A Stumbling Block in the SEC’s Crypto Crackdown: SEC v. Ripple Labs, Inc.
On July 13, 2023, a decision by Federal District Judge Analisa Torres of the Southern District of New York dealt a significant blow to the Securities and Exchange Commission’s enforcement efforts in the crypto space by holding that Ripple Labs, Inc.’s sale of crypto tokens on public exchanges was not a sale of unregistered securities because, in that situation, the tokens themselves were not securities.1 While the decision is undoubtedly a win for the crypto industry, Judge Torres did side with the SEC on one of the three categories of sales under consideration, holding that Ripple did sell unregistered securities when it sold the same crypto tokens directly to institutional investors.1 The SEC seems likely to appeal the decision, which will surely not be the last word on the critical question of when cryptocurrency constitutes a “security” subject to regulation under the federal securities laws. And, further, other courts charged with determining similar issues could come to different conclusions.
Ripple’s XRP Sales and the Howey Test
In 2020, the SEC brought an enforcement action against Ripple, alleging that the firm had sold its XRP crypto tokens as unregistered securities in violation of the securities laws. Relying on well-established precedent from SEC v. W.J. Howey Co., 2 the SEC argued that Ripple’s sales of XRP qualified as investment contracts and, thus, as securities subject to the SEC’s registration requirements. In her July 13th decision, Judge Torres rejected a significant portion of the SEC’s argument.
Under the Howey test, XRP would be sold as investment contracts if a purchaser “(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.” Applying Howey, the Court considered three different categories of Ripple’s XRP sales:
- Programmatic Sales: Ripple sold roughly $757.6 million of XRP through different digital asset exchanges. These sales were typically “blind bid/ask transactions,” where buyers and sellers conducted transactions through trading algorithms that did not identify the buyer or seller of the tokens.
- Institutional Sales: Ripple sold roughly $728.9 million of XRP directly to institutional investors, such as hedge funds or institutional buyers.
- Other Distributions: Ripple distributed XRP as a form of payment for third-party services and employee compensation.
The Court considered each of the three transaction categories under Howey and, ultimately, concluded that the Programmatic Sales and Other Distributions were not investment contracts, while the Institutional Sales were investment contracts. The Court also concluded that XRP sales on digital asset exchanges by Ripple’s Chairman Christian Larsen and CEO Bradley Garlinghouse were not investment contracts.
Programmatic Sales On Public Exchanges Are Not Investment Contracts
In a major win for the crypto industry, the Court held that the Programmatic Sales on public exchanges were not investment contracts and thus were not subject to the SEC’s registration requirements. It reasoned that these XRP sales did not pass the third element of the Howey test, in that the programmatic purchasers could not “reasonably expect that Ripple would use the capital it received from its [programmatic] sales to improve the XRP ecosystem and thereby the price of XRP.” Importantly, the Programmatic Sales were “blind bid/ask transactions,” and thus the purchasers would not have known if their money went to Ripple or any other seller of XRP. Ripple’s own sales of XRP accounted for less than 1% of the global trading volume of XRP, so a purchaser could not reasonably predict if its purchase money went to Ripple or any other seller.
While the SEC tried to argue that the Programmatic Sales of XRP were an investment contract since Ripple “explicitly targeted speculators,” the Court rejected this argument, holding that a purchaser’s potentially speculative motive was not in and of itself enough to show the existence of an “investment contract” under the securities laws.
Further, the Court reasoned that the Programmatic Sales were not made pursuant to any contracts restricting the resale or end-use of the crypto tokens. Thus, these purchasers could have been buying XRP for either investment purposes or for consumptive purposes, such as use as a currency. Finally, there was no evidence that Ripple sent broadly to the general public any promotional materials that linked its business efforts to the success of XRP.
Like Ripple’s Programmatic Sales, Larsen’s and Garlinghouse’s XRP sales on various digital asset exchanges, also through blind bid/ask transactions, were programmatic sales. Accordingly, the Court held that these sales were likewise not investment contracts under the third element of the Howey test.
Sales To Institutional Investors Are Investment Contracts
On the other hand, the Court held that the Institutional Sales met every element of the Howey test and therefore the XRP tokens were securities in that context, and thus their sale was an unregistered offer and sale of securities. With respect to the third element, the Court held that institutional investors “would have purchased XRP [from Ripple] with the expectation that they would derive profits from Ripple’s efforts.” In support of this conclusion, the Court cited Ripple’s distribution of marketing materials to potential investors that tied Ripple’s business model to the success of the XRP currency, with one brochure stating that Ripple’s “business model is predicated on a belief that demand for XRP will increase . . . if the Ripple protocol becomes widely adopted.” In addition, the Court noted a Reddit post from one of Ripple’s own senior leaders stating that Ripple’s interests were closely tied to those of XRP holders and that Ripple had a “team of dedicated professionals” that are “develop[ing] an ecosystem around XRP.” Similarly, Garlinghouse had stated that “Ripple is very, very interested in the success and health of the [XRP] ecosystem and will continue to invest in the ecosystem.” Taking all this evidence together, along with other similar statements, the Court held that institutional investors would have clearly understood that Ripple was promoting XRP as a way to generate income it would then invest in the ecosystem of XRP with the goal of increasing its value.
Further, the Court found that the sales contracts between Ripple and institutional investors demonstrated that institutional investors were purchasing XRP as an investment rather than for consumptive use. These contracts had certain “lockup provisions” and “resale restrictions” that were inconsistent with the use of XRP as a currency or any other consumptive purpose. For example, one contract stated that the institutional investor was purchasing XRP “solely to resell or otherwise distribute” rather than use XRP as an end user.
Other Distributions Are Not Investment Contracts
The Court held that the Other Distributions were not investment contracts, but for a different reason than the Programmatic Sales. According to Judge Torres, these distributions did not satisfy the first prong of the Howey test (i.e., investment of money) since the XRP recipients did not invest any money or other “tangible and definable consideration” to receive their crypto tokens.
A Dramatic Response and An Uncertain Future
This first-of-its-kind case is a significant obstacle for the SEC’s recent crackdown on the crypto industry and has so far proven to be a boon for crypto investors. In the immediate wake of the decision, the price of XRP rose substantially, and many crypto exchanges have taken steps to relist XRP for trading in the U.S.
But the decision’s long-term impact remains to be seen. While the SEC has stated that it is still assessing the Court’s holding as it relates to the Programmatic Sales, it may well seek to appeal the decision. SEC Chair Gary Gensler recently noted that he was disappointed in this aspect of the Court’s ruling, and emphasized that the SEC will continue its enforcement focus in the crypto space. In addition, while influential, the decision is not binding on other judges, and other courts faced with the issue of when crypto tokens are securities within the meaning of the federal securities laws — such as the judges considering the SEC’s recent actions against several crypto trading platforms — could come out a different way. Accordingly, crypto investors and industry participants should continue to proceed with caution and monitor further developments in this quickly evolving area of the law.
1 SEC v. Ripple Labs, Inc., 20 Civ. 10832 (AT), 2023 WL 4507900 (S.D.N.Y. July 13, 2023), available at https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf.
2 SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.