A key question for any company considering the issuance of cryptocurrency is whether that digital asset will be treated by regulators as a security, like BP stock, or a commodity, like Bitcoin.[i] In 2019, the Securities and Exchange Commission (the “SEC” or the “Commission”) provided guidance on this issue in a “Framework for ‘Investment Contract’ Analysis of Digital Assets” (“Framework”).[ii] The Framework lists characteristics that make it more or less likely that the SEC will deem a given cryptocurrency to be a security. The SEC’s enforcement action against Ripple Labs (“Ripple”) for the sale of a digital asset named “XRP,” filed in December 2020 and currently pending before the U.S. District Court, Southern District of New York, illustrates the manner in which the SEC has applied the Framework, and serves as an early test of whether courts agree with the SEC’s broad view of the investment contract analysis with respect to crypto assets.
Background: The Framework
Under federal law, a security is defined expansively to include “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights . . . .”[iii] If something is deemed a security, then it is subject to a regulatory regime that includes registration of public offers and sales with the SEC. Failure to register a public offering and sale of securities—absent a legal exception—could result in an SEC investigation, penalties, fines and litigation.[iv]
The SEC has taken the position that cryptocurrencies may constitute securities under the category of investment contracts.[v] In 1946, the Supreme Court issued a ruling in SEC v. W.J. Howey Co., which defined an investment contract as “a contract, transaction or scheme whereby a person [1] invests his money in [2] a common enterprise and [3] is led to expect profits solely from the efforts of the promoter or a third party . . . .”[vi] While Howey involved land sale and service contracts for citrus groves in Florida, the Supreme Court noted that the definition “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”[vii] As a result, analysis under the Howey test tends to be highly fact dependent.
The Framework is intended to act as a vehicle through which the Howey test is applied. In the Framework, the SEC noted that for offers and sales of digital assets, the Commission typically finds that the first and second prongs of the Howey test—for the investment of money and common enterprise—are met. Therefore, in the SEC’s view, the analysis generally hinges on the third prong—the reasonable expectation of profits from reliance on the efforts of others.
The “reliance on the efforts of others” analysis focuses on whether a purchaser of a digital asset reasonably expects to rely on the efforts of the promoter, sponsor, or other third party associated with the asset (defined by the Commission as the “Active Participant” or “AP”) and whether these efforts are essential for the success of the enterprise, as opposed to merely ministerial. To answer this question, the Commission considers six characteristics and eleven sub-characteristics—none of which is “necessarily determinative,” but “the stronger their presence, the more likely it is that a purchaser of a digital asset is relying on the ‘efforts of others’.”[viii] These include whether there are essential tasks that are performed by the AP as opposed to a decentralized network of users, and whether the AP creates or supports a market or price for the digital asset. The Commission also considers three additional characteristics for reliance that only come into play for evaluating subsequent offers and sales of digital assets that were previously sold as securities.[ix]
For the second part of the test (i.e., whether there is a reasonable expectation of profit), the analysis focuses on whether the purchaser of the digital asset has reasonable expectations of profits from, among other things, capital appreciation and/or participation in earnings. To conduct this analysis, the Commission considers ten characteristics and eleven sub-characteristics—with more characteristics being present making it more likely that this facet is satisfied.[x] Some of these characteristics include whether the digital asset was marketed as an investment; whether there is a lack of correlation between the price of the asset, on the one hand, and the goods or services to be acquired it, on the other; and whether the digital asset is or is anticipated to be traded in a secondary market. The SEC also considers six additional characteristics for reasonable expectation that are relevant for evaluating subsequent offers and sales of digital assets that were previously sold as securities.[xi]
Along with this two-tiered analysis, the Framework includes a list of eleven characteristics and five sub-characteristics that may be used to otherwise evaluate whether the Howey test has been met.[xii] These characteristics include whether the holder of the digital asset is immediately able to use it for its intended purpose and whether prospects for appreciation are limited.
The SEC’s Action Against Ripple Labs
On December 22, 2020, the SEC filed a complaint against Ripple and two of its executives in the Southern District of New York, alleging (1) that they engaged in the unlawful offer and sale of securities and (2) that the executives aided and abetted Ripple’s violations of securities law.[xiii] The Commission then filed an amended complaint on February 18, 2021—adding further allegations against the Ripple executives.[xiv] An examination of the amended Ripple complaint demonstrates the manner in which the SEC has applied the Framework.
Ripple is a payment technology company, founded in 2012, that uses blockchain technology, with its native XRP cryptocurrency and XRP ledger, to settle transactions. In 2012, Ripple owned 80 billion XRP, with another 20 billion owned by three individuals who were founders of Ripple and involved in the creation of XRP.[xv] The SEC alleges that the sale of 14.6 billion XRP between 2013 and 2020 constitutes an unregistered offering of securities that violated federal law.[xvi]
The SEC alleges that XRP had little consumptive use when it was offered and sold.[xvii] Instead, the Commission contends that Ripple made representations that it would use its expertise to create an ecosystem for the digital asset.[xviii] These allegations line up with characteristics listed in the Framework concerning the reasonable expectation of profit and reliance on the efforts of others.[xix]
The Commission further contends that Ripple and the other defendants marketed XRP to the public as an investment.[xx] This marketing strategy supports the Commission’s view that a purchaser of XRP would have a reasonable expectation of profit.
Finally, the Commission alleges that defendants and/or their employees retained or intended to retain certain of the digital assets at issue.[xxi] Under the Framework, the Commission considers this to be relevant to analyzing both reliance on the efforts of others and reasonable expectation for profit—as it aligns the interests of the defendants with the purchasers.
The SEC’s enforcement action in Ripple covers seven years of offers and sales (from 2013 to 2020) and treats those offers and sales collectively as a single “Offering.”[xxii] Moreover, the SEC alleges that these offers and sales—along with purchases of XRP and the creation of an escrow for Ripple’s XRP—were part of an effort by the defendants to create and support a market for XRP.[xxiii] The Commission considers this type of activity to be relevant to determining whether there was reliance on the efforts of others under the Framework.[xxiv]
As noted above, the SEC also brought claims against two executives of the company, Garlinghouse and Larsen.[xxv] These individual defendants filed separate motions to dismiss. Both of the defendants argued that the aiding and abetting claims should be dismissed, because the agency did not adequately plead state of mind.[xxvi] They also argued that the unlawful offerings claims against them should be dismissed on exterritoriality grounds.[xxvii] Separately, Larsen further argued that the SEC failed to allege that he substantially assisted Ripple’s alleged violations and that the Commission’s claims for disgorgement and monetary relief were time-barred.[xxviii] The parties have fully briefed the motions to dismiss, and they are currently pending before the court.[xxix]
After a contentious year of litigation, including disputes and recent rulings on deliberative process privilege, Ripple is reaching the end of discovery.[xxx] It is uncertain how long it will be before there is a decision on the merits in this case, although we expect that there will by appeals and significant rulings that arise out of this matter, which will provide further clarity to how the Howey test should be applied to crypto assets.
This blog will continue to monitor the Ripple case closely, and will provide updates on this case as well as on other noteworthy enforcement actions involving crypto assets.
[iii] 15 U.S.C.S. § 77b (a)(1).
[iv] 15 U.S.C.S. §§ 77e–77f, 77t.
[v] SEC v. Kik Interactive, Inc., 492 F. Supp. 3d 169, 177–178 (S.D.N.Y. 2020) (holding “that the Pre-Sale, and the TDE sale to the general public, constituted an unregistered offering of Securities . . . .”); see also SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352, 381 (S.D.N.Y. 2020) (“The Court finds that the SEC has shown a substantial likelihood of success in proving that the Gram Purchase Agreements, Telegram's implied undertakings, and its understandings with the Initial Purchasers . . . amount to the distribution of securities, thereby requiring compliance with section 5”); see generally Framework.
[vi] S.E.C. v. W. J. Howey Co., 328 U.S. 293, 298–299 (1946).
[viii] Framework, supra note 2. The six characteristics, denoted by solid bullet points, and eleven sub-characteristics, denoted by hollow bullet points, for reliance on the efforts of others are listed below.
- “An AP is responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an AP to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality.”
- “Where the network or the digital asset is still in development and the network or digital asset is not fully functional at the time of the offer or sale, purchasers would reasonably expect an AP to further develop the functionality of the network or digital asset (directly or indirectly). This particularly would be the case where an AP promises further developmental efforts in order for the digital asset to attain or grow in value.”
- “There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a "decentralized" network).”
- “An AP creates or supports a market for, or the price of, the digital asset. This can include, for example, an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as by limiting supply or ensuring scarcity, through, for example, buybacks, "burning," or other activities.”
- “An AP has a lead or central role in the direction of the ongoing development of the network or the digital asset. In particular, an AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset.”
- “An AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents including, for example:”
- “Determining whether and how to compensate persons providing services to the network or to the entity or entities charged with oversight of the network.”
- “Determining whether and where the digital asset will trade. For example, purchasers may reasonably rely on an AP for liquidity, such as where the AP has arranged, or promised to arrange for, the trading of the digital asset on a secondary market or platform.”
- “Determining who will receive additional digital assets and under what conditions.”
- “Making or contributing to managerial level business decisions, such as how to deploy funds raised from sales of the digital asset.”
- “Playing a leading role in the validation or confirmation of transactions on the network, or in some other way having responsibility for the ongoing security of the network.”
- “Making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally.”
- “Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where:”
- “The AP has the ability to realize capital appreciation from the value of the digital asset. This can be demonstrated, for example, if the AP retains a stake or interest in the digital asset. In these instances, purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset.”
- “The AP distributes the digital asset as compensation to management or the AP's compensation is tied to the price of the digital asset in the secondary market. To the extent these facts are present, the compensated individuals can be expected to take steps to build the value of the digital asset.”
- “The AP owns or controls ownership of intellectual property rights of the network or digital asset, directly or indirectly.”
- “The AP monetizes the value of the digital asset, especially where the digital asset has limited functionality.”
[ix] Framework, supra note 2. The three additional characteristics that the SEC considers for reliance on the efforts of others for subsequent offers and sales of digital assets that were previously sold as securities are as follows:
- “Whether or not the efforts of an AP, including any successor AP, continue to be important to the value of an investment in the digital asset.”
- “Whether the network on which the digital asset is to function operates in such a manner that purchasers would no longer reasonably expect an AP to carry out essential managerial or entrepreneurial efforts.”
- “Whether the efforts of an AP are no longer affecting the enterprise's success.”
[x] Framework, supra note 2. The ten characteristics, denoted by solid bullet points, and eleven sub-characteristics, denoted by hollow bullet points, for reasonable expectation of profits are listed below.
- “The digital asset gives the holder rights to share in the enterprise's income or profits or to realize gain from capital appreciation of the digital asset.”
- “The opportunity may result from appreciation in the value of the digital asset that comes, at least in part, from the operation, promotion, improvement, or other positive developments in the network, particularly if there is a secondary trading market that enables digital asset holders to resell their digital assets and realize gains.”
- “This also can be the case where the digital asset gives the holder rights to dividends or distributions.”
- “The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.”
- “Purchasers reasonably would expect that an AP's efforts will result in capital appreciation of the digital asset and therefore be able to earn a return on their purchase.”
- “The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network.”
- “The digital asset is offered and purchased in quantities indicative of investment intent instead of quantities indicative of a user of the network. For example, it is offered and purchased in quantities significantly greater than any likely user would reasonably need, or so small as to make actual use of the asset in the network impractical.”
- “There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset.”
- “There is little apparent correlation between quantities the digital asset typically trades in (or the amounts that purchasers typically purchase) and the amount of the underlying goods or services a typical consumer would purchase for use or consumption.”
- “The AP has raised an amount of funds in excess of what may be needed to establish a functional network or digital asset.”
- “The AP is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public.”
- “The AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset.”
- “The digital asset is marketed, directly or indirectly, using any of the following:”
- “The expertise of an AP or its ability to build or grow the value of the network or digital asset.”
- “The digital asset is marketed in terms that indicate it is an investment or that the solicited holders are investors.”
- “The intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset.”
- “The future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality.”
- “The promise (implied or explicit) to build a business or operation as opposed to delivering currently available goods or services for use on an existing network.”
- “The ready transferability of the digital asset is a key selling feature.”
- “The potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials.”
- “The availability of a market for the trading of the digital asset, particularly where the AP implicitly or explicitly promises to create or otherwise support a trading market for the digital asset.”
[xi] Framework, supra note 2. The six additional characteristics that the SEC considers for reasonable expectation of profits—in relation to subsequent offers and sales of digital assets that were previously sold as securities—are as follows:
- “Purchasers of the digital asset no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.”
- “The value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed.”
- “The trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed.”
- “Whether holders are then able to use the digital asset for its intended functionality, such as to acquire goods and services on or through the network or platform.”
- “Whether any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.”
- “No AP has access to material, non-public information or could otherwise be deemed to hold material inside information about the digital asset.”
[xii] Framework, supra note 2. The eleven characteristics, denoted by solid bullet points, and five sub-characteristics, denoted by hollow bullet points, that the SEC also considers to be relevant for the Howey test are listed below.
- “The distributed ledger network and digital asset are fully developed and operational.”
- “Holders of the digital asset are immediately able to use it for its intended functionality on the network, particularly where there are built-in incentives to encourage such use.”
- “The digital assets' creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. For example, the digital asset can only be used on the network and generally can be held or transferred only in amounts that correspond to a purchaser's expected use.”
- “Prospects for appreciation in the value of the digital asset are limited. For example, the design of the digital asset provides that its value will remain constant or even degrade over time, and, therefore, a reasonable purchaser would not be expected to hold the digital asset for extended periods as an investment.”
- “With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts, or acts as a substitute for real (or fiat) currency.”
- “This means that it is possible to pay for goods or services with the digital asset without first having to convert it to another digital asset or real currency.”
- “If it is characterized as a virtual currency, the digital asset actually operates as a store of value that can be saved, retrieved, and exchanged for something of value at a later time.”
- “With respect to a digital asset that represents rights to a good or service, it currently can be redeemed within a developed network or platform to acquire or otherwise use those goods or services. Relevant factors may include:”
- “There is a correlation between the purchase price of the digital asset and a market price of the particular good or service for which it may be redeemed or exchanged.”
- “The digital asset is available in increments that correlate with a consumptive intent versus an investment or speculative purpose.”
- “An intent to consume the digital asset may also be more evident if the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network.”
- “Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.”
- “The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset.”
- “Potential purchasers have the ability to use the network and use (or have used) the digital asset for its intended functionality.”
- “Restrictions on the transferability of the digital asset are consistent with the asset's use and not facilitating a speculative market.”
- “If the AP facilitates the creation of a secondary market, transfers of the digital asset may only be made by and among users of the platform.”
[xiii] Complaint, SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. filed Dec. 22, 2020), ECF No. 4.
[xiv] First Amended Complaint, SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. filed Dec. 22, 2020), ECF No. 46.
[xv] Answer of Defendant Ripple Labs, Inc. to Plaintiff’s First Amended Complaint at ¶ 46, SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. filed Dec. 22, 2020), ECF No. 51.
[xvi]Ripple Amended Complaint, supra note 14, at ¶¶ 1, 5.
[xvii]Ripple Amended Complaint, supra note 14, at ¶¶ 358, 362.
[xviii] Ripple Amended Complaint, supra note 14, at ¶¶ 243–262.
[xix] Framework, supra note 2.
[xx]Ripple Amended Complaint, supra note 14, at ¶¶ 329–349.
[xxi] Ripple Amended Complaint, supra note 14, at ¶¶ 223, 305, 347.
[xxii] Ripple Amended Complaint, supra note 14, at ¶¶ 5, 432.
[xxiii] Ripple Amended Complaint, supra note 14, at ¶¶ 190–229.
[xxiv] Framework, supra note 2.
[xxv] Ripple Amended Complaint, supra note 14, at ¶¶ 17–18.
[xxvi] Memorandum of Law in Support of Defendant Christian A. Larsen’s Motion to Dismiss the First Amended Complaint at 1–2, 12-13, SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. filed Dec. 22, 2020), ECF No. 107; Memorandum of Law in Support of Defendant Bradley Garlinghouse’s Motion to Dismiss the Amended Complaint at 1–2, 3-4, 15, Ripple, ECF No. 111.
[xxvii] Larsen Memorandum, supra note 26, at 3, 22; Garlinghouse Memorandum, supra note 26, at 4–5, 20–21.
[xxviii] Larsen Memorandum, supra note 26, at 2–4.
[xxix] Larsen Memorandum, supra note 26; Garlinghouse Memorandum, supra note 26; Plaintiff Securities and Exchange Commission’s Memorandum of Law in Opposition to Defendants Christian A. Larsen’s and Bradley Garlinghouse’s Motions to Dismiss, Ripple, ECF No. 182; Reply Memorandum of Law in Further Support of Defendant Christian A. Larsen’s Motion to Dismiss the First Amended Complaint, Ripple, ECF No. 223; Reply Memorandum of Law in Support of Defendant Bradley Garlinghouse’s Motion to Dismiss the Amended Complaint , Ripple, ECF No. 224.
[xxx] See Opinion & Order, SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y. filed Dec. 22, 2020), ECF No. 413 (rulings on deliberative process privilege in discovery disputes); see also, Letter Motion, Ripple, ECF No. 410 (joint request for expert discovery extension to the end of February 2022).
In the Opinion & Order on deliberative process privilege, the Court first went through the various sets of SEC documents (grouped as entries) to determine the applicability of the deliberative process privilege—or some other privilege like attorney-client. The Court then considered five factors to determine whether disclosure was appropriate for the documents covered by the deliberative privilege. Those five factors were the following: “(i) the relevance of the evidence sought to be protected; (ii) the availability of other evidence; (iii) the seriousness of the litigation and the issues involved; (iv) the role of the government in the litigation; and (v) the possibility of future timidity by government employees who will be forced to recognize that their secrets are violable.” Rodriguez v. Pataki, 280 F. Supp. 2d 89, 101 (S.D.N.Y. 2003) (internal citations omitted). The Court found that “[a]lthough the first four factors weigh only slightly in favor or against disclosure, the fifth factor strongly weighs against disclosure. Given the importance in having the SEC ‘get it right’ on the highly consequential decisions of how (or whether) to regulate digital assets, the need to promote candor to improve agency decision making is critical.” Therefore, the Court held that disclosure was not appropriate for the documents covered by the deliberative process privilege, and only ordered disclosure of documents determined earlier in the opinion to be non-privileged.
