For the past several years, many have viewed “SEC v. Ripple” as one of the defining conflicts in the US crypto regulatory landscape. At the heart of this dispute is the question of whether digital tokens are “securities” for US securities law purposes. In a closely-watched ruling, on July 13, 2023 the US federal court hearing the case ruled on the parties’ cross-motions for summary judgment and made several key determinations on this question. While the Court’s decision provides a number of meaningful rulings, it leaves many questions unanswered and will not be the final chapter in this long-running dispute. Among the important findings are the Court’s holdings that:
- In the words of the Court, “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.”1
- Ripple’s contractual sales of XRP to direct counterparties, due to Ripple’s communications, marketing campaigns, and the stipulations built into the contracts themselves, constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act of 1933.2
- Sales of XRP by Ripple and its former and current CEOs on digital asset exchanges did not constitute the offer and sale of investment contracts because the buyers did not derive an expectation of profit from Ripple’s efforts, among other factors. Notably, however, the Court declined to address the question of whether secondary market sales of XRP constitute offers and sales of investment contracts, because that analysis would depend on “the totality of circumstances and the economic reality of that specific contract, transaction, or scheme.”
In this Legal Update, we will recap the long history of this dispute, analyze the Court’s rulings and describe what the Court’s decision means for digital assets in the United States.
XRP, and the electronically distributed ledger (or “blockchain”) on which it runs, was founded in 2012 as a faster, cheaper, and more energy-efficient alternative to the bitcoin blockchain.3 XRP is the native digital token of the XRP Ledger, and actions performed on the XRP Ledger require XRP in order to be completed.4 Ripple (formerly known as both NewCoin, Inc. and OpenCoin, Inc.) was created by Larsen and two other founders in order to develop and promote the XRP Ledger, with the goal of “moderniz[ing] international payments by developing a global payments network for international currency transfers.”5 Ripple was originally funded with 80 billion XRP (i.e., four-fifths of the total XRP supply), and, at all times prior to the end of 2020, held between 50 and 80 billion XRP.6
Between 2013 and 2020, Ripple, along with Christian Larsen and Bradley Garlinghouse (its former and current CEOs, respectively) in their respective roles as CEO of Ripple, engaged in sales and distributions of XRP pursuant to written contracts (“Institutional Sales”) and through digital asset exchanges (“Programmatic Sales”), and used XRP as a form of payment for services rendered by Ripple’s employees and third party companies seeking to develop new applications for XRP and the XRP Ledger (i.e., the “Other Distributions”).7 Ripple and its senior leaders, including Larsen and Garlinghouse, frequently promoted or marketed the advantages of the XRP Ledger throughout this period, including via brochures, quarterly “XRP Market Reports,” interviews as well as through posts on social media platforms.8
The SEC filed claims against Ripple, Larsen and Garlinghouse (each a “Defendant” and collectively, the “Defendants”) on December 22, 2020 in federal court in the Southern District of New York, alleging that each Defendant’s sales of XRP constituted the unlawful offer and sale of securities in violation of Section 5 of the Securities Act of 1933 (the “Securities Act”), 15 U.S.C. §§ 77e(a) and (c).9 The SEC also alleged that both Garlinghouse and Larsen aided and abetted Ripple’s Section 5 violations.10 The parties each moved for summary judgment on September 13, 2022.11
Section 5 of the Securities Act makes it unlawful for any person to directly or indirectly offer to sell or purchase a “security” in interstate commerce that has not registered with the SEC.12 The Defendants acknowledged that they did not file a registration statement with the SEC relating to the offer and sale of XRP. As a result, the Court’s decision focuses entirely on whether Defendants’ sales of XRP constituted sales of securities.13 The SEC alleged that Defendants marketed and sold XRP as an “investment contract,” which would constitute a “security” as the term is defined under the Securities Act.14 The Supreme Court set out the hallmark test for determining whether an instrument constitutes an investment contract in SEC v. W.J. Howey Co., determining that a contract, transaction or investment is an investment contract where “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.”15
Key Aspects of the Summary Judgment Ruling
- Digital Assets as investment contracts. Much like the citrus groves in Howey, the Court noted that sales of XRP would constitute the sale of investment contracts if the totality of the circumstances indicate that they satisfied the Howey test.16 That is, the totality of circumstances surrounding the different transactions and schemes involving the sale and distribution of XRP are critical to determining whether XRP is an investment contract, as “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.”17
- Contractual sales of XRP for money. The Court found that Ripple’s Institutional Sales of XRP, in each case conducted via written contracts to sophisticated individuals or entities, constituted the offer and sale of investment contracts under Howey. Ripple received money, and pooled such money into commonly-controlled accounts, in exchange for XRP. Ripple executives consistently marketed both the value of the payments industry they were trying to capture, as well as how their efforts were directly correlated with putting “upward pressure on XRP’s price.”18 Contracts governing Institutional Sales also often limited buyer’s conduct through obligations such as lockup provisions, resale restrictions based on XRP’s trading volume, indemnification provisions, or even express disclaimers that the buyer was purchasing XRP “solely to resell or otherwise distribute . . . and not to use [XRP] as an [e]nd [u]ser or for any other purpose.”19 The Court found that these facts were sufficient to support a finding that direct contracts for the purchase of XRP were entered into by institutional buyers as speculative investments in the future value of XRP, and ruled in favor of the SEC that Institutional Sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act.20
- Exchange-based sales. Even when taking Defendants’ public statements about price movements into account, the Court rejected the SEC’s argument that Programmatic Sales to public buyers on digital asset exchanges constituted the offer and sale of investment contracts. In particular, the Court held that the third Howey prong—requiring that an investment be made with the expectation to profit from the efforts of another—could not be met where purchasers of XRP could not have known whom they were transacting with when purchasing XRP from digital asset exchanges. The Court underscored that active speculation by buyers on future price movements of XRP, much like active speculation in the future value of other goods like horses or automobiles, “does not evidence the existence of an ‘investment contract’ within the meaning for the [Securities Act]” because “the expected return is not contingent upon the continuing efforts of another.”21 Programmatic buyers were also distinguished from their institutional counterparts; while Institutional Sales were conducted with sophisticated entities including institutional investors and hedge funds, who were targeted by direct marketing efforts and contractually bound to restrictions on their use of XRP, Programmatic buyers were generally “less sophisticated,” were not the recipients of direct marketing and had no way to know whether they were purchasing from Ripple or some other counterparty.22
- Distributions for consideration other than cash. The Court broadly held that distributions of XRP to employees or to third-party entities in exchange for their efforts to benefit XRP and the XRP Ledger failed the first prong of the Howey test and did not constitute the offer and sale of investment contracts because Defendants did not receive a payment of money or “some tangible and definable consideration” in exchange for the distributions.23
- Sales by Executives on digital asset exchanges. Consistent with its finding regarding Programmatic Sales, the Court held that Larsen and Garlinghouse’s sales of XRP—in each case occurring on various digital asset exchanges through blind bid/ask transactions—did not amount to offers and sales of investment contracts because neither Defendant knew to whom they sold XRP, and no buyer knew that Defendants were the ones selling their tokens.24
While this has been one of the most high-profile enforcement actions alleging that the sale or trading of certain digital assets constitutes a violation of Section 5, it is one of many that remain ongoing. Importantly, the Court’s decision does not bind other courts that are examining other digital assets or sets of facts to rule in the same manner. Nonetheless, this decision provides some useful guidance regarding how courts may consider offers and sales of digital assets as well as secondary transactions in digital assets. To that end, market participants may want to consider the following:
- The decision is unlikely to deter the SEC in its pending enforcement actions or cause it to change its approach to digital tokens. The SEC will likely look to the parts of the Court decision that are in its favor to validate its continued views on the regulatory status of digital tokens.
- The portions of the decision that are in Ripple’s favor are fairly fact-specific, and while there may be others similarly situated in the market, some others in the marketplace may find it challenging to rely on those portions of the decision if their circumstances do not directly align.
- Direct (or “primary”) token sales made to investors will have to surmount several hurdles in order to avoid running afoul of Howey. While the Court did not provide guidelines on when primary sales should not constitute sales of investment contracts, the decision clearly limits founders’ ability to engage in pre-offering token sales (which often feature lock-up periods and may occur prior to the time at which the tokens could be used for anything but speculative investing). Protocols should be mindful of the product-stage at which they choose to make private token offerings, any representations they make in connection with such offerings, and any restrictions they contractually place on the use of such tokens.
- “Blind” or anonymous token sales (“secondary sales”) conducted via digital asset exchanges (as opposed to launch pads25 or other transactions where the founding protocol is clearly selling the tokens) may not constitute the sale of investment contracts, subject to an assessment of the marketing efforts and communications relating to such secondary sales. One aspect that remains unclear is how protocols should properly fund exchanges or market makers with tokens in the first instance, particularly due to the Court’s analysis regarding direct contractual, or primary, sales.
- Distributions of tokens to employees as compensation for their efforts, or from foundations to third party companies to support development on a protocol, were found by the Court, in this instance, not to constitute investment contracts so long as they did not include “some tangible and definable consideration.” It is not clear from the Court’s ruling what might meet this standard; while it does not seem likely that task-based compensation (i.e., providing token payments or rewards for executing discrete tasks) would be sufficiently “definable,” protocols should be cautious of receiving any tangible assets (such as other tokens or currency) in exchange for any token distributions they issue.
- While questions may abound with respect to tokens generally under the Howey test, the Court’s ruling does not impact the status of a cryptocurrency token as a “commodity” under the Commodity Exchange Act (“CEA”), as administered by the Commodity Futures Trading Commission (“CFTC”).26 Irrespective of whether a token is a security, such cryptocurrency token remains a commodity under the CEA, which permits the CFTC to prosecute fraud and manipulative conduct in the spot and derivatives crypto markets.
25 “Launch pads” are decentralized exchanges that enable users to purchase tokens from emerging protocols that have not yet been listed on digital asset exchanges. These sales may be funded by tokens from the emerging protocols themselves, and are typically offered to purchasers in a variety of different sale or auction formats. As no third party market exists for the token at the time of the launch pad sale, users may infer that any purchases are being made directly from the emerging protocol.
26 See In the Matter of Coinflip, Inc. d/b/d Derivabit, and Francisco Riordan, CFTC Docket No. 15-29 (Sept. 17, 2015). See also, Commodity Futures Trading Comm’n v. McDonnell, 287 F.Supp.3d 213 (E.D.N.Y. 2018); see also Commodity Futures Trading Comm’n v. My Big Coin Pay, Inc., 334 F.Supp.3d 492 (D. Mass. 2018).