A bifurcated decision in a highly anticipated digital assets enforcement action may not provide the clarity that market participants want or need.
On July 13, 2023, Judge Analisa Torres of the US District Court for the Southern District of New York issued an order on motions for summary judgment in the civil enforcement action brought by the Securities and Exchange Commission (SEC) on December 22, 2020, against Ripple Labs Inc. (Ripple), its former CEO (Christian Larsen), and its former COO and current CEO (Brad Garlinghouse). The SEC’s claims include the unlawful offer and sale of securities in violation of Section 5 of the Securities Act of 1933 (the Securities Act), as well as aiding and abetting the allegedly unlawful offer and sale of securities by the individual defendants (see this Latham blog post for more information).
The issue before the Court was whether, at the time of the various offerings, the defendants sold XRP as an investment contract. The Court determined at the outset 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. Rather, the Court examines the totality of the circumstances surrounding the defendants’ different transactions and schemes involving the sale and distribution of XRP.”
The Court assessed four categories of XRP offers/sales under Howey: (1) Ripple’s institutional sales, (2) Ripple’s so-called “programmatic sales,” (3) Ripple’s other distributions, and (4) programmatic sales by Larsen and Garlinghouse individually.
The Court held Ripple’s sales of XRP to “institutional investors,” pursuant to written contracts, constitute investment contracts and were not issued pursuant to valid registration under the Securities Act,[i] and thus violate securities laws. As to Ripple’s sales to institutional investors, the Court denied the defendants’ “fair notice” defense, finding that the Howey case[ii] and its progeny provided sufficient notice of what constitutes a security.
The Court also held that the other three categories of sales by Ripple and the individuals did not constitute the unlawful offer and sales of securities:
- Ripple’s sales of XRP to “programmatic buyers” (i.e., to the general public through digital asset exchanges or trading algorithms) and distribution of XRP as compensation (e.g., to employees), did not constitute investment contracts, and thus did not violate securities laws.
- Sales by the individual defendants of XRP to programmatic buyers likewise did not constitute investment contracts, and thus did not violate securities laws.
The next sections of this article analyze these holdings and their legal ramifications in greater detail.
The Court’s Legal Analysis
First. the Court stated that it rejected the defendants’ novel “essential ingredients” test,[iii] which would have required some privity with Ripple. The Court said that the defendants’ proposed test “would call for the Court to read beyond the plain words of Howey and impose additional requirements not mandated by the Supreme Court.”
Rather, the Court applied Howey to assess the four categories of XRP offers/sales at issue.
As described in the Court’s decision, institutional sales were sales of XRP to sophisticated individuals and entities, like hedge funds, pursuant to written contracts. The Court held that the institutional sales of XRP met all three prongs of the Howey test, and were therefore unregistered offers and sales of investment contracts in violation of the securities laws. The Court reasoned:
- An “investment of money” occurred because institutional buyers paid money (fiat or other currency) for XRP.
- The sales constituted a “common enterprise” because (1) Ripple pooled the proceeds of institutional sales, and (2) each institutional buyer’s pro rata profit was tied to the success of the enterprise and the success of other institutional buyers (i.e., because Ripple used those funds to promote and increase the value of XRP).
- Institutional buyers purchased XRP with a “reasonable expectation of profits” from Ripple’s efforts. The Court highlighted that Ripple communicated and marketed XRP to potential investors in various ways that connected XRP’s price and trading to Ripple’s efforts.[iv] Certain sales contracts also support that Ripple sold XRP to institutional buyers as an investment, rather than for consumptive use. In fact, some of the sales contracts actually stated that the purchaser was not purchasing XRP for use in connection with Ripple’s services. The Court also found that provisions such as lockups, resale restrictions, and indemnification clauses were indications that sales to institutional investors were investment contracts.
The ruling here is consistent with SEC enforcement precedent, such as that in SEC v. LBRY[v] (see this Latham blog post for more information) and SEC v. Telegram[vi] (see this Latham blog post for more information), given the Court’s finding that that Ripple used the fundraising to support its efforts that were tied to the value of XRP.
The second category of transactions, programmatic sales, were sales of XRP to public, retail buyers on digital asset exchanges or through the use of trading algorithms. The Court held that the “the economic reality and totality of circumstances” around programmatic sales of XRP did not meet the third prong of the Howey test[vii] and therefore did not violate securities laws. The Court reasoned:
- The SEC did not establish that programmatic buyers could reasonably expect that Ripple would use capital from those XRP sales to “improve the XRP ecosystem and thereby increase the price of XRP.” The SEC reached that decision because Ripple’s programmatic sales were “blind bid/ask transactions,” and programmatic buyers did not even know they were purchasing XRP directly from Ripple.
- Notably, in contrast to institutional buyers who knowingly bought XRP “directly from Ripple pursuant to a contract, […] 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 noted that less than 1% of the global XRP trading volume was from Ripple’s programmatic sales.
- Similarly, unlike the institutional buyers, Ripple did not make any promises or offers to the programmatic buyers because Ripple did not know who was buying the XRP and the purchasers could not have known that they were buying from Ripple.
- No contract existed between the programmatic buyers and Ripple.
- The SEC did not produce evidence establishing (i) that promotional materials given to institutional buyers were broadly distributed to the general public, (ii) that programmatic buyers understood that statements made by Larsen, Garlinghouse, and others were representations of Ripple and its efforts, or (iii) that a reasonable programmatic buyer, who might be generally less sophisticated than an institutional buyer, could parse through the multiple documents and statements across many platforms from a variety of Ripple speakers over an extended period.
The Court also maintained that a speculative motive on the part of the programmatic buyers is insufficient to satisfy the third prong of Howey. That expectation needs to be derived from the efforts of others, rather than “general cryptocurrency market trends.” This aspect of the decision certainly aligns with caselaw, in which the speculative purchase of assets whose value is determined by a broad marketplace does not constitute an investment contract.[viii]
Ripple also distributed XRP as a form of payment for services (e.g., as employee compensation) and as grants to fund third-party development of apps on the Ripple ecosystem. The Court held that such distributions of XRP did not violate securities laws because the recipients of the distributions did not pay money or otherwise provide tangible consideration for the XRP. “To the contrary, Ripple paid XRP to these employees and companies.” Specifically:
- The Court rejected the SEC’s argument that the other distributions were “indirect public offerings” because the parties that received XRP from Ripple could transfer that XRP to another holder.
- The Court found the SEC did not allege those recipients were Ripple’s underwriters or argue that those alleged secondary market sales were offers/sales of investment contracts.
To some in the industry, this was a surprising outcome and seems to be a narrower reading of the investment of money prong than might have been expected. The Supreme Court under Int’l Bhd. of Teamsters, Chauffeurs, Warehousemen & Helpers of Am. v. Daniel[ix] clarified that an investment of goods or services can constitute an investment of money under Howey, and the 2nd Circuit (the appellate court for the SEC v. Ripple case) in Uselton v. Com. Lovelace Motor Freight[x] further clarified that the investment of money prong is satisfied if the “economic realities of the transaction as a whole demonstrate […] an investment or ‘an exchange of value’.” Other courts have held that in the context of securities offerings, the disposition of value from the recipient to the offeror is not limited to the payment of money, but that value may accrue to the offeror in various ways.[xi] The Court nonetheless found that employees providing services to the company, and various third parties building applications in exchange for payment or compensation in XRP, did not constitute “definable consideration” to create an exchange of value sufficient to satisfy the first prong of the Howey test.
Sales by Larsen and Garlinghouse Individually
Sales of XRP by Larsen and Garlinghouse on digital exchanges through the use of trading algorithms did not violate securities laws because the sales were to programmatic buyers and thus resulted in the same analysis as described above.
Defendants’ Fair Notice Defense
The defendants each asserted a “fair notice” defense, claiming that the SEC violated their due process rights. Larsen and Garlinghouse also asserted an as-applied vagueness defense based on due process principles. According to the Court, the defendants’ due process and vagueness defenses required them to show that the laws at issue either (i) fail to provide a person of ordinary intelligence fair notice of what is prohibited, or (ii) are so standardless that they authorize or encourage seriously discriminatory enforcement.
Given the rulings discussed above, the Court considered the defendants’ fair notice defense only with respect to institutional sales. The Court held the defendants had fair notice and the SEC did not violate their due process rights:
- Howey sets forth a clear test for determining what constitutes an investment contract, and Howey’s progeny provide guidance on how to apply that test to a variety of factual scenarios.
- Howey is an objective test that provides the flexibility necessary to assess a wide range of contracts, transactions, and schemes. Further, Howey’s progeny articulate sufficiently clear standards to eliminate the risk of arbitrary enforcement.
- The SEC’s action against Ripple is “consistent with the enforcement the agency has brought relating to the sale of other digital assets.”
The ruling here is also consistent with that of SEC v. LBRY, Inc., where another district court dismissed a defendant’s claims of lack of fair notice (see this Latham blog post for more information).
Aiding and Abetting Claims Against Individual Defendants
To establish liability for aiding and abetting a securities violation, the SEC must show:
- the existence of a securities law violation by the primary (as opposed to the aiding and abetting) party;
- knowledge of this violation on the part of the aider and abettor; and
- substantial assistance by the aider and abettor in the achievement of the primary violation.
The Court found that the defendants raised a genuine dispute of material fact as to element (ii), and also as to element (iii) for the time after Larsen stepped down as Ripple’s CEO and became executive chairman (the defendants conceded element (iii) for the time Larsen and then Garlinghouse acted as Ripple’s CEO). The Court therefore denied the SEC’s motion for summary judgment as to the aiding and abetting claim, leaving these issues for trial.
Remedies Against Ripple Remain at Issue for Trial
In its First Amended Complaint, the SEC sought a final judgment with the following remedies:
- permanently enjoining the defendants from violating, directly or indirectly, Sections 5(a) and 5(c) of the Securities Act by delivering XRP to any persons or taking any other steps to effect any unregistered offer or sale of XRP;
- ordering the defendants to disgorge all ill-gotten gains obtained within the statute of limitations, with prejudgment interest thereon[xii];
- prohibiting the defendants from participating in any offering of digital asset securities; and
- ordering the defendants to pay civil money penalties.
As discussed above, the Court found that Ripple is liable only for Institutional Sales of XRP. These sales allegedly total approximately $729 million. The remedies against Ripple for this violation of securities law remains at issue for trial.[xiii]
As also noted above, Garlinghouse’s and Larsen’s potential individual liability for allegedly aiding and abetting Ripple’s Institutional Sales of XRP in violation of Section 5 of the Securities Act also remains at issue for trial.
As we discussed in a previous blog post, this case has been widely publicized as a lynchpin in the ongoing public discussion about the viability of digital assets and blockchain technology. Many market participants and media outlets quickly lauded the decision as a landmark legal victory and a watershed ruling for the crypto industry. But the direct implications of the ruling remain to be seen, given the nonbinding nature of a district court ruling on other cases and the fact-specific nature of the analyses, which are necessarily dependent on the “economic realities” and contractual terms of the offering, the nature of management’s involvement, and the specific representations made by the offerors.
While the industry has reason to celebrate the fact that the Court noted 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,” all should be mindful that the statement is not binding precedent on others courts.
The most helpful aspect of the Order may be that it reminds all involved that the securities laws are transactional in nature and do not necessarily rest on a certain status on an instrument. For example, if an instrument has the indicia of stock, it may be deemed a stock in each transaction in which such indicia continue to exist. On the other hand, the nature of an investment contract is such that the agreements and relationships of the parties involved are likely critical to the resulting analysis, and those could change from transaction to transaction. Further, this analysis supports the argument that at least some digital assets traded on exchanges and secondary markets — regardless of where the assets originated — may no longer be investment contracts. This would contravene the oft-repeated assertion of SEC Chairman Gary Gensler that “the vast majority of crypto tokens meet the investment contract test.”
An odd outcome of the Order is that it may lead to more robust protections for sophisticated institutional investors than for less sophisticated retail investors (programmatic buyers). The Order in effect treats retail investors as technical traders who buy and sell based on market dynamics rather than invest based on an evaluation of investment fundamentals. It is unclear what impact this may have on incentives to provide robust disclosures in connection with token transactions.
Lawmakers were quick to react to this counterintuitive policy result. On July 14, 2023, Patrick McHenry (Chairman of the House Financial Services Committee) and Glenn Thompson (Chairman of the House Agriculture Committee) issued a statement on the decision, noting that “outcomes like this are what happens when regulators force courts to make policy instead of Congress,” and that the split decision “underscores the need for Congress to provide clear rules of the road for the digital asset ecosystem.” They took the opportunity to endorse their own digital asset market structure bill (Financial Innovation and Technology for the 21st Century Act), draft legislation that seeks to close regulatory gaps and provide a functional framework for digital asset regulation in the US (see this Latham blog post for more information).
As noted, the Court’s conclusions do not represent binding precedent on other courts. They are subject to appeal to the Second Circuit Court of Appeals by the SEC or the defendants (or both sides). Indeed, the SEC has publicly stated that it will “continue to review the decision” In a recent filing in another digital asset enforcement action progressing in the Southern District of New York, the SEC called the Court’s reasoning into question and indicated its intention to consider and seek “the various available avenues for further review.”[xiv] A trial date on the remaining questions of fact has yet to be announced. The holdings should therefore not be taken to represent the final say on these complex issues.
[i] The Court did not address whether the sales were made pursuant to a valid exemption from the securities laws.
[ii] SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (holding that a contract, transaction, or scheme is an investment contract if a purchaser (1) invests money, (2) in a common enterprise, and (3) is led to expect profits solely from the efforts of the promoter or third party).
[iii] The defendants’ “essential ingredients” test held that in addition to the Howey test, all investment contracts must contain three essential ingredients: (i) a contract between a promoter and an investor that establishes the investor’s rights as to an investment, which contract (ii) imposes post-sale obligations on the promoter to take specific actions for the investor’s benefit, and (iii) grants the investor a right to share in profits from the promoter’s efforts to generate a return on the use of investor funds.
[iv] The Court cites for the factual record that “Ripple used the proceeds from the Institutional and Programmatic Sales to fund its operations.”
[v] SEC v. LBRY, Inc., No. 1:21-cv-00260-PB (D.N.H. 2022) (in which the Court found that LBRY’s offerings of LBC tokens were a form of capital raising to develop and operate the LBRY Network, which led token purchasers to have a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of LBRY).
[vi] SEC v. Telegram Group, Inc., No. 19 Civ. 9439 (S.D.N.Y. 2020) (in which the Court found that Telegram’s offerings of Gram tokens were a form of capital raising to develop and operate the TON Blockchain, which led token purchasers to have a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of Telegram).
[vii] The Court declined to address the first or second prong of Howey with respect to programmatic sales.
[viii] See, e.g., Noa v. Key Futures, Inc., 638 F.2d 77 (9th Cir. 1980); S.E.C. v. Belmont Reid & Co. Inc., 794 F.2d 1388 (9th Cir. 1986).
[ix] Int’l Bhd. of Teamsters, Chauffeurs, Warehousemen & Helpers of Am. v. Daniel, 439 U.S. 551, 560 (1979).
[x] Uselton v. Com. Lovelace Motor Freight, Inc., 940 F.2d 564 (10th Cir. 1991).
[xi] See, e.g., SEC v. v. Datronics Engineers, 490 F.2d 250 (4th Cir. 1973) (citing SEC v. Harwyn Industries Corp., 326 F. Supp. 943, 954 (S.D.N.Y. 1971)).
[xii] While the SEC can seek disgorgement from Ripple, the amount of disgorgement awarded, if any, will depend on a variety of factors and interpretation of recent case law and legislation.
[xiii] The jury would likely consider Ripple’s “pecuniary gain” resulting from the Institutional Sales.
[xiv] “[W]ith respect to the Programmatic and other sales, the SEC respectfully avers that [the] Ripple [decision] conflicts with and adds baseless requirements to Howey and its progeny. Respectfully, those portions of [the] Ripple [decision] were wrongly decided, and this Court [S.D.N.Y.] should not follow them.” SEC v. Terraform Labs Pte Ltd., No. 1:23-cv-01346 (S.D.N.Y. 2023), ECF No. 49.