On July 13, 2023, the U.S. District Court for the Southern District of New York issued a decision in SEC v. Ripple Labs, Inc., a closely watched cryptocurrency case involving alleged securities law violations. The court held that Ripple Labs unlawfully sold unregistered securities in violation of the Securities Act of 1933 (“Act”) when it sold its cryptocurrency token, XRP, to certain institutional buyers. The court also held the XRP token was not a security under the Act when sold on digital asset exchanges because of the different circumstances and expectations of buyers in those transactions. The court finally held the Company’s distributions of XRP tokens to employees and third parties for development of its project did not constitute sales of unregistered securities.
This is an important decision for the cryptocurrency industry and a significant win for cryptocurrency exchanges. While the decision will likely be appealed, the court’s detailed analysis may well have a significant impact on the SEC’s pending enforcement efforts across the industry.
Background of the Case
The SEC brought an action against Ripple Labs and two officers who founded the company for the unlawful offer and sale of securities in violation of section 5 of the Act. It also alleged the officers aided and abetted the company’s violations of section 5. Section 5 of the 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. Because there was no dispute that a registration statement was never filed for XRP, the court’s decision turned on whether XRP was a security under the seminal case of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and whether defendants offered to sell XRP as an unregistered security in violation of the Act.
Beginning in 2011, the company’s founders began developing a secured ledger (read “blockchain”) called the XRP Ledger. They launched the XRP Ledger in 2012, at which time is generated a fixed supply of 100 billion XRP. XRP is the native digital token of the XRP Ledger. The XRP Ledger requires XRP to operate. When the founders formed the Company, they kept 20 billion XRP for themselves and provided 80 billion XRP to Ripple Labs. Between 2013 and 2020, the company transacted various sales and distributions of XRP. The SEC questioned whether the sales and distributions constituted offers and sales of unregistered securities in violation of section 5 of the Act.
The SEC’s Enforcement Action
The SEC’s lawsuit alleged the Company engaged in 3 types of unregistered XRP offers and sales.
- Sales to sophisticated individuals and entities under written contracts for which the company received $728 million (“Institutional Sales”).
- Sales to the public on digital asset exchanges for which the company received $757 million (“Program Sales”).
- Grants to employees and third parties under written contracts for which the company received $609 million in consideration other than cash (“Other Distributions”).
The Court’s Decision
The court initially made clear that a digital token like XRP is not a security, but rather a form of investment contract that may constitute a security, depending on the terms and conditions under which it’s sold.
The court then analyzed each category of transaction separately under Howey, which defined an investment contract as “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.” The Court made clear that an investment contract does not require anything that looks like a written contract of sale or equivalent. It found that any set of transactions or schemes taken together can establish the essential elements of Howey’s 3-part test. A point the defendants argued against, but one on which the SEC prevailed.
The court stated that a determination as to whether a digital asset like XRP is a security is analyzed under Howey. It said it had no concerns whatsoever about applying federal securities statutes and case law 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 of the case, which could have a significant impact on how cryptocurrency markets are ultimately regulated.
Institutional Sales are Unregistered Offer & Sales of Securities in Violation of the Act
The court first applied the 3-party Howey test to Institutional Sales. It found the first prong was easily met because the institutional buyers invested money in exchange for XRP. The Court found the second prong was also met because the company pooled the proceeds from institutional buyers into a network of subsidiary bank accounts, and the buyers’ profits were tied to the company’s fortunes and other buyers’ fortunes because they all received XRP. The court noted that when the value of XRP rose, all institutional buyers profited in proportion to their XRP holdings.
The court finally found the third prong of the test was met because, based on the totality of circumstances, and the company’s publicly disseminated materials, institutional buyers had a reasonable expectation they would profit from the company’s efforts. Those buyers would expect the company to use investment capital it received to improve the market for XRP and develop uses for the XRP Ledger, thus increasing the value of XRP and the buyers’ profits.
The Court concluded the company’s Institutional Sales were unregistered offer and sales of securities in violation of the Act and ruled in favor of the SEC on these claims.
Program Sales Are Not Unregistered Offers & Sales of Securities
The court sided with the company on Program Sales and Other Distributions. It found that based on the specific transactions involved in the case XRP was not a security under the Act and registration was not required before it could be sold. In reaching these conclusions, the court relied on the fact that Program Sales were blind bid/ask transactions where buyers would not know if their payments went to the company or another XRP seller.
The court determined these buyers were not investing money in the company or expecting a profit based on its efforts. Buyers on digital asset exchanges expected to profit from XRP based on other factors like cryptocurrency trends and market speculation. The Court found the third prong of Howey was not met and thus Program Sales did not constitute offers or sales of unregistered securities.
Other Distributions Are Not Unregistered Offers and Sales of Securities
As for the Other Distributions, the Court found that these distributions did not satisfy Howey’s first prong requiring there be an investment of money. Unlike other buyers, the employees and third parties who received the Other Distributions did not pay money or any other tangible or definable consideration to the Company in exchange for XRP. The court reasoned that even though Ripple Labs 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.
The court found the Other Distributions also did not constitute the offer or sale of investment contracts, and thus ruled in favor of the Company on these transactions.
Important Take-Aways from the Ripple Labs Case
While not an outright win for Ripple Labs and its founders, the court’s decision is a significant ruling for the cryptocurrency industry. If it’s upheld on appeal, it will highlight a fundamental distinction 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. The decision could have an immediate impact on the SEC’s enforcement actions against a number of cryptocurrency exchanges, and a lasting impact on the SEC’s efforts more broadly.
The court appears to have effectively held that secondary market transactions in cryptocurrency are akin to trades in commodities outside the SEC’s jurisdiction, as opposed to trades in securities, whose price is theoretically tied to the success of an underlying business.
The Ripple Labs’ decision is consistent with a prior decision from the U.S. District Court for New Hampshire in a case involving the LBRY token, SEC v. LBRY, Inc., in which that court found in favor of the SEC when it decided 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. The Ripple Labs’ decision offers much more analysis and a broader holding and warrants further review by the securities bar. It has been widely celebrated by the crypto community. There is little reason to think the SEC will curtail its cryptocurrency enforcement, which is a stated enforcement priority for the agency, based on the New Hampshire or New York decisions. And it’s almost certain the SEC will appeal the Ripple Labs’ decision. Whatever the ultimate result, the decision highlights that the law is not as clear as the SEC suggests and further regulatory clarity is necessary in this area.
About Finkel Law Group
Finkel Law Group, with offices San Francisco and Oakland, has close to 30 years of experience counseling its corporate clients on compliance with federal and state securities laws, and assisting them with offers and sales of their securities to purchasers in California and across the United States. We have the knowledge and experience to help your company navigate the delicate issues associated with complying with federal and states securities laws. When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with managing and planning for the future of your business enterprise, please contact us at (415) 252-9600, (510) 344-6601, or info@finkellawgroup.com to speak with one of our attorneys about your matter.