[co-author: Henry Deteskey*]
Three days before Christmas 2020, the SEC served Ripple Labs Inc. and two of its executives with a lawsuit. How is that for a present under the tree? As the SKrypto Blog reported at the time, the main issue was whether XRP,1 a token that Ripple created, was a security or an asset. Nearly three years later, Judge Analisa Torres of the Southern District of New York delivered a mixed verdict on summary judgment: direct sales by Ripple to institutional investors created an investment contract (which is a security), but “programmatic selling” of XRP on various digital asset exchanges did not make XRP a security as a matter of law.2
In Ripple’s summary judgement briefing, Ripple looked back at the features of “investment contracts” under state law before the Securities Act was passed in 1933.3 Ripple proposed a novel “essential ingredient” test to decide whether an asset is an investment contract that could have introduced a new element to the Howey test. Judge Torres flatly rejected this approach, in favor of the tried-and-true Howey test.
Judge Torres applied the Howey test to four categories of unregistered XRP offers and sales: (1) institutional sales by Ripple pursuant to written contracts, (2) “programmatic sales” by Ripple on digital asset exchanges, (3) other distributions by Ripple in consideration other than cash, and (4) sales by Larsen and Garlinghouse on digital asset exchanges. For institutional sales to sophisticated individuals and entities, the Court concluded, given the totality of the circumstances, that Ripple’s XRP sales constituted the unregistered offer and sale of investment contracts in violation of the Securities Act. In particular, the Court considered Ripple’s marketing communications to investors as evidence that these investors purchased XRP reasonably expecting to reap a gain based on the efforts of others (i.e., Ripple). For sales by Ripple on digital asset exchanges, which the Court referred to as “programmatic sales,” the Court concluded that Ripple’s XRP sales did not create an investment contract, in large part because purchasers of XRP through such sales did not know that they were buying from Ripple directly.4 The Court also ruled that Ripple’s distribution of XRP for consideration other than cash, such as paying employees in XRP, and sales of XRP by Larsen and Garlinghouse on digital asset exchanges, did not create an investment contract and hence did not constitute the sale of a security.5
LEGAL TOKENS
Even though Judge Torres ruled in part for the SEC and in part for Ripple (and Larsen and Garlinghouse), there actually might be a winner here. At least Ripple thinks so!
As the SKrypto blog reported in December 2020, the SEC filed suit against Ripple alleging that its token, XRP, was a security (or at least that its sales involved the sale of a security).6 Last week, Judge Torres implied that the XRP token7 itself is not a security,8 and that the existence or creation of an investment contract in connection with such sale depended on the contract, transaction, or scheme by which it was sold. Coinbase reacted by gleefully and immediately relisting XRP on its exchange.
Focusing on how[ey]9 assets were sold, the Court examined the facts and circumstances surrounding the sale of XRP. Sales to institutional buyers involved contracts, direct relationships, and the demonstrable delivery of marketing materials. But the programmatic sales were blind bid/ask exchange transactions, so purchasers on such exchanges could not know they were purchasing XRP from Ripple (or Larsen/Garlinghouse).
Judge Torres held that because no purchaser in transactions on the exchanges could know who they were buying from, these transactions failed to meet the third prong of the Howey test — the expectation of profits solely from a third party or promoter. In the court’s view, because the buyer did not know the seller, as a matter of law, there could be no contract between a buyer and seller for purposes of fundraising. Therefore, programmatic sales did not constitute the offer and sale of investment contracts.
Like the court in LBRY, the Ripple Court expressly10 did not address the question of whether all secondary market sales, as a matter of law, constitute the offer and sale of investment contracts. By labeling sales on digital asset exchanges as programmatic, Judge Torres narrowed the reach of her opinion. If anything can be taken from this, it’s that an issuer’s promotion of an asset may drive the outcome of whether an investment contract could be offered. Moreover, if the issuer puts the consumer on notice as to who issued the token and whose efforts to rely upon for profit, then a court likely would find that token attached to an investment contract.
What does this mean for Coinbase and Binance? Well, it probably depends on the economic reality of the schemes involving each individual token listed in the SEC’s complaint. If a specific token was marketed to the public in a clear, concerted way via an exchange that could lead to an opposing outcome. Also, if a token has enough indicia of a traditional security, the token itself could be a security.
Notwithstanding its impact on Ripple and XRP, the Ripple case is just another piece of the mosaic that is the SEC’s “regulation by enforcement” approach to crypto tokens — in other words, whatever its merits, the case only answers the question of whether the token is a security with respect to a single token. This leaves the SEC in a quandary. Should it appeal this decision? Or should it walk away from this decision in hopes that it will have a “second bite at the apple” via the Coinbase case, also brought in SDNY? If the SEC appeals Judge Torres’ decision and the decision is upheld by the Second Circuit, the decision will be binding law in the Second Circuit, while currently the case is “just” a decision by a trial court with no direct precedential value.11
Coinbase already relisted XRP.12 Will the two companies come out of this as winners, together? Or will their fates take a turn over the next few months? Given the pace at which this case has progressed, this likely will not be resolved for years.
1 At the time of the filing, XRP was the third-largest cryptocurrency measured by daily volume.
2 Summary judgement is appropriate when there is no genuine dispute as to any material fact and the party is entitled to judgement as a matter of law. The Court’s decision addressed Ripple’s and the SEC’s cross-motions for summary judgement.
3 Possibly with an eye to appeal to the views of certain “originalist” Justices in Washington, D.C.
4 Internally, Seward & Kissel has been short-handing this concept as “privity,” which is a legal concept meaning a direct legal relationship between two parties (usually a contractual relationship). Early on in their history, car manufacturers argued that car purchasers could not sue them for defects since the purchasers bought the cars from dealers and not the manufacturers, and therefore no privity existed between the manufacturers and the ultimate buyers.
5 One claim not disposed through summary judgement was the SEC claim that Larsen and Garlinghouse aided and abetted Ripple’s violations of securities laws, which will be resolved in trial.
6 This is the lawyerly equivalent of the question of “how many angels can dance on the head of a pin.” TDLR: One.
7 In April, SEC Commissioner Gensler sat in front of the House Financial Services committee unwilling or unable to fully answer the question as to whether ETH or XRP in of themselves were securities.
8 Judge Torres relied, in part, on the Telegram case, comparing XRP to Telegram’s Gram.
9 Yes, this is the worst pun in the world, and yes, we are not sorry.
10 “The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court.”
11 Though we expect that this case will become part of next year’s All-Star Howey lineup, at minimum because of citations to Judge Torres’ “programmatic sales” terminology.
12 As have Kraken, Binance.US, and Bitstamp, with Gemini to follow.
*Henry Deteskey is currently a summer associate at Seward & Kissel. He attends Fordham Law School.
