constituted investment
contracts. The court found that the institutional buyers had made
an investment of money. Applying the horizontal commonality test,
the court found they had done so in a common enterprise because the
institutional investors’ assets were pooled, and their fortunes
were tied to the fortunes of other investors and the success of the
enterprise. Finally, the court found that the institutional
investors had a reasonable expectation of profits to be derived
from the efforts of Ripple.
2. Ripple’s ‘Programmatic Sales’ of XRP
didn’t constitute offer and sale of investment
contracts
The court found that the “Programmatic Sales” did not
satisfy Howey‘s third prong because such buyers could
not reasonably have expected that Ripple would use the proceeds of
the sales to improve the XRP ecosystem and thereby cause an
increase in the price of XRP. Citing SEC v. Telegram Group Inc., the court
stated that this inquiry turns on the “promises and offers
made to investors” and not each buyer’s motivation, making
the blind bid/ask aspect of the transactions a key consideration.
Ripple did not make any promises or offers because it did not know
who was buying the XRP, and the purchasers did not know who was
selling it. Even if the motive was to turn a profit, these buyers
“did not derive that expectation from Ripple’s efforts (as
opposed to other factors, such as general cryptocurrency market
trends)” for that same reason. The court further
differentiated the “Programmatic Sales” from
“Institutional Sales” based on the sophistication of the
buyers and other factors, such as the contractual provisions and
promotional materials relating to the “Institutional
Sales.”
3. Ripple’s ‘Other Distributions’ didn’t
constitute offer and sale of investment contracts
“Other Distributions” did not satisfy
Howey‘s first prong requiring an “investment of
money” as part of the transaction or scheme. The court, citing
International Brotherhood of Teamsters v.
Daniel, stated that a buyer must give up some
“tangible and definable consideration” in exchange for
the security. Here, the record showed an inverse of this
relationship, where Ripple paid out XRP to the service providers
and never received payments from those XRP distributions.
Significance
Although this decision likely will be appealed, it provides
stakeholders with a fresh perspective on the offer and sale of
digital assets.
Companies with ongoing commercial projects now have support for
the position that not all digital assets are securities. To avoid
the characterization of a token as a security, a token issuer would
nonetheless still have to ensure that the sale does not satisfy the
Howey elements, similar to the analysis the court went
through with the “Programmatic Sales” and “Other
Distributions” of XRP. If the project is raising money in a
manner similar to the “Institutional Sales,” securities
laws limitations would likely apply, at least until such time as
there is rulemaking or legislation providing otherwise.
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.
