On July 13, 2023, the U.S. District Court for the Southern District of New York issued its highly anticipated summary judgment decision in the U.S. Securities and Exchange Commission’s (SEC) action against Ripple Labs, Inc. (Ripple) and two of its senior leaders, Bradley Garlinghouse and Christian Larsen.  Significantly, the Court found that blind sales of cryptocurrency through digital asset exchanges did not violate federal securities laws.  This decision is the first major ruling in which a U.S. federal judge has found that certain digital assets sales fall outside the ambit of U.S. securities law.  While certain key portions of the decisions will likely be challenged by all parties, for now the decision appears to provide potential ways forward for the U.S. crypto market, which has been targeted by the SEC.

Key Takeaways

• The Court reinforced that whether the sale of XRP (Ripple’s native token) is sold as a security is based on the circumstances of the transaction and not the mere status of XRP as a cryptocurrency token.
• The Court ruled that sales of XRP conducted on digital asset exchanges as described in this case—where buyers and sellers do not know each other’s identities—did not constitute investment contracts and, therefore, there were no violations of federal securities law.  Accordingly, this supports the argument that selling cryptocurrency on a public exchange in a blind transaction, without more, would not constitute a securities sale.
• The Court ruled that Ripple’s distribution of XRP as payment to third parties, such as compensation to employees and developers, did not constitute an investment contract, as a matter of law, and, therefore, there were no violations of federal securities law. 
• However, the Court ruled that Ripple’s unregistered sale of XRP pursuant to written agreements to known institutional buyers, in which Ripple’s conduct gave such buyers an expectation of profit, constituted an investment contract, and because the parties agreed that it was not registered, the sale thereof violated the registration requirements of the federal securities law.  Here, the Court focused on how Ripple marketed XRP, Ripple’s statements that its efforts would increase XRP’s value, and the fact that the institutional buyers were aware that their money was going to Ripple to aid in its efforts.  Notably, the Court did not examine whether there was an exemption from registration that could apply to the securities transactions.
• The Court’s ruling arguably presents a path for introducing a new digital asset into the market that complies with the U.S. federal securities laws.  This decision presents potential legal precedent to introduce new digital assets into the U.S. market in which digital assets are (i) first transferred to employees as compensation and then sold to third parties on exchanges; (ii) simply sold directly on public exchanges in blind transactions, including by starting on decentralized exchanges; or (iii) airdropped.
• While this is a major ruling, it is not binding on other district courts, even those in the Southern District of New York.  Other courts could disagree with its holdings, as well as the decision in other cases, such as Telegram and Kik,[1] and it is unknown to what extent the Second Circuit will uphold the decision on the likely appeal by all parties.

I.         Background

Ripple is a privately held payments technology company that uses blockchain technology to enable the efficient transmission of money.  XRP is the native token (aka “digital asset” or “cryptocurrency”) on the Ripple blockchain. In December 2020, the SEC sued Ripple, Garlinghouse, and Larsen (collectively, “Defendants”), alleging that (1) Defendants’ sales of XRP were unregistered offers and sales of securities (that were not conducted pursuant to an exemption from registration) and, therefore, violated Section 5 of the Securities Act of 1933 (“Securities Act”), 15 U.S.C. §§ 77e(a) and (c); and  (2) Garlinghouse and Larsen aided and abetted Ripple’s Section 5 violations.[2]  The SEC’s case was based on the allegation that XRP is a security, specifically, an investment contract, and, therefore, subject to federal securities laws that require sales to be registered or offered and sold pursuant to an exemption from registration.[3] 

In September 2022, after the completion of fact and expert discovery, all parties moved for summary judgment on whether the sales of XRP constituted the unregistered sale of a security.[4]  The SEC also moved for summary judgment (1) on its aiding and abetting claim against Larsen and Garlinghouse, and (2) against Defendants’ affirmative “fair notice defense,” which asserted that the SEC’s actions violated their due process rights.

II.        The Court’s Decision

A.        Section 5 Liability:  Howey Test Explained and Applied

In determining whether Defendants’ sale of XRP violated Section 5, the Court repeatedly distinguished the investment contract (which is a “contract, transaction, or scheme”) from the subject of the investment contract (here, XRP).[5]  As such, the Court focused not on the characteristics of the token itself, but on the Defendants’ transactions involving XRP.  The Court classified the transactions into four different categories, based on the differing facts and circumstances of each:

1. Institutional Sales:[6] Ripples’ sale of XRP pursuant to written contracts to known institutional purchasers, such as hedge funds, on demand liquidity customers, and other institutional buyers;
2. Programmatic Sales:[7] Ripple’s sale of XRP on digital asset exchanges, which was both blind (i.e., neither Ripple nor the buyer knew the other’s identity) and programmatic (e.g., sold through the use of trading algorithms);
3. Other Distributions:[8] Ripple’s payment of XRP to third parties, such as employees as compensation and developers to further develop the ecosystem; and
4. Individual Defendants’ Sales:[9] The blind sale of XRP on digital asset exchanges by Larsen and Garlinghouse in their individual capacities.

In its analysis, the Court relied on the seminal case, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which defines  “investment contract,” as a contract, transaction, or scheme whereby a person (1) invests his money (2) in a common enterprise and (3) with the reasonable expectation of profits based on the managerial efforts of a promoter or a third party.[10]  Again, the Court emphasized that the inquiry was focused on the transaction and not the subject of the transaction, and stated that even if an initial sale of a commodity constituted an investment contract under Howey, “resales may or may not constitute investment contracts, depending on the totality of circumstances surrounding the later transaction.”[11] 

The Court then applied the Howey test to each of the four categories of XRP transactions.

1.         Institutional Sales of XRP Are Investment Contracts

The Court first addressed Ripple’s Institutional Sales of XRP to “sophisticated individuals and entities” (Institutional Buyers) pursuant to written contracts.[12]  The Court found the first Howey prong easily met because the Institutional Buyers provided fiat or other currency in exchange for XRP.  The Court also found that the second Howey prong of a “common enterprise” was met through a showing of “horizontal commonality,” which exists “where the investors’ assets are pooled and the fortunes of each investor are tied to the fortunes of other investors, as well as to the success of the overall enterprise.”[13]

The Court then turned to the third prong— “a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.” [14]  The Court explained that the inquiry here “is an objective one focusing on the promises and offers made to investors; it is not a search of the precise motivation of each individual participant.”[15]  Thus, the Court focused on what Ripple told investors:  “From Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP . . . thereby increasing the value of XRP.”[16]

The Court also declined to adopt the Defendants’ “Essential Ingredients Test,”[17] reasoning that it imposes requirements beyond Howey. The Court did not analyze whether the first “essential ingredient” —that “a contract must exist for an investment contract to exist” — was required because, under the circumstances in which the Court concluded that XRP was sold as a security (the Institutional Sales transactions), there was a contract between the buyer and seller.[18]  The Court, relying on Telegram, noted that investment intent was also inferred from the lockup period: “Simply put, a rational economic actor would not agree to freeze millions of dollars . . . if the purchaser’s intent was to obtain a substitute for fiat currency.”[19]  It is worth noting that on appeal Ripple may disagree with the Court’s interpretation of its argument that any type of contract will suffice, as opposed to a contract that establishes certain rights and obligations on the parties involved in the transaction.

Having found all Howey prongs met, the Court concluded that Ripple’s Institutional Sales of XRP constituted a security transaction, and because it was undisputed that neither the XRP nor the transactions were registered, that Ripple conducted the unlawful and unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act.  Notably, the Court did not analyze whether Ripple’s Institutional Sales of XRP were offered and sold pursuant to an exemption from registration, such as Securities Act Section 4(a)(2).[20]

2.         Programmatic Sales of XRP are NOT Investment Contracts

The Court next addressed Ripple’s Programmatic Sales, analyzing only the third Howey prong.  The Court found that, in contrast to Institutional Sales, Programmatic Sales “were blind bid/ask transaction” where the buyers “could not have known if their payments of money went to Ripple, or any other seller of XRP.”[21]  The Court further noted that, since 2017, Ripple’s Programmatic Sales represented less than 1% of the global XRP trading volume, and therefore “the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all.”[22]  Indeed, buyers in Programmatic Sales “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.”[23]

The Court noted that, while these buyers “may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts[,] . . . the record establishes that with respect to Programmatic Sales, Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it.”[24]  Significantly, the Court reasoned that speculative intent alone was not enough to support a finding of an investment contract and that such intent needed to be tied to the continuing efforts of others.  Because the purchaser did not know that Ripple was the recipient of the funds, and that the funds would be used towards efforts to increase the value of XRP, the Court found that the third prong of Howey was not met, and, thus, the transaction did not involve a security or a violation of the Securities Act.

3.         Other Distributions of XRP are NOT Investment Contracts

When assessing the “Other Distributions” of XRP, such as distributions to employees as compensation and third-party developers, the Court found that “[t]he Other Distributions do not satisfy Howey’s first prong that there be an ‘investment of money’ as part of the transaction or scheme.”[25]  Rather, “Ripple paid XRP to these employees and companies” not the other way around.[26]  The Court further explained that the SEC did not develop the argument that the employees and/or third-parties companies are conduits, or underwriters because any receipt of funds for the sale of XRP by employees and/or third-parties does not trace back to Ripple.  As such, the Court held that there were no investment contracts and no Securities Act violations. [27]

4.         Individual Defendants’ Sales

Lastly, the Court found that Larsen’s and Garlinghouse’s sales of XRP were not investment contracts and did not violate federal securities law because, like the Programmatic Sales, these transactions were conducted on digital asset exchanges through blind bid/ask transactions.  Because “Larsen and Garlinghouse did not know to whom they sold XRP, and the buyers did not know the identity of the seller,” the Court reasoned, that based on the facts and circumstances here, “as a matter of law, the record cannot establish the third Howey prog as to these transactions.”[28]

B.        Defendants’ Due Process Defense

The Court rejected the Defendants’ due process defenses reasoning that Howey “sets forth a clear test for determining what constitutes an investment contract” and the case law interpreting it “articulates sufficiently clear standards to eliminate the risk of arbitrary enforcement.”[29]

C.        SEC’s Motion for Summary Judgment on Aiding and Abetting

The Court denied the SEC’s motion for summary judgment on its aiding and abetting claim against Larsen and Garlinghouse.  To establish liability here, the SEC had to show:[30]

1. the existence of a securities law violation by the primary party (as opposed to the aiding and abetting party);
2. knowledge of this violation on the part of the aider and abettor; and
3. substantial assistance by the aider and abettor in the achievement of the primary violation.

The Court found that the first element was met as to the Institutional Sales.[31]  As for the second prong, the Court explained that it need only find that Larsen and Garlinghouse had a “general awareness of their overall role in Ripple’s illegal scheme,” and that they “knew, or recklessly disregarded, the facts that made Ripple’s transaction and schemes illegal.”[32] 

The Court found that the SEC had not made the requisite showing. “Based on the record, Defendants have raised a genuine dispute of material fact as to whether Larsen and Garlinghouse knew or recklessly disregarded the facts that made Ripple’s scheme illegal.”[33]  The Court noted that Larsen and Garlinghouse had “stated that when the U.S. Department of Justice and the U.S. Treasury Department’s Financial Crimes Enforcement Network labeled XRP a “virtual currency” in 2015,[34] they understood this as an “official United States government declaration that XRP [was] a currency” and “exempt from [U.S.] securities laws.”[35]  The Court also noted a 2012 law firm memorandum that Larsen reviewed which concluded that there is a “compelling” argument that XRP “do not constitute ‘securities’ under the federal securities laws” and “that there is some risk, albeit small, that the [SEC] disagrees.”[36] The Court concluded that Defendants had raised a genuine issue of material fact as to whether Larsen and Garlinghouse “knew or recklessly disregarded facts about each of the Howey elements,”[37]  and found triable issues of material fact as to the third prong of “substantial assistance.”[38] 

III.      Conclusions

The Court’s decision breathes new life into the U.S. crypto market, which has been beleaguered by an onslaught of SEC enforcement actions premised on the SEC’s assertion that nearly all tokens are securities regardless of context.  All parties will likely appeal the decision.  As discussed above, this decision is not binding precent on other courts, but provides legal support for companies operating in the digital asset industry, and specifically, in the distribution of digital assets.

• Investment Contract Determinations Are Based on the Transaction, Scheme, or Contract. The Court continued to follow Howey and rejected the Defendants’ “Essential Ingredients” test and reaffirmed the facts and circumstances analysis required for these transactions.  The Court emphasized that the underlying asset of an investment contract cannot be conflated with the investment contract.  The asset that is subject of the investment contract, such as gold, sugar, and other ordinary assets may be sold as investment contracts, but the asset itself is not the security.  This part of the decision brings crypto jurisprudence back to the heartland of historical federal securities law application because, while a share in an orange grove may be a security, the orange itself is not.   
• Contracts Seem to Support Investment Contract Finding. The Court did “not address the SEC’s arguments that Howey does not require the existence of a written contract,” but noted that a contract did exist between Ripple and the XRP institutional purchasers.  The court noted that certain contract provisions, particularly the lockup provisions, implied that the purchasers had an investment intent, as opposed to a consumptive intent.  Those agreements also supported those purchasers’ expectation of profits from the efforts of others because they evidenced that the purchasers were aware that their money went directly to Ripple to aid in those efforts.  In contrast, the Programmatic and Individual Defendants’ Sales did not have any agreement between Ripple and the buyers, and no such provisions to support such an expectation.
• Marketing Efforts Continue to Support Finding an Expectations of Profits Based on the Efforts of Others.  Consistent with other courts’ reasoning, the Court relied on the marketing statements of Ripple promoters and whether those statements would lead a reasonable purchaser to expect profits derived from the continued efforts of a third party after purchasing the asset.[39]  Notably, the Court differentiated between how sophisticated and retail investors were aware of and understood these public statements.  In particular, the Court found that, unlike with the Institutional Buyers, there was no evidence that Ripple’s marketing materials were “distributed more broadly to the general public” to be considered by retail investors buying XRP through Programmatic Sales or even that such investors “understood that statements by Larsen, Schwartz, Garlinghouse, and others were representations of Ripple and its efforts.”[40]  In doing so, the Court appeared to be critical of the SEC’s selective excerpts from “multiple documents and statements” including “statements (sometimes inconsistent) across many social media platforms and news sites from a variety of Ripple speakers (with different levels of authority) over an extended eight-year period.”[41]  Regardless, any project distributing digital assets should be careful in understanding how its public statements—whether intended for marketing purposes or otherwise—may be interpreted by the public at the time of the statement or after the fact.
• In-Kind Payments or Airdrops May Defeat An Investment Contract Finding.  Perhaps the most novel implication of the Court’s ruling is that it arguably presents a path for introducing a new digital asset into the market that complies with U.S. federal securities laws.  This decision presents potential legal precedent to introduce new digital assets into the U.S. market, in which assets are (i) first transferred to employees as compensation and then sold to third parties on exchanges; (ii) sold directly on public exchanges in blind transactions, including through decentralized exchanges; or (iii) airdropped.
• Impact on Enforcement Actions Against Exchanges. Although the Court noted that it did “not address whether secondary market sales of XRP constitute offers and sales of investment contracts,” the decision still has immediate implications for the SEC’s ongoing investigations and enforcement actions, including, most notably, its proceedings against Coinbase and Binance. This case lends legal support to the argument that blind bid/ask transactions, like those conducted on Coinbase and Binance, are not offers or sales of securities.

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