I. Introduction
On July 13, 2023, the United States District Court for the Southern District of New York (the “Court”) issued a major ruling in in a closely-followed lawsuit brought by the Securities and Exchange Commission (the “SEC”) against Ripple Labs (“Ripple”) over the securities law status of XRP, Ripple’s native token XRP.1
In sum and substance, the Court held that XRP is not a security when sold to the general public, but is a security when sold to institutional investors.
II. Background & “Howey Test”
Ripple, a technology company, offers XRP, a cryptocurrency token designed to provide an energy-efficient alternative to other blockchain tokens. XRP has ranked among the top ten cryptocurrencies by global market capitalization.2 The SEC initiated an enforcement action against Ripple in 2020,3 alleging that Ripple had engaged in the unregistered offer and sale of securities in violation of the Securities Act of 1933 (the “Securities Act”) when it offered XRP to investors.
The primary test for determining whether a given digital asset constitutes an “investment contract” (and therefore a security) is the so-called “Howey test,” established in the case SEC v. W.J. Howey Co. decided by the Supreme Court of the United States.4 Under Howey, an “investment contract” exists where there is (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits to be derived from the efforts of others.
Where a contract, transaction, or scheme constitutes an “investment contract”, a securities transaction is present, and those securities must be registered with the SEC unless an exception or exemption apply. The SEC had previously issued its interpretation of how the Howey applies to the digital asset context in 2019, and, not surprisingly, the SEC’s interpretation favored the registration of digital assets.5
III. The Decision
The Court ruled that Ripple’s “institutional sales” of XRP (i.e., the direct sale of XRP to investors, including institutional buyers and hedge funds) constituted an impermissible offer and sale of investment contracts in violation of Section 5 of the Securities Act. However, the Court also held that “programmatic sales” of XRP on public digital asset exchanges or through the use of trading algorithms did not constitute such an impermissible offer and sale. In so ruling, the Court evaluated each offering under Howey, clarifying 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” and that “[r]ather, the Court examines the totality of circumstances surrounding [the] different transactions and schemes involving the sale and distribution of XRP.”
Institutional Sales
The Court determined that Ripple’s institutional sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act because all three prongs of the Howey test were met. First, the Court noted that the sale of XRP constituted an “investment of money” because investors paid fiat or other currency in exchange for the tokens. The Court found that the proceeds of Ripple’s institutional sales were invested “in a common enterprise,” observing that (i) Ripple pooled the proceeds of these sales into a network of bank accounts under its control and (ii) investors were given the same fungible XRP. The Court then stated that investors in the XRP offered as part of Ripple’s institutional sales would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts. The Court pointed to Ripple’s communications and marketing campaign, including its promotional brochures and public statements in support of XRP, as well as its continual business engagements and improvements to the Ripple blockchain. The Court further reasoned that the nature of the institutional sales themselves point to an understanding that investors would profit from Ripple’s effort to improve and manage XRP.
Programmatic Sales
The Court next considered Ripple’s programmatic sales of XRP through to public buyers through digital asset exchanges and through trading algorithms and decided that the third Howey prong was not met. The Court reasoned that, in contrast to Ripple’s institutional sales of XRP, the programmatic sales were blind bid/ask transactions and investors could not know the seller from which they purchased XRP. Accordingly, the Court stated that such sales did not constitute an investment in Ripple at all, and that investors would not be in a position to reasonably expect that Ripple would receive the purchase proceeds and subsequently use the capital it received from the sales to improve XRP. The Court reasoned that “[a]n Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract,” but that “the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.” The Court further noted there was no evidence that the purchasers of XRP would necessarily be sophisticated parties aware of Ripple’s connection to the price of XRP or that Ripple’s promotional and marketing materials were distributed to the wider public.
Having determined that the third Howey prong was not met, the Court held that Ripple’s programmatic sales of XRP did not constitute the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act and granted Ripple’s motion to dismiss.
Other Distributions
The court also concluded that certain distributions of XRP to employees and other third parties as compensation did not satisfy Howey because such distributions did not involve an “investment of money.”
IV. Takeaways
Although the Court’s decision is a significant development, the ultimate impact of the Court’s ruling on the trajectory of the regulation of digital assets is remains to be determined. Both parties may appeal the Court’s ruling, and the Court’s decision is not binding on other courts, which may disagree with the Court’s conclusions or reasoning. Nevertheless, the decision can be seen as a “split verdict”: It provides ammunition for the SEC on one issue, but also offers a favorable holding for digital asset companies in future litigation. Specifically:
First, the Court’s reasoning with respect to institutional sales represents a partial victory for the SEC. The Court’s decision fits Ripple’s institutional sales neatly into the Howey analysis, and this not only vindicates the SEC’s position with respect to approximately $728.9 million in XRP sales, but also will likely provide a basis for the SEC to initiate future lawsuits against tokens sold under similar scenarios.
However, the Court’s reasoning with respect to programmatic sales also represent a partial victory for Ripple and the digital assets industry more broadly, as the Court’s analysis provides a path for digital assets to be sold on digital asset exchanges outside the constraints of the federal securities law. According to the Court, if investors are not directly engaging with the underlying creator of a digital asset or in a position where they have the knowledge to expect the creator to enhance the digital asset or underlying blockchain, then sales to such investors would be permissible under the Securities Act.
It may be difficult to determine how the Court’s reasoning will be applied on a practical level. The analytical distinction between institutional and programmatic sales that the Court draws may be a challenging standard to administer, as the Court does not define a bright-line standard for assessing when secondary market sales of XRP would constitute an offer and sale of investment contracts. For example, under the Court’s reasoning, an institutional buyer who enters agreements directly with Ripple to purchase XRP may potentially face different resale restrictions than a programmatic buyer who purchased the XRP on an exchange from an unknown seller; the Court’s decision appears to allow that the institutional buyer, having entered into an investment contract, would be restricted in re-selling that XRP, but the programmatic buyer, having purchased a non-security, would not. Accordingly, the decision may lead to a dual status for certain digital assets, where some tokens acquired as part of an “investment contract” are subject to the restrictions of the federal securities laws and other tokens are not so encumbered.
It also remains to be seen the extent to which the Court’s decision will re-shape the SEC’s interpretative framework for assessing the application of federal securities laws to the digital asset context. SEC Chair Gary Gensler has noted that the SEC is assessing the implications of the Court’s ruling, and market participants and interested parties should continue to monitor this case in the event of an appeal.
Going forward, entities that offer digital assets or are considering entering the space should take steps to better insulate themselves against future SEC action. Companies issuing digital assets should re-consider how their offering practices align with Howey in light of the Court’s ruling. In addition, market participants should exercise caution and care with respect to the manner in which they discuss their token projects in promotional and marketing materials.
Footnotes
1) SEC v. Ripple Labs, Inc. (2023). https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf.
2) Market capitalization of Ripple (XRP) from August 2013 to August 2, 2022 https://www.statista.com/statistics/807216/ripple-market-capitalization-quarterly/.
3) Press Release, “SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering” https://www.sec.gov/news/press-release/2020-338.
4) 328 U.S. 293 (1946).
5) SEC, Framework for “Investment Contract: Analysis of Digital Assets” https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets.
