New York District Court Decides Significant Cryptocurrency Case, Holding That Whether Cryptocurrency Is A Security Turns On When And How It Was Sold
On July 13, 2023, Judge Analisa Torres of the United States District Court for the Southern District of New York issued a decision on the parties’ cross-motions for summary judgment in SEC v. Ripple Labs, Inc., No. 1:20-cv-10832-AT-SN, holding that Ripple Labs, Inc. (the “Company”) unlawfully sold unregistered securities in violation of the Securities Act of 1933 (the “Securities Act”) by selling its cryptocurrency token, XRP, to certain institutional buyers, while at the same time holding XRP was not a security within the meaning of the Securities Act when sold on digital asset exchanges, given the different circumstances and expectations of buyers in those transactions. The Court also held that the Company’s distributions of XRP to employees and third parties for the development of its project did not constitute sales of unregistered securities. This is a pivotal decision for the cryptocurrency market and is a significant win for cryptocurrency exchanges in particular. While the decision will almost certainly be appealed in due course, the Court’s thorough analysis could have a significant impact on the SEC’s pending enforcement efforts across the industry.
The SEC brought an action against the Company and two of its senior officers and founders for “the unlawful offer and sale of securities in violation of Section 5 of the Securities Act.” The SEC also alleged that the officers aided and abetted the Company’s Section 5 violations. Section 5 of the Securities Act makes it unlawful for any person to offer to sell, offer to buy, or sell a security unless a registration statement has been filed with the SEC for that security. And because there was never any dispute that no registration statement was filed for XRP, the Court’s decision turned on whether XRP was a security under the seminal Supreme Court case, SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and therefore whether defendants offered to sell or sold XRP as an unregistered security in violation of the Securities Act.
Beginning in 2011, the Company’s founders began developing a secured ledger (a “blockchain”) called the XRP Ledger. When the XRP Ledger launched in 2012, it generated a fixed supply of 100 billion XRP, which is the “native digital token of the XRP Ledger.” The XRP Ledger requires XRP to operate. After the founders formed the Company, they retained 20 billion XRP for themselves and provided 80 billion XRP to Ripple. From 2013 through 2020, the Company engaged in and allowed for various sales and distributions of XRP. It is these sales and distributions that the SEC challenged as offers and sales of unregistered securities (investment contracts).
The SEC alleged that the Company engaged in three categories of unregistered XRP offers and sales: (1) sales to sophisticated individuals and entities (the “Institutional Buyers”) pursuant to written contracts (“Institutional Sales”) for which the Company received $728 million; (2) sales to public buyers on digital asset exchanges (“Programmatic Sales”) for which the Company received $757 million; and (3) distributions granted to employees and other third parties under written contracts (“Other Distributions”) for which the Company received $609 million in “consideration other than cash.”
As an initial matter, the Court made clear that a token such as XRP itself is not a security, but rather, depending on the terms and conditions under which it is sold, may form an investment contract that constitutes a security. Thus, the court analyzed each of these categories of transactions separately under Howey, which defined an investment contract 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.” And in doing so, the Court made clear that an investment contract does not require anything that looks like a written contract of sale or equivalent; any set of “transactions” or “scheme” taken together can ultimately establish the essential elements of Howey’s three-part test—something that defendants had argued against but an analytical point on which the SEC prevailed. The Court also had no issue with the idea that the determination of whether digital assets like XRP are securities is readily susceptible to analysis under Howey—in other words, the Court did not suggest that there was any concern with applying current securities law and its interpretations to digital assets, an issue that has been much debated. Where the SEC did not fully prevail is how the Court applied that test to the facts at hand, which could have significant consequences.
The Court first applied the three-party Howey test to the Institutional Sales. It found the first prong was easily met because the Institutional Buyers invested money in exchange for XRP. For the second prong, the Court analyzed whether investors’ assets were pooled and, relatedly, whether the fortunes of each investor were tied to the fortunes of other investors and the overall enterprise (i.e., Ripple). The Court found that this second prong was also met because the Company pooled the proceeds from Institutional Buyers into a network of subsidiaries’ bank accounts, and the Buyers’ profit was tied to the Company’s fortunes and the fortunes of other Buyers because they all received XRP (noting that “[w]hen the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings.”). Finally, for the third prong, the Court found that based on the “totality of circumstances,” the Institutional Buyers had a reasonable expectation that they would profit from Ripple’s efforts based on the Company’s publicly disseminated materials. The Institutional Buyers would expect the Company to use the capital it received “to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP” and thus the Buyers’ profit. The Court therefore held that the Company’s Institutional Sales constituted unregistered offer and sales of securities in violation of the Securities Act and granted summary judgment in the SEC’s favor as to these claims.
However, the Court sided with the Company as to the Programmatic Sales and Other Distributions, finding that, as sold in these transactions, XRP was not a security under the Securities Act and therefore registration was not required. The Court relied on the fact that the Programmatic Sales were blind bid/ask transactions where the buyers would not know if their payments went to the Company or another XRP seller. These buyers, according to the Court, were not investing their money in the Company nor did they expect to profit based on the Company’s efforts. Instead, these buyers expected to profit from XRP based on other factors, such as cryptocurrency trends and market speculation. Accordingly, the Court held that the third prong of Howey was not met and therefore the Programmatic Sales did not constitute the offer or sale of unregistered securities. As a result, the Court granted summary judgment in the Company’s favor.
As for the Other Distributions, the Court found that these Distributions did not satisfy Howey’s first prong that there be an “investment of money.” Unlike other buyers, the employees and third parties for the Other Distributions did not pay money—or any other tangible or definable consideration—to the Company. The Court reasoned that even though the Company paid XRP to these employees and companies, there was no evidence the Company funded its projects through these Distributions because it never received payments from these Distributions. Thus, the Court found that the Other Distributions also did not constitute the offer or sale of investment contracts and therefore granted summary judgment in the Company’s favor.
In sum, the Court held that the Institutional Sales constituted a violation of the Securities Act, while the Programmatic Sales and Other Distributions did not.
While not an outright win for the Company and its founders, this is a very significant decision for the cryptocurrency market—and if upheld—highlights a fundamental decision between stock (which is a security regardless of when or how it is sold) and cryptocurrency (which as an investment contract may only be a security in certain instances). It could have an immediate impact on the SEC’s active enforcement actions against a number of cryptocurrency exchanges, and a lasting impact on the SEC’s efforts more broadly. In effect, the Court held that secondary market transactions in cryptocurrency are akin to trades in commodities outside of the SEC’s jurisdiction, as opposed to trades in securities (whose price is at least theoretically tied to the success of an underlying business). The decision is consistent with a prior decision from the District of New Hampshire in a case involving the LBRY token, SEC v. LBRY, Inc., in which the court granted summary judgment in favor of the SEC, finding that LBRY had sold unregistered securities in violation of Section 5 but refused to enjoin sales of the token on the secondary market on the record before it; but this decision provides further analysis and a broader holding. Indeed, it has already been widely celebrated by the crypto community. But there is little reason to think that the SEC—which has made cryptocurrency an enforcement priority—will simply stop here. While the SEC will almost certainly appeal this decision in due course; regardless, it highlights yet again that the law is not as clear as the SEC says it is—if it were, presumably the SEC and the Court would not have such different views about whether XRP was a security in two out of the three at-issue contexts—and how regulatory clarity is necessary in this area.