On July 13th, Judge Analisa Torres of the United States District Court for the Southern District of New York entered an order that was quickly celebrated by the crypto world (SEC v. Ripple Labs, Inc., No. 20CIV10832ATSN; S.D.N.Y. July 13, 2023). Essentially, the token XRP, which is offered by Ripple Labs, Inc. (“Ripple”) was found to not be a security, and therefore not under SEC jurisdiction when sold on exchanges via blind/ask transactions. The celebration, however, may be premature, as the opinion is not binding on other district courts and still may be appealed by both sides.
The court used the Howey test to determine whether four different categories of XRP sales could be considered an investment contract. Under the Howey test, an investment exists under three conditions: there is (1) an investment of money (2) in a common enterprise with a (3) reasonable expectation of profits derived from the work of others (See SEC v. W.J. Howey Co., 328 U.S. 293, 299; 1946). The court found that XRP’s institutional sales satisfied the Howey test, meaning institutional sales by XRP would fall under SEC jurisdiction. However, the other three sales categories –– programmatic sales, the sales by co-founder Bradley Garlinghouse and CEO Christian Larsen, and other sales – all failed to satisfy the Howey test, meaning that the SEC would not have jurisdiction over these sales.
Ripple’s institutional sales of XRP, which total $728 million, was the only sales category found to be in violation of securities law. The judge found the payment of money is no different than an “investment of money,” which was exactly what the defendants wanted, as this would potentially end the case against them (SEC v. Ripple Labs, Inc., No. 20CIV10832ATSN, slip op. 16; S.D.N.Y. July 13, 2023). The court also found there was a common enterprise by a showing of horizontal commonality, or the tying of each individual investor's fortunes to the fortunes of the other investors through the pooling of assets. The court finally concluded that reasonable investors such as the institutional buyers would purchase XRP and expect to derive profits from such. As all of the elements of the Howey test were satisfied and in the totality of the circumstances, the defendants violated Section 5 of the Securities Act by offering and selling unregistered securities.
However, as previously stated, no other category of sales satisfied the Howey test.
Programmatic sales failed the third component of the test (reasonable expectation of profits derived from the work of others). The court reasoned programmatic buyers on an exchange performing blind bid/ask transactions would not reasonably expect Ripple to use the capital received from XRP to improve the XRP ecosystem and the price of XRP. The court reasons this as these transactions were all blind bid/ask, meaning the purchasers could not know if their payment went to Ripple, unlike the institutional buyers. As these transactions were sold through an intermediary, a crypto exchange, all these buyers knew was they were buying or selling XRP without knowledge of other parties involved with the transaction. The institutional buyers had contracts that spelled out the plan for XRP and Ripple and it would be much easier to figure out the connection between the two. The court concluded that a reasonable programmatic buyer is generally less sophisticated than an investor; they would be unlikely to review documents and statements over an eight-year period. As a result, offering XRP to programmatic buyers is not an investment contract, according to the court.
The court found that individuals’ sales of XRP (i.e., Garlinghouse and Larens’ sales), were also programmatic sales, thus violating the third component of Howey for the same reasons, and excluding these sales from SEC jurisdiction.
The broad “other sales” category included Ripple’s payment of XRP to employees and companies. Since it did not involve individuals purchasing XRP, the court did not consider these sales an investment of money. Therefore, Ripple’s “other sales” failed to meet the first component of the Howey test, and likewise were ruled to be outside of SEC jurisdiction.
This order sets forth that the defendants only violated the law in respect to institutional sales, and there will be further proceedings to determine the remedy for this violation.
This case, if upheld on appeal and becomes precedential, has the power to limit the SEC’s enforcement power in relation to cryptocurrencies on exchanges. The potential for fraud in the digital sector rises with the threat of lessened enforcement jurisdiction. However, another judge from the same court has already explicitly ruled against this decision. On July 31st, Judge Jed S. Rakoff stated Howey makes no difference between these types of buyers in the third prong, “[a]nd it makes good sense that it did not.” (SEC v. Terraform Labs Pte. Ltd. & Do Hyeong Kwon, No. 123CV01346JSR, slip op. at *40-41; S.D.N.Y. July 31, 2023).
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