On July 13, 2023, the Court ruled in partial favor of Ripple Labs Inc.’s argument that many of its XRP sales did not violate investor-protection laws. The ruling has sent the crypto world ablaze with speculation on the future of crypto.
Ripple and XRP
Ripple is a digital payment network that uses blockchain technology to process money transfers across the globe. It operates on the XRP ledger, which was developed by a few of Ripple’s founders, and uses the XRP token to operate.
The Court categorized Ripple’s income into two primary groups: (1) institutional sales and (2) programmatic sales. Institutional sales represent direct sales of XRP to institutional buyers, hedge funds, and “on-demand liquidity” customers (customers who exchange one fiat currency for XRP and then exchange XRP for another fiat currency)1. Programmatic sales represent sales of XRP on digital asset exchanges and through trading algorithms2. It is important to note that XRP transactions on digital asset exchanges are considered blind in that Ripple is blind to the identity of the purchaser and the purchaser is blind to the identity of the seller.
The Court also analyzed other distributions of XRP as a form of payment for services, for example as employee compensation and incentives for third parties to develop new applications for XRP and the XRP ledger, as well as the offer and sale of XRP by two of Ripple’s executives in their individual capacities.
Legal Definitions
To appreciate the ultimate impact of the Court’s ruling, it is crucial to understand the legal standard by which the case was tried.
The Securities Act of 1933’s definition of a security does not define a security as one might expect but rather lists over 30 examples of financial instruments that are asserted to be securities. It states that a security is “any note, stock, treasury stock, security future, security-based swap, bond, … investment contract, … in general, any interest or instrument commonly known as ‘security’.”3
In 1946, SEC v W.J. Howey Co was brought before the U.S. Supreme Court and further clarified the definition of an investment contract. The following three elements or prongs would later be known as the “Howey Test.” The Court concluded that an investment contract is:
- “A contract, transaction, or scheme whereby
- a person invests his money in a common enterprise and
- is led to expect profits solely from the efforts of the promoter or a third party.”4
The Ruling
The SEC’s action against Ripple was centered around the belief that the sale of digital tokens like XRP is an investment contract, which is defined as a security by the Securities Act. The SEC alleged that Ripple and two of its executives raised over $1.3 billion from the sale of XRP through unregistered securities offerings, violating Section 5 of the Securities Act. In contrast, Ripple rejected the presumption that XRP is a security and therefore believed it did not need to publicly file registration documents or financial reports with the SEC.
U.S. District Judge Analisa Torres of the Southern District of New York ruled the following5:
- Institutional sales of XRP do constitute unregistered offers and sales of investment contracts in violation of Section 5 of the Securities Act. The Court found that institutional sales of XRP passed the Howey Test, specifically that “reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts.”6
- Programmatic sales of XRP do not constitute unregistered offers and sales of investment contracts. The Court concluded that programmatic sales of XRP did not pass the third prong of the Howey Test. It said, “It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple.”7
- Other distributions of XRP made by Ripple in exchange for non-cash consideration do not constitute unregistered offers and sales of investment contracts because these distributions did not represent an investment of money as required by the first prong of the Howey Test.
- Sales of XRP made by two Ripple executives on digital asset exchanges do not amount to offers and sales of investment contracts for the same reason as the decision on programmatic sales. The executives offered and sold XRP on digital asset exchanges, which were anonymous transactions and therefore do not satisfy the third prong of the Howey Test.
In summary, the Court ruled partially in favor of the SEC, only granting the SEC’s motion as it related to institutional sales of XRP. All other SEC motions were denied.
Importantly, Judge Torres wrote, “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.”8 Instead, the particular facts and circumstances surrounding the sale and distribution of a digital token must be examined.
Responses to the Ruling
A few days after the Ripple ruling, SEC Chair Gary Gensler said during a National Press Club event in Washington DC that he was pleased with the Court’s decision on institutional investors, but disappointed with retail investors.9 In a response on July 21, 2023, to a filing by Terraform Labs to dismiss its ongoing case against the SEC based on the Ripple ruling, the SEC said, “the SEC respectfully avers that Ripple conflicts with and adds baseless requirements to Howey and its progeny. Respectfully, those portions of Ripple were wrongly decided, and this Court should not follow them.”10 Terraform’s motion to dismiss was subsequently denied by Judge Jed Rakoff, also from the U.S. District Court for the Southern District of New York. He rejected the use of the Ripple ruling, stating that “secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf.”11
Following the ruling, Coinbase, which was sued by the SEC in June 2023 for operating an unregistered exchange, broker, and clearing agency, relisted XRP on its platform. Coinbase’s chief legal officer, Paul Grewal, said in an interview with CNBC, “There’s no question that this ruling strikes a blow to the idea that somehow securities are being traded when people go onto exchanges and trade the assets.”12 On how the Ripple ruling will impact Coinbase’s case against the SEC, he said, “I think we will win. Now, I thought we would win before this decision. We think this decision has only further strengthened the case.”13 On August 4, 2023, Coinbase filed a motion to dismiss their lawsuit, also citing the Ripple ruling.14
Gemini, also facing a lawsuit brought by the SEC, tweeted after the ruling that they are “exploring the listing of XRP for both spot and derivatives trading.”15
Other parties weighed in on the Ripple decision as well, including Congressman Ritchie Torres (D-NY), who tweeted “Judge Analisa Torres’s decision in the Ripple case establishes what I call the Torres Doctrine, rejecting @SECGov Chair Gary Gen[s]ler’s indiscriminate assault on crypto. Digital assets aren’t securities in themselves but can be part of investment contracts, which are securities”.16
UCLA Law Professor James Park told Bloomberg Law that despite the ruling, the SEC will likely redouble their efforts before other court venues. “The lawyers are going to make more money because the SEC will continue litigating,” he said.17
After the ruling was announced, the value of XRP rose 96% to a high of 93.8 cents, according to CryptoWatch, which was its highest level since March 2022.18
Looking Forward
On its face, the July 13 ruling appears to be a win for the crypto community. However, it may be too early to celebrate. On August 18, the SEC filed a motion to leave to file for an interlocutory appeal against Ripple, meaning the SEC will have the opportunity to appeal Judge Torres’ preliminary motion. Ripple has until September 1 to respond.
Despite the unknown and regulatory scrutiny, the crypto industry continues to grow. The question our society faces now is the capacity in which crypto will operate. Will it remain a contentious and relatively unchecked market or will it become mainstream and subject to increased regulation? More importantly, how will you and your organization stay on top of the ever-changing landscape? Our team at Ankura consists of experienced digital asset experts across multiple disciplines. We have significant experience investigating crypto assets and platforms, developing proprietary data processes from on-chain and off-chain sources, leading complex crypto fraud and securities violation investigations for government and law enforcement agencies, and reviewing and aligning anti-money laundering and sanctions compliance programs. Reach out today to hear more about our experience and let us show you how we can help guide you through every step of your digital asset journey.
Footnotes
[1] Securities and Exchange Commission v. Ripple Labs Inc., 20 Civ. 10832, (S.D.N.Y. 2023). https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf
[2] Ibid.
[3] 15 U.S.C. §§ 77b(a).
[4] Securities and Exchange Commission v. Howey Co., 328 U.S. 293 (1946). https://supreme.justia.com/cases/federal/us/328/293/
[5] Securities and Exchange Commission v. Ripple Labs Inc., 20 Civ. 10832, (S.D.N.Y. 2023). https://www.nysd.uscourts.gov/sites/default/files/2023-07/SEC%20vs%20Ripple%207-13-23.pdf
[6] Ibid.
[7] Ibid.
[8] Ibid.
[9] https://www.youtube.com/watch?v=xR4l5F8fLRU
[10] Securities and Exchange Commission v. Terraform Labs Pte. Ltd. and Do Hyeong Kwon, 23 Civ. 1346, (S.D.N.Y. 2023). https://assets.bwbx.io/documents/users/iqjWHBFdfxIU/raAgcBtaEU24/v0
[11] Securities and Exchange Commission v. Terraform Labs Pte. Ltd. and Do Hyeong Kwon, 23 Civ. 1346, (S.D.N.Y. 2023). https://storage.courtlistener.com/recap/gov.uscourts.nysd.594150/gov.uscourts.nysd.594150.51.0.pdf
[13] Ibid.
[14] Securities and Exchange Commission v. Coinbase Inc and Coinbase Global Inc, 23 Civ. 4738 (S.D.N.Y 2023). https://storage.courtlistener.com/recap/gov.uscourts.nysd.599908/gov.uscourts.nysd.599908.36.0.pdf
[15] https://twitter.com/Gemini/status/1679550388272283649
[16] https://twitter.com/RepRitchie/status/1681423113227993088?s=20
© Copyright 2023. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.
