The crypto industry secured a key victory in its court battles with the Securities and Exchange Commission (SEC or Commission) on Thursday, July 13, when Judge Analisa Torres of the U.S. District Court for the Southern District of New York said that Ripple did not break the law when the cryptocurrency it created, XRP, was sold on public exchanges.
Background
In 2012, Ripple Labs—a United States-based technology company—developed Ripple’s blockchain infrastructure hoping to build on then-nascent Bitcoin technology. RippleNet, the resulting payment network, was designed to provide banks with a faster, more cost-effective and streamlined option for conducting cross-border transactions. RippleNet is a real-time gross settlement system, a currency exchange and remittance network, and the company behind the XRP ledger (XRPL), which facilitates payments through its XRP (XRP) cryptocurrency.1
SEC Lawsuit
XRP was offered through an initial coin offering that the SEC contends was an illegal unregistered securities offering. Ripple contended that XRP was not a security and therefore it could not have violated the federal securities laws. The SEC disagreed and brought an enforcement action.
The SEC has been bringing enforcement actions against ICO issuers for a number of years.2 The Commission has contended that most crypto assets meet the definition of a security under the 1946 Supreme Court decision SEC v. S.J. Howey Co.3 because purchasers buy them hoping to profit from the efforts of their promoters and creators. The so-called Howey Test has been used to analyze whether an asset is a security by looking to (1) an investment of money, (2) an expectation of profits from the investment, (3) the investment of money is in a common enterprise, and (4) the expectation of profit comes from the efforts of promoters. In addition to ICO issuers, the SEC has sought significant actions against some of the world’s largest crypto exchanges and platforms,4 alleging that they facilitate a marketplace for transactions in unregistered securities or receive transaction-based compensation for the sale of securities, both hallmarks of the definition of a “broker.”5
After initial discussions failed to yield a compromise, on December 22, 2020, the SEC filed suit against Ripple and its executives Brad Garlinghouse and Christian Larsen for failing to register XRP as a security before offering around $1.3 billion of tokens.6 The SEC and Ripple brought cross-motions for summary judgment.
SDNY Ruling
SEC’s Motion for Summary Judgment Granted as It Applies to Institutional Sales
According to the order from the U.S. Court for the Southern District of New York, Ripple first sold roughly $728.9 million worth of XRP directly to institutional investors, hedge funds and other parties. These “institutional sales” constituted an unregistered offer and sale of investment contracts in violation of federal securities law as the court found that these sophisticated investors would have purchased XRP with the expectation that they would profit from Ripple’s work.7 The ruling further noted that Ripple used the funds it received from these institutional sales to “promote and increase” the value of its native XRP coin by developing uses for XRP and protecting the XRP trading market. Therefore, to the chagrin of the company, XRP when offered in this manner, is a security. Moreover, the offering failed to avail itself of the typical exemptions from registration such as the private placement exemptions of Regulations D and S.8
Ripple’s Motion for Summary Judgment Granted as to All Other Sales
The court later in the decision ruled that “programmatic sales” and resales of XRP through exchanges and algorithms, on the other hand, did not qualify as the sale of securities because the SEC could not definitively prove that speculative investors had “a reasonable expectation of profits to be derived from the entrepreneurial efforts of others.” In concluding this, the court keenly noted that noninstitutional buyers9 are generally less sophisticated and could not share similar understandings and expectations of profit as institutional ones. In a sense, the investors on the resale market were probably unaware of what XRP was and were expecting profits not from the efforts of the company but from the dynamics of being on a liquid trading market. Stocks go up because they do, in a sense. The court further held that Garlinghouse’s and Larsen’s own sales of XRP fell into this category as well.
This is a curious decision in our view since it bifurcates whether an offering is a securities offering by whether the investor had actual intent to profit from the enterprise behind XRP or just that it’s a token that might trade higher. One could argue many investors in the stock market have the exact same characteristics, and they are not trading for fundamental reasons but for technical reasons. It begs the question how any issuer is supposed to discern investor intent in any sale of a security, and that two identical sales could each have a different status based on the intent and awareness of the purchaser. It is of course possible that a thoughtful non-accredited investor was purchasing XRP expecting profits from the Ripple common enterprise; conversely, an institutional investor may not have known what XRP was or why it would trade up or down. Many in the cryto space are highly knowledgeable and thoughtful about the technology through the chat spaces (eg, Twitter, Telegram, Reddit) despite not being necessarily accredited.
If one were to expand this ruling more broadly, it calls into question whether secondary stock trading involves securities. Stock of course go up and down and even experts disagree frequently on the trajectory of a particular listing. Does this ruling stand for the notion that fundamental investors are purchasing and selling securities and technical strategists and index buyers are not? There will be many questions raised here even outside of crypto in the overall financial markets.
Market Response
In response to the ruling, XRP soared to around 80 cents per token—representing over a 70% increase from the previous day, much of it due to the resolution (for now) of the litigation. Ripple’s chief legal officer, Stuart Alderoty, celebrated the ruling on Twitter, declaring it a “huge win” and stating that “sales [of crypto assets] on exchanges are not securities.”10 We would caution issuers and investors to be more tempered in their responses. The ruling is clearly an important step in establishing that some sales of some tokens are not securities offerings, but it does not stand for the idea that the securities laws do not apply to token sales. Clearly in Judge Torres’ ruling they do, and this is only the denial of a motion to dismiss; our read is that the court was not satisfied that the SEC satisfactorily proved its case to merit the granting of its motion to dismiss.
What’s Next
The Ripple ruling is a significant decision and represents a major win for industry leaders seeking to avoid regulation by the SEC. However, it does not mean that all cryptocurrencies are not securities, or that sales of cryptocurrencies are not securities offerings. The SEC has argued that a wide array of cryptocurrencies constitute securities. The judges in those cases will have to make separate rulings when analyzing whether the sale of those digital assets broke securities laws. We believe this decision will be interpreted to narrowly apply to the programmatic resale market, which is not what issuers use to raise capital.
It is likely both sides will appeal the decision the U.S. Court of Appeals for the Second Circuit, where the judges will be able to affirm, overturn or modify Judge Torres’ decision. Based on the principles of stare decisis, it would seem only the U.S. Supreme Court or Congress can modify the Howey test or narrow it in a meaningful way.
How to properly regulate cryptocurrencies will remain a hot-button issue. Just this week, a revised bipartisan bill was reintroduced in the Senate that would grant the CFTC power to be crypto’s primary regulator.11
We appreciate the contribution of Summer Associate Jake Barroway to this article.
1 https://cointelegraph.com/learn/what-is-ripple-a-beginners-guide-for-understanding-ripple
2 See https://www.sec.gov/news/press-release/2019-87 and https://www.sec.gov/news/press-release/2020-146.
3 328 U.S. 293 (1946).
4 https://www.npr.org/2023/06/10/1181242780/sec-gary-gensler-binance-coinbase-crypto-lawsuits-battle
5 https://www.sec.gov/news/public-statement/lee-proposed-finders-exemption-2020-10-07
6 https://www.sec.gov/news/press-release/2020-338
7 https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf
8 It is common for well-advised issuers who are selling tokens to institutional and high net worth purchasers to “hedge their bets” on whether the token is a security by nonetheless complying with the exemptions from registration available to such offerings under the federal securities laws. Compliance with the private placement exemption, for example, would not cost very much up front and the issuer would have been able to raise the same amount in proceeds, assuming the investors met the modest accredited investor test. The downside of doing this, besides only be able to sell to accredited investors, is that tokens would have a one year holding period before they could be sold on the secondary market.
9 The secondary market for XRP was not limited to accredited investors.
10 https://twitter.com/s_alderoty/status/1679553612236881921
11 Blockchain Update: Lummis-Gillibrand Crypto Regulation Bill Reintroduced Following Tumultuous Year - Manatt, Phelps & Phillips, LLP