In brief

In one of the first cases in United States of America in which the court ruled that a cryptocurrency token (XRP specifically) in and of itself is NOT a security, the U.S. District Court for the Southern District of New York has now handed down judgment in the trial of Securities Exchange Commission vs Ripple Labs.

The court held that XRP, as a digital token, is not in and of itself is not a security per se. Instead, the court looks at the totality of circumstance to determine if the sale & distribution of a token in each situation meets the Howey requirements. Most things like gold, silver & even digital tokens like XRP may on certain circumstances be deemed a security that is regulated under Section 5 of the Securities Act.

The court gave a split decision holding that the sale of XRP tokens on exchanges (programmatic sales) were not securities whilst the sale of XRP tokens to institutional investors were securities based on the totality of the circumstance. The Court also rejected the due process & fair notice defenses raised stating that “The law does not require the SEC to warn all potential violators on an individual or industry level.”

Key Takeaways

1. Whilst digital tokens or cryptocurrency on its own is not a security, they may be sold as investment contracts (i.e securities), depending on the circumstances of each sale.

2. The court will look at the totality of circumstance to determine if each of the three prongs of the Howey test is met. To recap the 3-prong of the Howey test is as follows:

a. an investment of money,

b. in a common enterprise,

c. with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.

Institutional Sales

3. In holding that Ripple’s Institutional Sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act, the court analyzed and found that each of the 3 Howey prongs were met.

a. For the 1st prong “investment of money”, the court found that intent does not matter but rather whether did the investors put up money (capital or cash). In this case, Ripple conceded that they received money from institutional investors.

b. For the 2nd prong “common enterprise”, the court adopted the horizontal commonality test where investors’ assets are pooled and the fortunes of each investor are tied to the fortunes of other investors, as well as to the success of the overall enterprise. In this case, Ripple pooled proceeds of Institutional Sales into a network of bank accounts under the names of its subsidiaries.

Having separate Bank accounts does not absolve Ripple as Ripple controlled all the accounts and used the funds raised from the Institutional Sales to finance its operations. Further, 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. Ripple used funds received from Institutional Sales to promote and increase the value of XRP by developing uses for XRP and protecting the XRP trading market.

And as a result, when the value of XRP rose, all Institutional Buyers profited in proportion to their XRP holdings. On the totality of circumstance, the court held that the 2nd prong of Howey was met.

c. For the 3rd prong “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others”, the court broke down the prong into different parts.

For “profit”, the court held that “income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment” can also be considered profits. For “reasonable expectation of profit”, the court held that expectation of profit need not be the sole reason a purchaser buys the asset. The court mentioned that “an asset may be sold for both consumptive and speculative uses”.

Further, the court held that “the inquiry is an objective one focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual.” The court held that based on Ripple’s communications, marketing campaign, and nature of the institutional sales, reasonable investors will find that Ripple will use the capital from institutional sales to improve the market for XRP and develop uses for XRP, thereby increasing the value of XRP.

Further the nature of the institutional sales evinced that Ripple sold XRP as an investment rather than for consumptive use. This is because in the sales contracts, some institutional buyers agreed to lockup provisions/resale restrictions based on XRP’s trading volume. The court held that such restrictions are inconsistent with notion that XRP was used as a currency or for consumptive use because “rational economic actor would not agree to freeze millions of dollars . . . if the purchaser’s intent was to obtain a substitute for fiat currency.” Hence, the 3rd prong of Howey was met.

Programmatic Sales

4. In holding that the Programmatic Sale on exchanges were not securities transactions, the court found in favor of Ripple. In finding that the 3rd prong of Howey was not met, the court found that programmatic buyers could not reasonably expect the same expectation of institutional investors that Ripple would use capital it received from sales to improve the XRP ecosystem and thereby increase the price of XRP.

Given the nature of Ripple’s Programmatic Sales being blind bid/ask transactions, and that Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. The court also rejected the SEC’s argument that Ripple “explicitly targeted speculators” and found that a speculative motive “on the part of the purchaser or seller does not evince the existence of an ‘investment contract’ because anyone who buys or sells, for example, a horse or an automobile hopes to realize a profitable ‘investment’ but the expected return is not contingent upon the continuing efforts of another.

In the present case, the court held that whilst people purchased XRP with an expectation of profit, they did not derive that expectation from Ripple’s efforts as opposed to other factors, such as general cryptocurrency market trends. Further, most were unaware they were buying XRP from Ripple. The court repeated that the inquiry is an objective one focusing on the promises and offers made to investors and is not a search for the precise motivation of each individual participant. Unlike Institutional Sales, Programmatic Sales were not made pursuant to contracts that contained lockup provisions, resale restrictions, indemnification clauses, or statements of purpose.

Finally, the court held that no evidence that a reasonable Programmatic Buyer, generally less sophisticated as an investor, shared similar “understandings and expectations” and could parse through the multiple documents SEC suggested. Hence, given that the 3rd Prong of Howey was not met, the court held that Ripple did not violate Section 5 of the Securities Act.

Due process, Fair Notice & Vagueness Defences

5. The court rejected the due process, fair notice & vagueness defences raised by Ripple. The court held that existing caselaw defines an investment contract and provides a person of ordinary intelligence a reasonable opportunity to understand what conduct it covers.

Further, Howey sets forth a clear test for determining what constitutes an investment contract, and Howey’s progeny provides guidance on how to apply that test to a variety of factual scenarios. In addition, caselaw articulates sufficiently clear standards to eliminate the risk of arbitrary enforcement. Howey is an objective test that provides the flexibility necessary for the assessment of a wide range of contracts, transactions, and schemes.

Ripple’s arguments that the SEC failed to issue guidance on digital assets and inconsistent statements and approaches to regulate sale of digital assets as investment contracts were rejected as the court held that at least with respect to the institutional investors, the SEC enforcement as consistent with their past enforcements. Finally, the court held that “the law does not require the SEC to warn all potential violators on an individual or industry level.”

Abetment

6. On abetment charges for Larsen & Garlinghouse (senior executives of Ripple), the court found that the defendants have raised a genuine dispute of material fact as to whether Larsen and Garlinghouse knew or recklessly disregarded the facts that made Ripple’s scheme illegal. Here, the salient point is that relying on external counsel may be one of the factors that may help defendants.

Practical Implications

The practical implications of this case can be summarized as follows:

1. By rejecting the token-as-security argument, the Court landed a blow to the SEC’s stated position that digital assets are always securities in every context. Instead, the totality of circumstances will be examined under each prong of Howey. As such, every transaction or sale of tokens (fungible or non-fungible) will be determined based on its own circumstances. It is easy to overlook that practically speaking the ruling changes nothing much as each transaction or scheme in terms of sales of digital assets will still be assessed on a case-by-case basis.

2. Judge Torres’s detailed analysis and application of the Howey test is illuminating. In particular, intent does not matter with respects to the 1st prong, as long as money or capital is involved, the 1st prong will likely be invoked.

3. With regards to the 2nd prong of “common enterprise”, the fact that one uses separate banks accounts will not be enough to claim that there’s no common enterprise, instead the court looks at who controls the bank accounts and the purpose the money raised was used for.

NFTs given there non-fungibility may be seen differently as the court pointed to that the fact that institutional investors receiving the “same fungible XRP” to tie the fortunes of an institutional investor to Ripple & other investor’s success. Finally, if the raised funds were used to raise the value of the digital assets/tokens be it through marketing or activation of roadmaps, this may add to the fact that a common enterprise exists.

4. With regards to the 3rd prong of Howey, the court took a broad approach to the term “profit”, so it is likely that floor price increase of NFTs or cryptocurrency price increase will likely be seen as profits.

More importantly in terms of “reasonable expectation of profit”, investor’s individual motivation does not matter. Plainly speaking, it is not enough to say I bought the digital asset for consumptive rather than investment purposes. Instead, the court looks at the actions of the seller of the digital assets and makes an objective inquiry whether a reasonable expectation of profit can be made out.

External communications, marketing campaigns/promises as well as the nature of transactions whether it involves a lock-up period for investors all play a vital role. So, projects or teams promising roadmaps, activations, airdrops that may lead to the increase in value of digital assets should be extra careful. Further, pre-sale lockups of tokens or NFTs which have become more popular in recent times, are likely to be seen as a factor pointing towards a reasonable expectation of profit.

5. In what seems like a win for crypto exchange platforms like Binance and Coinbase, the court found that sales based on blind bid/ask transaction of the XRP token was not a securities transaction as buyers did not know who they were buying the tokens from and by extension cannot be said to rely on Ripple or others to generate profits hence the 3rd prong of Howey was not met.

Interestingly, the court also rejected the SEC’s argument that Ripple explicitly targeted speculative investors, the court held that it did not matter as most people invest or buy something with expectation of profits, but the 3rd prong of Howey requires a further step that the profits be contingent on the efforts of others.

Practically speaking, this may be good enough to ensure most purchases of digital tokens via exchanges will not violate securities regulations but pre-sale tokens directly from projects (ICOs, meme coins) and NFT purchases may still violate regulations. Additionally, the court also held that the lack of lock-up provisions and indemnification clauses in programmatic sales helped in adding to the totality of circumstance that the 3rd prong of Howey was not met. Hence, teams may want to avoid providing such provisions generally.

6. Reliance on external counsel advice, taking steps to prevent violating Section 5 of the Securities Act as well as relying on statements by other US regulators and other jurisdictions’ regulators may be viewed positively by the courts.