Ripple Labs: long-awaited decision answers some questions but gives rise to further uncertainty
Dario de Martino
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In SEC v. Ripple Labs, the U.S. Securities and Exchange Commission (“SEC”) alleges that Ripple Labs, Inc. and two of its executives raised over $1.3 billion through an unregistered and ongoing digital asset securities offering (“XRP”).
On July 13, 2023, District Judge Analisa Torres of the Southern District of New York issued the long-awaited decision (the “Order”) on the parties’ motions for summary judgments concerning whether XRP constitutes a security under the Supreme Court’s Howey test. In a headline ruling, the district court determined: “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 Defendants’ different transactions and schemes involving the sale and distribution of XRP.”
In the Order, the district court held that institutional sales of XRP to sophisticated individuals and entities constituted the unregistered offer and sale of securities in violation of Section 5 of the Securities Act of 1933, granting summary judgment on this point to the SEC, because institutional buyers purchased XRP directly from Ripple pursuant to a written contract. Still, perhaps more consequentially, the district court held that Ripple’s sale of XRP to the general public through algorithms and exchanges and other distributions did not constitute an offer and sale of an investment contract, granting summary judgment on those separate points to Ripple.
Ripple has marketed cryptocurrency XRP since 2013, selling the asset in exchange for fiat or other currencies. Between 2013 and 2020, Ripple sold over $1.38 billion worth of XRP, but did not file a registration statement listing XRP as a security with the SEC. The SEC alleges that Ripple and its executives marketed XRP as an investment opportunity and influenced its price and liquidity by controlling the supply and distribution of the digital asset. The SEC also alleges that the executives personally profited by selling XRP worth about $600 million to the public, while making false and misleading statements about XRP's status, utility, and regulatory compliance.
The crux of the SEC’s allegations is that XRP is a security that, in every instance, must be offered and registered pursuant to Sections 5(a) and 5(c) of the Securities Act of 1933 or qualify for an exemption from registration. The agency argues that XRP is an “investment contract” under SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which held that “investment in a common venture premised on a reasonable expectation of profits to be derived from the . . . efforts of others.”
Howey considered whether an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor, constituted an “investment contract” under Section 2(1) of the Securities Act of 1933. The Supreme Court held that an investment contract under the Act meant a contract, transaction, or scheme whereby a person invested his money in a common enterprise and was led to expect profits solely from the efforts of the promoter or a third party. It is immaterial under Howey whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
Ripple contends that the offer and sale of XRP do not have the “essential ingredients” of an investment contracts: (i) many XRP transactions occurred without a contract between Ripple and the buyer; (ii) the contracts that did exist did not impose post-sale obligations for Ripple to act for the buyer’s benefit; and (iii) the contracts gave buyers no right to any share in Ripple’s profits. Thus, Ripple maintains that XRP is not a security, but a digital currency that functions as a medium of exchange and a bridge between different fiat currencies and other digital assets. Ripple also claims that the SEC's lawsuit is arbitrary and inconsistent, as the agency has previously recognized that Bitcoin and Ethereum, two other popular cryptocurrencies, are not securities.
July 13, 2023 Order
Out of three disputed categories of sales of XRP by Ripple, the district court held that Ripple’s sales of XRP to institutional investors via written contract met the first two prongs of the Howey test, which are an investment of money and a common enterprise, based on the undisputed facts that Ripple received money for XRP, pooled the proceeds, and tied the profits and risks of the buyers to each other and to Ripple’s efforts. As to the third prong of Howey, the court found that these institutional sales of XRP created a reasonable expectation of profits for the institutional buyers as they were sophisticated enough to understand Ripple’s promises and actions to increase XRP’s value, including Ripple’s marketing and development of XRP and the XRP Ledger which led the institutional buyers to expect profits from Ripple’s efforts. As part of this analysis, the district court rejected the Ripple’s proposed “essential ingredients” test as unmoored from Howey’s plain words. The court also noted that the nature of the sales to institutional buyers via a written contract that included lock-up provisions or resale restrictions based on XRP’s trading volume supports the conclusion that Ripple sold XRP as an investment rather than for consumptive use.
By contrast—in a ruling that covers roughly half of the sales of XRP—the district court held that Ripple’s programmatic (algorithmic) sales of XRP to the general public through blind bid/ask trades on public exchanges did not constitute an unregistered offer and sale of securities. Notably, the court concluded that programmatic sales did not satisfy the third prong of the Howey test, as the public buyers could not have been aware of the various statements and marketing campaigns linking the token’s price performance to the company’s performance. The court applied similar reasoning to its treatment of other distributions where employees and third parties were awarded XRP as compensation, noting that such other distributions did not constitute an offer and sale of investment contracts because there was no investment of money.
An important ambiguity in the decision relates to trading in secondary markets. On the one hand, the district court ruled that XRP sales to the general public through exchanges and algorithms did not constitute a violation of the securities laws. At the same time, however, in footnote 16, the court expressly provided that Order does not address “whether secondary market sales of XRP constitute offers and sales of investment contracts.”
In other parts of the Order, the district court rejected the due process defense based on lack of notice for claims relating to the institutional sales. In addition, the court found a triable issue of fact as to whether Ripple’s senior executives aiding and abetting the underlying securities violations, citing determinations by non-U.S. regulators that XRP did not constitute a security and prior statements by SEC officials that certain digital assets (bitcoin and ether) were not securities.
The Order is not necessarily inconsistent with prior decisions in the Telegram case (2020) or the more recent decision in LBRY (2022) holding that offerings of digital assets constitute securities. The Order by Judge Torres, while addressing many important questions predominating over the regulation of digital assets, likely raises as many new question as it answers. We believe there will be substantial regulatory debate and further litigation along a number of substantive lines. Here are a few to consider:
- Who won? In the immediate aftermath, both the SEC and the digital asset industry are claiming success. Market participants and counsel should watch whether either the SEC or Ripple, or both, seek immediately to appeal Judge Torres’ Order to the Second Circuit Court of Appeals in order advance controlling questions of law where there is substantial ground for a difference of opinion.
- The dividing line between security and no longer a security. The Order appears to demarcate the treatment of tokens depending on whether it is sold pursuant to a formal undertaking or merely distributed through an exchange or a decentralized secondary market. This distinction is crucial when it comes to programmatic sales and other sales. Once the development of the enterprise that is imbedded in the investment contract is either severed from the underlying token or the undertaking has been completed, the Order indicates that it is difficult to continue to characterize the token as a security. Where exactly this line is drawn (the border between “security” to “no longer a security”) is still very murky, but at least superficially, the district court accepted the existence of this line. This theoretical line drawing exercise is integral to the defenses advanced by other defendants in the SEC’s on-going suits in both primary issuances and sales in secondary markets. If the district court’s position that XRP sales to the general public through exchanges and algorithms did not constitute a violation of the securities laws is adopted with respect to secondary market activity, this principle may prove dispositive in claims against digital asset exchanges alleged to have operated unlicensed securities exchanges.
- Implications for DOJ and SEC enforcement matters: Very clearly the Order will have broad implications for the many DOJ and SEC enforcement actions alleging fraud, manipulation and insider trading in digital asset instruments and markets. We note that as part of the various enforcement actions filed yesterday (July 13) against Celsius and its founder and chief executive officer, the SEC appears to have adopted a more traditional approach in order to establish that the Celsius token is a security. For example, the SEC alleged that Celsius executives “viewed CEL as comparable to stock in a public company” and that the chief executive officer “wrote in an internal message that he wanted ‘to be able to talk about CEL just like public companies talk about their stock.’”
- Implications for exemptions. Another potential implication of the Order is that if the issuer relies on an available exemption from registration for an initial placement—whether Regulation S for offshore sales to buyers who are not U.S. persons or Section 4(a)(2) of the Securities Act for private placements—then subsequent market sales by the initial token holders may be sales of non-security digital assets. The district court’s distinction between an institutional buyer who directly purchases a token and the programmatic buyer who “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money” suggests that a buyer of tokens from an initial holder of tokens purchased through a Regulation S or private placement also may not know to whom or what it is paying its money to and deemed not to be holding a security.