[co-author: Craig McCarron Turner]

In a monumental decision that will likely have substantial ramifications for crypto industry developers, securities practitioners, and millions of investors and token purchasers alike, on July 13, 2023, the U.S. District Court for the Southern District of New York issued its long-anticipated opinion ruling on competing summary judgment motions in SEC v. Ripple Labs, et al., 20-cv-10832 (S.D.N.Y). Judge Analisa Torres issued a split decision, granting and denying different aspects of each of the parties' motions. Torres found that XRP, the primary digital token at issue in the matter, "is not in and of itself a 'contract, transaction [,] or scheme' that embodies the Howey requirements of an investment contract." This finding is singularly important not only for the Ripple defendants, but also to the larger digital assets industry, as the SEC has long taken the position that nearly all tokens are, in and of themselves, investment contract securities.

Rejecting the token-as-security argument as to XRP, the court assessed the totality of the circumstances for each type of transaction at issue, finding that three of the four categories of XRP transactions did not involve securities and thus could not serve as the basis for liability under federal securities laws. Although issued at the summary judgment stage with cabined language from the court and subject to potential down-the-line appeals, the potential implications for this decision are significant. For its part, the SEC walked away from the decision claiming a partial, but more limited victory: It defeated defendants' due process challenge that they lacked "fair notice" that the token and transactions at issue were securities, and it secured a finding that Ripple's XRP sales to institutional investors were, in fact, securities transactions.

The split nature of the decision is bound to raise questions, such as: Why doesn't a decision that an XRP token itself isn't a security end the analysis altogether? How could sales of XRP tokens be securities for some transactions and not for others? In this post, we distill the answers to these questions, provide an overview of the key aspects of the decision and offer several key takeaways.

Background

As we previously covered, in December 2020, the SEC charged Ripple and two of its executives (Christian Larsen and Bradley Garlinghouse) with purportedly raising more than $1.3 billion through an unregistered offering of digital asset securities in alleged violations of Section 5 of the Securities Act of 1933 (Securities Act). To establish violations of Section 5 under the Securities Act, the SEC needs to establish no registration statement was filed or in effect as the transaction at issue and the defendant directly or indirectly offered to sell or sold securities via interstate commerce. In simplest terms, the SEC needed to persuade the court that securities were involved.

The crux of the lawsuit involves whether Ripple's token – XRP – is itself a security under the federal securities laws or if the underlying transactions involving XRP were securities transactions. This analysis turned on the court's application of the multipart test established by the U.S. Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which held that an investment contract is 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 third party." 328 U.S. at 298-99.

After years of discovery battles chock full of combative briefing and compelling debates around such things as deliberate process privilege, the SEC and defendants filed cross motions for summary judgment earlier this year. The court's decision focused on two primary issues:

1. Did the four categories of XRP transactions constitute securities transactions based on the Howey test for establishing an investment contract security?¹
2. Did the defendants have "fair notice" about what conduct they were required or forbidden to take?²

Four Categories of XRP Sales

Although the parties disagreed on many aspects of the factual record in their briefing, there was seeming agreement on the four types of XRP distribution transactions at issue:

1. Sales of XRP directly to institutional investors (Institutional Sales)
2. Algorithmic sales of XRP on digital asset trading platforms (Programmatic Sales)
3. XRP distributions to Ripple employees and third parties (Other Distributions)
4. Sales of XRP by Garlinghouse and Larsen on various digital asset trading platforms

Each of these transactions occurred without the defendants filing any registration statements. With a nod to the Southern District of New York's opinion in SEC v. Telegram Grp., Inc., the Ripple court examined the totality of the circumstances around the XRP transactions. (Opinion, pp. 14-15).

Concerning the Institutional Sales, Ripple, through wholly owned subsidiaries, sold XRP directly to counterparties (primarily institutional buyers and hedge funds) pursuant to written contracts. The court found each element of Howey satisfied, holding that the evidence supported 1) an investment of money by the institutional investors; 2) "horizontal commonality" between Ripple and the Institutional Sales investors based on a pooling of investor funds whereby the investors' fortunes were tied to the success of the common enterprise; and 3) Ripple's communications, marketing campaign and the nature of the Institutional Sales would lead a reasonable investor to have a reasonable expectation of profits based on Ripple's efforts. For the third prong, the court relied heavily on Ripple's own promotional brochures, marketing reports and executives' public statements as "representative of Ripple's overall messaging to the Institutional Buyers about the investment potential of XRP and its relationship to Defendants' efforts." (Opinion, p. 21).³ Although siding with the SEC that these sales constituted securities, without discussion, the court summarily rejected the SEC's additional argument that the purchasers of XRP via the Institutional Sales served as underwriters. (Opinion, p. 22, FN 15).

For the Programmatic Sales, Ripple sold XRP tokens utilizing trading algorithms on digital asset exchanges via blind bid/ask transactions (meaning Ripple did not know who was buying the XRP and the purchasers did not know who was selling). Although Ripple used the proceeds from these sales to fund its operations, the court did not find sufficient evidence to support the SEC's allegations around the third Howey prong for the Programmatic Sales (expectation of profits based on efforts of others). The court relied heavily on the nature of the Programmatic Sales (blind bid/ask transactions), finding that purchasers in the 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." (Opinion, p. 23). Although the court acknowledged that purchasers via Programmatic Sales may have possessed some profit motive, "they did not derive that expectation from Ripple's efforts (as opposed to other facts, such as general cryptocurrency market trends) …" (Opinion, p. 24).⁴ Furthermore, the court found that there wasn't evidence that the Ripple promotional materials, marketing reports and public statements by Ripple executives were distributed broadly to XRP purchasers on digital asset exchanges, thus impacting the objective expectations of the Programmatic Sales purchasers.

Concerning the Other Distributions, these transactions included distribution of XRP as payment for employee compensation and to third parties in exchange for services. The court quickly disposed of the SEC's allegations, finding that the Other Distributions do not satisfy the "investment of money" prong for Howey. The court reiterated long-established Supreme Court precedent that "[i]n every case [finding an investment contract] the purchaser gave up some tangible and definable consideration in return for an interest that had substantially the characteristics of a security." (Opinion, p. 26 citing Int'l Bhd. Of Teamsters v. Daniel, 439 U.S. 551, 560 (1979)). The court found the record devoid of evidence that Ripple was able to fund its projects by virtue of these transfers, as Ripple never received payments in connection with the Other Distributions.

Finally, Larsen and Garlinghouse both sold XRP in their individual capacities on digital asset exchanges.⁵ As with the Other Distributions, the court quickly dispensed with this argument. Leveraging its analysis regarding the Programmatic Sales, the court found that the purchasers of the Larsen and Garlinghouse XRP sales did know the identity of the seller, thus undercutting any argument that the purchasers had expectations of profits based on the efforts of others.

Fair Notice Defense Rejected

As we previously detailed, the Due Process Clause of the Fifth Amendment entitles all persons to be informed as to what the State commands or forbids – in other words, to provide them "fair notice" of what they are supposed to do or not do. "A fundamental principle in our legal system is that laws which regulate persons or entities must give fair notice of conduct that is forbidden or required." FCC v. Fox Television Stations, Inc., 567 U.S. 239, 253 (2012). Laws fail to comport with due process when they 1) "fail[] to provide a person of ordinary intelligence fair notice of what is prohibited," or 2) are so standardless that they authorize or encourage "seriously discriminatory enforcement." Id.

Many within the crypto industry – particularly those embroiled in SEC enforcement investigations and litigation – have explicitly or implicitly asserted the fair notice defense for years. However, consistent with every other federal court considering the issue, the Ripple court found that – at least with regard to the Institutional Sales – the progeny of Howey case law that defines an investment contract provides a reasonable opportunity to understand what conduct is covered to a person of ordinary intelligence and articulates sufficiently clear standards to eliminate the risk of arbitrary enforcement. (Opinion, at 29). The court found that the SEC's particular allegations regarding Ripple's Institutional Sales were consistent with "enforcement actions that the agency has brought relating to the sale of other digital assets to buyers pursuant to written contracts and for the purpose of fundraising." However, as detailed further below, the court left the door open for fair notice challenges concerning other types of transactions.

Key Takeaways

As the SEC has transitioned its digital asset enforcement activities from token offering crackdowns to targeting crypto titans in the digital asset exchange space, the potential impact of this decision on the agency's enforcement efforts against intermediaries and exchanges is substantial.

• Significant Impact on Exchange-Based Sales: As discussed further below, Southern District of New York Judge Torres specifically noted that the court's opinion regarding secondary market transactions (sales via digital asset exchanges) was limited to the XRP sales at issue in the case. However, the decision seemingly has immediate implications for the agency's efforts to regulate digital assets issuances on exchanges where blind bid/ask transactions occur. If other federal courts follow similar reasoning – examining the economic realities and totality of the circumstances for those types of transactions – it's hard to envision how courts could deem such secondary transactions by developers and other insiders as satisfying the requirements of Howey without additional evidence tying such sales to specific statements or promotions by insiders.

More broadly, the opinion is a blow to the SEC's stated position that digital assets are always securities in every context, thus complicating enforcement investigations and potentially limiting certain theories going forward.

• Crypto Industry Claims of Victory May (or May Not) Be Overstated: It's hard to argue that this isn't a watershed win for the crypto industry, dealing the SEC a significant setback in a major digital asset litigation. However, there is a few aspects of the holding that could limit the impact many have read into the opinion.

First, the stage at which this decision was issued, and the court issuing the opinion, both matter. Although the court's grant of summary judgment on certain aspects of the case signal some measure of finality with regard to the SEC's jurisdictional reach (or lack thereof), an appeal would be deemed interlocutory at this stage, as the court did not dispose of the case in its entirety.⁶ Accordingly, absent an interlocutory appeal, the parties will need to wait to appeal this decision until the conclusion of the case, suggesting a complete resolution to this matter could take many months – and possibly years. Additionally, even though we expect that courts around the country will give considerable weight to this opinion, it is not binding on other courts within the Southern District of New York or U.S. Court of Appeals for the Second Circuit, or on other federal courts across the country.

Second, Judge Torres expressly declined to expand her opinion to secondary market sales of XRP or other tokens, noting that:

"[w]hether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme."

(Opinion, p. 23, FN 16)

Although we expect that digital asset exchanges will be able to leverage several aspects of this opinion for their benefit – most notably extending the Programmatic Sales analysis to argue there are no securities transactions at issue and thus they can't be considered unregistered exchanges – the order here does not resolve this question fully.

Third, the SEC now has the benefit of Judge Torres's opinion, meaning the agency's evidentiary development and argument advancement may – and likely will – adapt to the extent it pursues similar theories going forward. For example, the SEC may develop and advance more robust evidence of consideration offered by employees in exchange for tokens. Likewise, it may develop more concrete through lines between secondary market purchases and the "promises and offers made to investors." Given the SEC's explicit and aggressive enforcement stance regarding tokens as securities, we do not expect the SEC to retreat from the positions it has staked out – positions reinforced this week by Chair Gensler in his testimony before a Senate subcommittee where he referred to the crypto industry as "rife with noncompliance." Instead, we anticipate that the agency will look for ways to adapt to challenges and potentially undo this decision on appeal or attempt to minimize it over time as an outlier. These points bear watching going forward.

Fourth, Judge Torres highlighted several XRP- and Ripple-specific factors that weighed in favor on finding the Programmatic Sales did not constitute securities transactions. For example, 1) Ripple's Programmatic Sales represented less than 1 percent of XRP global trading; 2) Ripple's promotional materials that it distributed to institutional investors were not widely circulated; and 3) there wasn't evidence that the Programmatic Buyers understood statements by the individual defendants and others were tied to Ripple and its efforts (Opinion, at 23-24). Other parties may not have the benefit of these specific facts in their matters, which could swing a court's opinion in the other direction.

Although the opinion remains a landmark moment in the crypto industry's regulatory battle with the SEC, it hardly settles the debate on key issues facing the industry.

• Fair Notice Badly Wounded for Direct Sales but Still Alive for Other Transactions: The court's cutdown of the defendants' fair notice argument suggests that current and future defendants in other SEC enforcement actions will have a difficult time succeeding on this front. Here, the defendants had unique facts at their disposal – foreign regulators identifying XRP as a currency, with similar views from the Financial Crimes Enforcement Network (FinCEN) and U.S. Department of Justice (DOJ) – and they deftly secured a peek behind the proverbial SEC curtain to review drafts of speeches and other statements where SEC personnel highlighted concerns about potential agency inconsistencies. None of that swayed the court. For situations similar to the Institutional Sales facts here, it's hard to envision a successful challenge (at least within the Second Circuit).

However, Judge Torres did leave the door open for the three other categories of transactions at issue, stating in a footnote that "the SEC's theories as to the other sales in this case are potentially inconsistent with its enforcement in prior digital asset cases." (Opinion 29, FN 20). Notably, in support of this point, the court cited to Ripple's authority of Upton v. SEC, 75 F.3d 92 (2d Cir. 1996), a case advanced by several parties in support of fair notice arguments. We expect to see this Due Process argument repeatedly advanced by exchanges and other intermediaries in ongoing and future litigation.

Notes

¹ We note that the defendants dedicated a significant portion of their briefing advocating for an "essential ingredients test," a proposed three-prong addendum to Howey analysis centered around pre-Securities Act Blue Sky case law. In short, the proposed essential ingredients test involves 1) a contract between the promoter and investors that established rights to investment; 2) post-sale obligations by the promoter for the investors' benefit; and 3) a contract that grants the investor rights to share in profits from the promoters' efforts. The court declined to adopt the test, finding it "would call for the Court to read beyond the plain words of Howey and impose additional requirements not mandated by the Supreme Court." (Opinion, at 11).

² The opinion also considered whether Garlinghouse and Larsen aided and abetted Ripple's alleged violations of Section 5 of the Securities Act. The court briefly addressed this argument, finding that the defendants raised triable issues of fact as a reasonable juror could find that Larsen and Garlinghouse "did not know or recklessly disregard Ripple's Section 5 violations." (Opinion, pp. 32-33). We save for another day a discussion about the debate among longsuffering securities lawyers regarding proof of knowledge and intent for an aiding and abetting count, especially when the primary underlying violation is one involving non-scienter strict liability, as under Section 5 of the Securities Act.

³ The court also noted that certain characteristics of the Institutional Sales – such as lockup provisions, resale restrictions and indemnification obligations – were far more consistent with the character of a security than currency. (Opinion, pp. 21-22); see also SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352, 373 (S.D.N.Y. 2020). The court later contrasted these factors with the Programmatic Sales, finding that such limitations were not present for those transactions. (Opinion, p. 24).

⁴ Importantly, the court noted that this assessment is an objective one, meaning that it is not an assessment of the precise motivation for each individual purchaser.

⁵ One argument advanced by the defendants was that the SEC failed to prove that Larsen and Garlinghouse sold XRP on domestic exchanges. The court noted that it didn't need to address the arguments based on other findings. (Opinion, p. 28, FN 19).

⁶ Although interlocutory appeals are permissible, they are rarely granted in practice.