In the absence of a more specialized regime for the regulation of crypto assets, one of the key hooks utilized by the American Securities and Exchange Commission (the SEC) for asserting regulatory jurisdiction over the distribution of digital tokens is by characterizing those tokens as ‘securities’ or ‘derivatives’. On July 13, 2023, the United States District Court ruled that while Ripple Labs, Inc.’s (Ripple) XRP token was a security when it was sold directly to institutional investors, and therefore subject to SEC oversight in that context, it ruled that the token could not be characterized as a security when it was sold on a digital exchange or trading algorithm to the general public. Accordingly, in the absence of greater regulatory clarity, the Court’s decision indicates that certain similar constituted tokens, including exchange-traded tokens, may be outside the regulatory jurisdiction of American securities regulators’ reach.
The question of how to regulate certain crypto assets, such as tokens, has been the subject of consideration and debate for some time now. In Canada, the Canadian Securities Administrators, the collaborative umbrella organization of provincial capital markets regulators, issued a Staff Notice in June 2018, CSA Staff Notice 46-308: Securities Law Implications for Offerings of Tokens [PDF], where it stated that tokens could be securities, but essentially left it in the hands of market participants and consumers to take the risk of determining whether enforcement will follow a token-related transaction. In December 2022, the CSA reiterated its position in the context of stablecoins, stating “stablecoins, or stablecoins arrangement, may constitute securities and/or derivatives”, but again failed to provide any further guidance on when stablecoins would be considered securities. On July 7, 2022 [PDF], IOSCO, the International Organization of Securities Commissions, published its Crypto Asset Roadmap for 2022/2023, and in May 2023 its consultation paper “global standard setter for securities markets”, describing it as “detailed recommendations to jurisdictions across the globe as to how to regulate crypto-assets”.
All of this activity, discussion and proposed regulatory action reflects the absence of a clear and consistently applied global approach to crypto asset creation and distribution, which has resulted in forcing securities regulators to try to fit crypto assets regulation into the traditional capital markets regime on an ad hoc case-by-case basis.
Factual background to the U.S. District Court decision
Between 2013 and 2020, Ripple engaged in three types of sales and distributions of XRP.
First, Ripple, through wholly owned subsidiaries, sold approximately $728.9 million XRP directly to certain counterparties, primarily institutional buyers, hedge funds, and on demand liquidity customers, pursuant to written contracts (the Institutional Sales). Second, Ripple sold approximately $757.6 million XRP on digital asset exchanges programmatically or through the use of trading algorithms (the Programmatic Sales). Ripple’s XRP sales on these digital asset exchanges were “blind bid/ask transactions”. Ripple did not know who was buying the XRP and the purchasers did not know who was selling it. Lastly, Ripple also distributed $609 million XRP as a form of payment for services. Ripple distributed XRP to its employees as a form of compensation and to third parties to fund the development of new applications for XRP and the XRP Ledger (Other Distributions).
Ripple’s former CEO, Christian A. Larsen, and current CEO, Bradley Garlinghouse, also offered and sold XRP in their individual capacities through programmatic sales and made $450 million and $150 million from their sales respectively.
From 2013 to 2020, Ripple, Larsen, and Garlinghouse neither filed a registration statement for any XRP offers or sales, nor submitted financial or periodic reports for Ripple or XRP. They also failed to make any EDGAR filings with the U.S. Securities and Exchange Commission (SEC).
In December 2020, the SEC filed a lawsuit against Ripple, Larsen, and Garlinghouse, alleging that the defendants sold XRP as an “investment contract,” a type of security, and were therefore in violation of a section of the Securities Act of 1933 (the Securities Act). The Securities Act provides that it is “unlawful for any person, directly or indirectly, . . . to offer to sell, offer to buy or purchase[,] or sell” a “security” unless a registration statement is in effect or has been filed with the SEC as to the offer and sale of such security to the public.
The District Court’s decision
In a mixed decision which was met with considerable approval from the crypto community[1], the District Court ruled that Ripple’s Programmatic Sales and Other Distributions did not constitute “the offer and sale of investment contracts”, but its Institutional Sales were an unregistered sale of securities.
In deciding the case, the U.S. District Court turned to the U.S. Supreme Court’s seminal decision, SEC v. W.J. Howey Co.,[2] to assist it in determining whether the SEC had jurisdiction over the impugned products and activities, and whether the tokens could be characterized as an investment contract. Howey held that under the Securities Act, an investment contract is a contract, transaction, or scheme whereby a person: (1) invests their money; (2) in a common enterprise; and (3) is led to expect profits solely from the efforts of the promoter or a third party. In analyzing whether a contract, transaction, or scheme is an investment contract, the Court stated that the emphasis should be on the substance, economic reality, and the totality of circumstances, not the form of the contract, transaction, or scheme.
The Programmatic Sales
The Court determined that Programmatic Sales did not meet the third prong of the Howey test, the existence of which is fundamental to establishing an investment contract. After evaluating the economic reality of Programmatic Sales, the Court concluded that programmatic buyers had no reasonable expectation for Ripple to invest the funds from XRP sales into the betterment of the XRP ecosystem, leading to an increase in price and consequent profit. This was largely due to the fact that such sales were “blind bid/ask transactions” and buyers did not know where their payments went. Moreover, they represented less than 1% of the global XRP trading volume. The Court found that Ripple did not make any promises because Ripple did not know who was buying XRP and the purchasers did not know who was selling it.
Moreover, the Programmatic Sales were not made pursuant to contracts that contained lockup provisions, resale restrictions, indemnification clauses, or statements of purpose. And, while Ripple’s promotional materials were circulated widely amongst potential institutional buyers, there was no evidence in the record that Ripple’s marketing efforts were directed towards the general public. Moreover, there was no evidence that the comparatively less sophisticated programmatic buyers would have developed shared understandings and expectations through Ripple’s statements across various platforms the way comparatively sophisticated institutional buyers could have. Having therefore considered the economic reality and totality of circumstances, the Court concluded that Ripple’s Programmatic Sales of XRP did not constitute the offer and sale of investment contracts.
(3) Other Distributions
The Other Distributions also failed to meet the first prong of Howey test. The Court found that the recipients of the Other Distributions did not pay money or “some tangible and definable consideration” to Ripple. Ripple paid XRP to these employees and companies. As a result, Ripple’s Other Distributions did not constitute the offer and sale of investment contracts.
As noted above, Larsen and Garlinghouse offered and sold XRP in their individual capacities. The Court found that Larsen and Garlinghouse sales were Programmatic Sales on various digital asset exchanges through blind bid/ask transactions and therefore failed to meet the third prong of the Howey test.
The Institutional Sales
Applying the first prong of Howey to the Institutional Sales, the Court concluded that the investment of money by Institutional buyers was part of the relevant transaction; Ripple received money for XRP through its Institutional Sales.
On the second prong of Howey, the Court found that there was a common enterprise (specifically termed “horizontal commonality”) because Ripple pooled investor funds, resulting in the fortunes of institutional buyers being tied to each another as well as to the success of Ripple. In particular, the Court found Ripple pooled the proceeds of its Institutional Sales into a network of bank accounts that were held under the names of Ripple’s subsidiaries, Ripple’s accountants recorded all of its XRP-related proceeds together, and each institutional buyer’s ability to profit was tied to Ripple’s fortunes and the fortunes of other institutional buyers because all institutional buyers received the same fungible XRP. When the value of XRP rose, all institutional buyers profited in proportion to their XRP holdings. The Court found this was sufficient to establish horizontal commonality and a common enterprise.
The Court also concluded that the Institutional Sales met the third prong of the Howey test, which pertains to the reasonable anticipation of profits. A reasonable institutional investor would have purchased XRP with the expectation that it would derive profits from Ripple’s efforts based on the defendants extensive marketing efforts casting XRP as an investment opportunity. Ripple made many statements on “informational brochures, internal talking points, public blog posts, statements on social media, videos, interviews with various Ripple employees, and more” connecting XRP’s success to their own efforts and the Court found that this messaging would have led institutional buyers to understand that Ripple was “pitching a speculative value proposition for XRP with potential profits to be derived from Ripple’s entrepreneurial and managerial efforts”.
As a result, the Court found that the Institutional Sales of XRP constituted an unregistered offer and sale of investment contracts in violation of the Securities Act.
Takeaways
The District Court’s decision is a significant one and includes wins for both the SEC and the crypto community. In a tweet, Ripple’s CEO Garlinghouse highlighted the Court’s decision that the XRP token itself is not a security as the most important part of the decision, an issue that is the subject of multiple cases the SEC has brought against other crypto exchanges. The SEC, for its part, has said that it continues to review the decision and has not arrived at a decision on whether it will appeal parts of the ruling, and was also quoted in the New York Times in a statement that the agency was “pleased that the court found that XRP tokens were offered and sold by Ripple as investment contracts in violation of the securities laws in certain circumstances.”
As stated above, the decision was decided in the context of significant policy and regulatory developments, making enforcement actions taken by regulators appear premature. While regulatory policy making could never be characterized as break-speed, in the absence of clear public investor/consumer harm, such as instances of fraud and/or manipulative practices, the divided outcome of the Ripple case emphasizes the need for greater certainty, which can only come about through a global regulatory position on how best to regulate digital tokens and other new and evolving activities.
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