Under the helm of SEC Chairman Gary Gensler, the Securities and Exchange Commission has argued that many cryptocurrencies qualify as “securities” under federal law, and therefore fall within the SEC’s bailiwick.[1] The SEC hasn’t shied away from acting on this asserted authority: just since the start of the new year, it has brought 24 cryptocurrency enforcement actions.
The SEC’s desire to regulate crypto suffered a blow on July 13, when Judge Analisa Torres of the United States District Court for the Southern District of New York issued her opinion on cross-motions for summary judgment in SEC v. Ripple Labs (“Ripple Labs”). Judge Torres ruled that while Ripple Lab Inc.’s (“Ripple”) sale of its crypto asset XRP to institutional investors constituted the unregistered sale of a security in violation of Section 5 of the Securities Act of 1933, its sale of XRP to less sophisticated “Programmatic Buyers” did not.[2]
While Ripple’s stock price soared after Judge Torres’s ruling, we argue that the crypto market’s enthusiasm for this opinion should be tempered by three considerations. First, the SEC also scored important victories in Ripple Labs related to institutional investors and Defendants’ due process defense. Second, the Court’s counterintuitive holding may be vulnerable on appeal. Third, even if Ripple Labs stands, its holding that many crypto tokens are not securities may inhibit the growth of a healthy crypto market.
Background:
As we have previously discussed, under federal law, a security is expansively defined to include “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights . . . .”[3] Whether something is deemed a security matters, in part, because under Section 5 of the Securities Act, it is unlawful to sell a security “unless a registration statement is in effect or has been filed with the SEC as to the offer and sale of such security to the public.”[4]
On December 22, 2020, the SEC filed a complaint against Ripple and two of its executives, alleging that they had engaged in the unlawful offer and sale of unregistered securities.[5] The parties filed their cross-motions for summary judgment in September 2022.[6]
Institutional Sales:
Judge Torres first held that Ripple violated Section 5 by selling XRP to institutional investors. In doing so, she applied the Howey Test, derived from Supreme Court’s opinion in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Howey defined an investment contract—which, in turn, is one of the definitions of a “security”—as “a contract, transaction, or scheme whereby a person (1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.”[7]
According to Judge Torres, Ripple’s sale of XRP to “sophisticated individuals and entities . . . pursuant to written contracts” (“Institutional Buyers”) satisfied Howey’s first prong because the Institutional Buyers made a “payment of money” to Ripple.[8] The same sales satisfied Howey’s second prong because the Institutional Buyer’s assets were “pooled and the fortunes of each investor [were] tied to the fortunes of other investors, as well as to the success of the overall enterprise.”[9] And the sales satisfied Howey’s third prong because the Institutional Buyers reasonably expected for profits to be derived from the efforts of others.[10] Specifically, the Court found “[f]rom Ripple’s communications, marketing campaign, and the nature of the Institutional Sales, [that] reasonable investors would understand that Ripple would use the capital it received from its Institutional Sales to improve the market for XRP and develop uses of the XRP Ledger, thereby increasing the value of XRP.”[11] The Court therefore found that under the Howey test, Ripple formed an investment contract when it sold XRP to Institutional Buyers, and had therefore engaged in the “unregistered offer and sale of [a security] in violation of Section 5 of the Securities Act.”[12]
Programmatic Sales:
In addition to its sales directly to Institutional Buyers, Ripple also made sales to “public buyers . . . on digital asset exchanges.”[13] Judge Torres held that these so-called Programmatic Sales did not constitute investment contracts because they did not satisfy Howey’s third prong.[14] Per the Court, the Programmatic Sales “were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP.”[15] Moreover, the Court determined that this subset of purchasers “did not derive [an] expectation [of profit] from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)” because many “were entirely unaware of Ripple’s existence and, unlike Institutional Buyers, had likely not seen Ripple’s promotional materials.”[16] Moreover, the Court concluded, these less sophisticated investors could not be expected to “parse through multiple documents and statements” to conclude that XRP’s value was linked to Ripple’s efforts.[17] Accordingly, Judge Torres held that “Ripple’s Programmatic Sales of XRP did not constitute the offer and sale of an investment contract.”[18]
Three Cautions for Crypto:
While Ripple Labs has been understood as “a win for Ripple,” we offer three cautions for crypto enthusiasts.
First, the SEC still notched an important victory of its own as to Institutional Buyers. If Judge Torres’s opinion takes hold nationwide, the swath of crypto sales made to institutional investors would likely be governed by the SEC. (Ripple Labs is just a district court opinion. It is not binding precedent even within the Southern District.) The SEC also succeeded in convincing the Court to reject Defendants’ due process defense that the SEC had not put them on notice that their conduct was unlawful.[19] The Court held that Howey and its progeny provided adequate notice to Defendants that they were engaging in the unlawful sale of unregistered securities as to Institutional Buyers.[20] The SEC will likely use this ruling in future enforcement actions when future crypto defendants raise due process defenses.
Second, the upshot of Ripple Labs is essentially odd and may be vulnerable on appeal as a result. It would require Ripple to register its sales only to those investors savvy enough to consume Ripple’s disclosure to discern that their funds would ultimately flow to Ripple for Ripple’s use to improve the price of XRP; conversely, had Ripple not made any disclosures, it likely would not have been found to have sold unregistered securities. This outcome inverts first principles of securities law, including that disclosures should be encouraged so as to allow investors to better assess risk, and that less sophisticated investors need more protection than the more sophisticated.[21] These odd results may encourage the SEC to file an interlocutory appeal and the Second Circuit to reverse.
Third, even if Ripple Labs does result in less SEC oversight of crypto, it is not obvious that it would help the industry. Especially in the aftermath of FTX’s implosion, crypto firms have struggled to convince investors that their industry is a good bet, and politicians that it should not be more heavily regulated. Should crypto tokens be subjected to a lighter regulatory touch as a result of this opinion, that could make it harder for crypto companies to dispel these concerns.
Conclusion:
Absent an interlocutory appeal, Ripple Labs is now slated to go to trial on remaining issues, including the SEC’s aiding and abetting claims against the two Ripple executives. This blog will continue to monitor Ripple Labs closely, and will provide updates on this case as well as on other noteworthy enforcement actions involving crypto assets.
[1] See, e.g., Gary Gensler, Prepared Remarks of Gary Gensler on Crypto Markets, Penn Law Capital Markets Ass’n Annual Conference, https://www.sec.gov/news/speech/gensler-remarks-crypto-markets-040422 (arguing that “many of the tokens trading on [crypto] platforms may well meet the definition of ‘securities’”).
[2] Compare Op. at 22, with id. at 25.
[3] 15 U.S.C.S. § 77b(a)(1) (emphasis added).
[4] Op. at 10.
[5] Id. at 8.
[6] Id. at 9.
[7] Id. at 11 (quoting Howey, 328 U.S. at 298–99 (cleaned up)).
[8] Id. at 16.
[9] Id. at 17.
[10] See id. at 18–22.
[11] Id. at 19.
[12] Id. at 22. (There was no dispute that Ripple’s sales satisfied the other elements of a Section 5 violation—that no registration was filed, and that the security was sold through interstate commerce.)
[13] Id.
[14] Id. at 23.
[15] Id.
[16] Id. at 24–25.
[17] Id. at 25.
[18] Id.
[19] Id. at 28–30.
[20] See id. at 29–30.
[21] Cf. Matt Levine, Ripple Is a Security and it Isn’t: Crypto Tokens are Securities Unless You Are Anonymously Dumping Them on Retail Investors, Bloomberg July 14, 2023, https://www.bloomberg.com/opinion/articles/2023-07-14/ripple-is-a-security-and-it-isn-t#xj4y7vzkg (arguing that Ripple Labs is “obviously terrible policy” that in “the exact opposite of the normal rule,” protects “sophisticated investors who negotiate directly with the company, not retail investors who trade on public exchanges” (cleaned up)); Edwin Hu, SEC v. Ripple: Everyone Loses, The CLS Blue Sky Blog July 18, 2023, https://clsbluesky.law.columbia.edu/2023/07/18/sec-v-ripple-everyone-loses/ (“[T]he opinion essentially holds that sophisticated institutions get the protections of the securities laws, while ordinary investors do not.”).
