Changing Tides or a Ripple in Still Water? Examining the SEC v. Ripple Ruling

On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York issued her highly anticipated ruling¹ on the parties’ cross-motions for summary judgment in the Securities and Exchange Commission’s (“SEC”) action against Ripple Labs, Inc. (“Ripple”) and two of its executives, alleging the unregistered offer and sale of XRP, a digital token, as a security. In the decision, Judge Torres rejected the theory that the XRP digital token itself embodied a security, and instead examined the different facts and circumstances by which the tokens were sold. In doing so, Judge Torres handed a rare (partial) victory to a cryptocurrency issuer in an action brought by the SEC, finding that offers and sales of XRP to institutions and sophisticated individuals constituted securities transactions, but that offers and sales of XRP on crypto exchanges, distributions to employees, and other distributions to third-party developers were not securities transactions. While the ruling is being celebrated by crypto market participants, the broader effect of the decision has yet to be seen. In this Alert, we examine the Court’s ruling and discuss the potential impacts it could have on future cases and the broader regulation of digital assets.

1. Procedural and Factual Background

The SEC’s action against Ripple began in December 2020, when the SEC filed its initial complaint against Ripple, alleging that Ripple and two of its executives, Bradley Garlinghouse and Christian Larsen, engaged in the unlawful offer and sale of securities in violations of Sections 5(a) and 5(c) of the Securities Act of 1933 (“Securities Act”) and that Garlinghouse and Larsen aided and abetted Ripple’s violations. Following discovery and various hearings, the parties filed cross-motions for summary judgment in September 2022.

The XRP Ledger, an open-source blockchain protocol, was launched in 2012 with a fixed supply of 100 billion XRP, the native token of the XRP Ledger. The founders, including Larsen, retained 20 billion XRP and provided 80 billion to Ripple. From 2013 through the end of 2020, Ripple engaged in various sales and distributions of XRP, including direct sales to certain institutional buyers and hedge funds pursuant to written contracts raising approximately $728 million (“Institutional Sales”), approximately $757 million in sales on crypto exchanges through trading algorithms (“Programmatic Sales”), and $600 million in distributions of XRP to employees as payment for services and to fund certain third parties developing new applications on the XRP Ledger (“Other Distributions”). Larsen and Garlinghouse also sold XRP on crypto exchanges in their individual capacities. At no time was a registration statement filed for any offers or sales of XRP, nor did Ripple make any public filings with the SEC.

The SEC alleged that, since at least 2013, Ripple engaged in extensive marketing efforts related to the utility and value of XRP, including through informational brochures, blog posts, social media, videos, and interviews with Ripple employees. Marketing materials were distributed to prospective and existing XRP investors and described, in part, the connection between XRP and Ripple’s business.

2. Court’s Findings

The SEC’s claims against Ripple, Garlinghouse, and Larsen under Section 5 of the Securities Act turned on whether Defendants unlawfully offered and/or sold an unregistered security. The Defendants did not dispute that they offered and sold XRP without filing a registration statement with the SEC. Therefore, the question before the Court was whether XRP was a security for purposes of the challenged transactions. Determining if XRP was offered and sold in securities transactions turned on whether XRP was sold in an “investment contract” under SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under Howey, an investment contract is generally characterized by (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit from the efforts of others.² In answering this question, the Court grouped offers and sales of XRP into distinct categories and analyzed the economic realities of each category of sales independently.

1. Institutional Sales

   The Court examined Institutional Sales of XRP to sophisticated individuals and entities made pursuant to written contracts between Ripple and the investors, and determined that Institutional Sales were unregistered offers and sales of securities in violation of Section 5 of the Securities Act. First, the Court determined that these sophisticated individuals and entities invested money by providing capital to Ripple in exchange for XRP. Second, the Court found that a common enterprise existed between Ripple and the institutional investors because (1) Ripple pooled the proceeds from Institutional Sales and (2) each institutional investor’s ability to profit was tied to the profitability of other institutional investors, because they all received the same fungible XRP.³

   Third, the Court determined that, based on Ripple’s communications and marketing and the nature of the Institutional Sales, institutional investors had a reasonable expectation of profits derived from the entrepreneurial or managerial efforts of Ripple. As found by the Court, Ripple marketed XRP directly to the institutional investors by distributing promotional brochures that linked the investment potential of XRP to Ripple’s business. Ripple’s senior executives and employees echoed this sentiment through various public communications that touted Ripple’s commitment to developing the XRP ecosystem. Further, Institutional Sales were made pursuant to written sales contracts that included lockup provisions and resale restrictions, similar to those included in contracts for the sale of securities. The Court found that Ripple’s marketing, coupled with written contracts directly between Ripple and institutional investors, demonstrated that such investors understood that they were not purchasing XRP as a currency or commodity, but rather as an investment in Ripple’s efforts. Because the Court concluded that a reasonable investor involved in Institutional Sales understood that Ripple would use the proceeds from such sales to develop the network and value of XRP, the Court held that Institutional Sales of XRP constituted investment contracts under Howey, and therefore were unregistered sales of securities in violation of Section 5 of the Securities Act.

2. Programmatic Sales

   The Court then addressed Ripple’s Programmatic Sales of XRP and determined that the third prong of Howey was not established.⁴ Unlike Institutional Sales, where institutional investors knowingly purchased XRP directly from Ripple through written contracts, Programmatic Sales occurred on crypto exchanges in blind bid/ask transactions, and buyers could not know that their payments were going directly to Ripple to fund its operations. The Court found it important that Ripple’s Programmatic Sales constituted less than 1% of global XRP trading volume, so most purchasers of XRP on exchanges were not investing directly in Ripple at all. Further, despite the SEC’s arguments to the contrary, the Court found that buyers in Programmatic Sales could not reasonably rely on Ripple’s general marketing and communications because there was no evidence that such marketing was distributed broadly to, or consumed broadly by, buyers on crypto exchanges. The Court also distinguished between the “understandings and expectations” of sophisticated institutional investors, who had formalized contractual relationships with Ripple and could understand Ripple’s statements as directed toward them, and purchasers on exchanges, who did not know that they were transacting with Ripple and could not reasonably understand Ripple’s generalized marketing statements as promises creating a direct relationship with them. Therefore, based on the economic realities of the Programmatic Sales, the Court found that such transactions did not constitute the offer and sale of investment contracts under Howey and were not securities transactions.

3. Other Distributions

   1. Distributions to Employees and Other Third Parties

      In the third category, the Court examined Other Distributions by Ripple, including distributions to employees as a form of compensation and distributions to third parties as compensation for services. Here, Judge Torres found that the first prong of Howey (an investment of money) was not satisfied because the recipients did not “pay money or ‘some tangible and definable consideration’ to Ripple”⁵ in exchange for receiving XRP. Rather, Ripple paid XRP to its employees and third-party developers. The SEC argued that Other Distributions were an indirect public offering because recipients could then transfer their XRP into the market, but the Court found the SEC did not allege that the recipients were Ripple’s underwriters, nor did the SEC establish that secondary transactions by employees or other third parties were securities transactions. Further, the Court found that there was no evidence that employees and third parties sold the XRP and returned any proceeds to Ripple. Therefore, the Court determined that such Other Distributions were not securities transactions.

   2. Offers and Sales of XRP by Garlinghouse and Larsen

      Finally, the Court examined offers and sales of XRP by Garlinghouse and Larsen on crypto exchanges and determined that such transactions were not securities transactions. The Court analogized Garlinghouse’s and Larsen’s sales of XRP on exchanges to Programmatic Sales and found that the third prong of Howey was not established because buyers in these transactions did not know the identity of the seller.

4. Fair Notice and Vagueness Defenses

In addition to examining whether sales of XRP constituted investment contracts, the Court also ruled on Ripple’s “fair notice” defense and Garlinghouse and Larsen’s “vagueness” defense based on due process principles. These defenses focused on whether existing law is clear such that regulated persons or entities could objectively know that their conduct is prohibited. The Court rejected these defenses in the context of Institutional Sales and concluded that the caselaw defining an investment contract, including Howey, provides a clear, objective test to be applied in a variety of factual scenarios, thus eliminating the risk of arbitrary enforcement. Further, the Court rejected Defendants’ arguments that the SEC has failed to provide sufficient guidance, finding that the SEC’s enforcement approach as to Institutional Sales was consistent with prior enforcement actions brought against other cryptocurrency issuers. Importantly, the Court’s holding regarding fair notice and vagueness was limited to the SEC’s enforcement related to Institutional Sales.

5. Aiding and Abetting Claims

   The Court also denied the SEC’s motion for summary judgment on the aiding and abetting claim against Garlinghouse and Larsen, finding that a genuine dispute of material fact existed as to whether Garlinghouse and Larsen knew or recklessly disregarded the fact that Ripple’s Institutional Sales violated securities laws.

3. Analysis and Impact

In a departure from a line of cases that have found tokens themselves (or all transactions in tokens) to be investment contracts,⁶ Judge Torres considered whether XRP was the subject of an investment contract in different contexts, rather than the investment contract itself, stating that, “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.”⁷ The Court found support for this approach in Howey and its progeny, including SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352 (S.D.N.Y. 2020), despite the fact that the latter is often invoked in support of arguments that digital tokens themselves constitute securities. According to Judge Torres, in Howey, Telegram, and numerous other cases, “the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.”⁸ The Court then examined different categories of sales of XRP and came to varying conclusions on whether they constituted sales of securities based on the specific facts and circumstances. Although observers should be aware that the ruling could be appealed and is not binding precedent on other courts, it may still offer critical guidance to token issuers and investors.

1. Sales to Accredited and Institutional Investors

   The Court’s finding that institutional sales of XRP, which were not conducted pursuant to an exemption from registration with the SEC, constituted investment contracts under Howey is not necessarily controversial. Today, companies and sophisticated investors in the crypto space often structure token sales to accredited investors, which are often intended to fund the development of a project or protocol, pursuant to an exemption from registration (e.g., through a Regulation D or Regulation S offering). In this context, tokens, often sold via a “SAFT” or a token warrant and accompanied by equity, are being provided to the investor in exchange for capital that will be used to fund a project’s growth. In the case of Ripple’s Institutional Sales, Ripple marketed directly to such sophisticated investors and received money in exchange for XRP pursuant to written sales contracts that delineated the terms of the sales, including lockup provisions and restrictions on resales, which are often included in contracts for the sale of traditional securities. These written contracts, coupled with targeted marketing, created a direct relationship between Ripple and these investors and supported Judge Torres’ ruling that such sales were not simply “sale[s] of a commodity or a currency”⁹ and instead were “investment[s] in Ripple’s efforts.”¹⁰ In light of this ruling, Crypto companies and sophisticated investors alike should work with qualified attorneys to ensure that such direct sales of tokens are made pursuant to a registration statement or, more likely, an exemption from registration.

2. Sales on Exchanges

   Judge Torres’ ruling that Programmatic Sales of XRP through blind bid/asks on crypto exchanges did not satisfy the third prong of Howey could impact the way other courts analyze an issuer’s sales of tokens on a crypto exchange. Judge Torres reasoned that, because exchange buyers did not know that they were transacting with Ripple, they could not reasonably expect profits based on Ripple’s efforts. This theory seems to suggest that satisfying the third prong of Howey requires an investor to know that their money will be used directly to fund the efforts of an issuer. If adopted by other courts, this theory might allow a company to sell its tokens on an exchange through algorithmic trading in certain circumstances without violating securities laws. Further, Judge Torres rejected the SEC’s argument that general marketing and statements by Ripple and its affiliates about their efforts to further develop XRP were “promises and offers” to exchange buyers that could satisfy the third prong of Howey. However, Judge Torres found it important that Ripple’s exchange sales accounted for less than 1% of XRP trading volume. In a situation where a company sells its tokens on an exchange early on or before there is significant trading volume, a court adopting Judge Torres’ ruling might find that a buyer could know that they are likely to be purchasing from the issuer and therefore could reasonably expect profits based on the issuer’s efforts. It is also unclear if the trading features on a specific exchange could change the analysis. While the impact of the Programmatic Sales ruling remains uncertain, it is important to bear in mind that applying Howey to a given token distribution depends on the specific facts and circumstances.

3. Investment of Money

   Judge Torres’ ruling that Other Distributions of XRP to employees and third parties did not satisfy the first prong of Howey because they did not involve an investment of money could also impact the way courts analyze certain token distributions. By finding that Other Distributions of XRP were not investment contracts because recipients in these distributions did not “pay money or ‘some tangible and definable consideration’” to Ripple, Judge Torres endorsed a narrow reading of “investment of money.”¹¹ To Judge Torres, distributions of XRP lacked sufficient consideration to satisfy Howey even where such distributions were made as compensation for services by employees or as payment to third parties who were working to develop new applications for XRP. The SEC has endorsed a much broader interpretation in guidance and enforcement actions, arguing that the investment of money prong of Howey could be satisfied even where there is a “lack of monetary consideration for digital assets” such as when a token is distributed through an “air drop.”¹² However, a judge adopting this Court’s narrow interpretation of Howey’s first prong might find that it is not enough to say that an air drop (a distribution of tokens to certain wallet addresses without an exchange of monetary consideration) satisfies the investment of money requirement simply because it was conducted to promote circulation.

4. Secondary Sales

   Although the Court did not reach the issue of secondary sales,¹³ the decision suggests that secondary sales of tokens on crypto exchanges may not constitute offers and sales of investment contracts. In finding that Programmatic Sales were not investment contracts, Judge Torres said that the buyers “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.”¹⁴ Following the Court’s reasoning, if buyers in secondary transactions on centralized and decentralized exchanges are unaware of the identity of their counterparties, without additional facts establishing requisite “promises and offers” to secondary purchasers, these transactions may not satisfy the third prong of Howey to the extent the Court’s reasoning is adopted by other courts. To the extent adopted, this reasoning could significantly disrupt the SEC’s current and potentially forthcoming enforcement actions against cryptocurrency exchanges, where many of the SEC’s claims rely on the argument that secondary transactions in tokens are investment contracts.

5. Regulatory Impact

   Companies operating in the crypto space have long complained about a lack of guidance in applying U.S. securities laws to digital assets and have called on Congress to pass laws that provide a framework for cryptocurrency in the U.S. While SEC Chair Gensler has repeatedly said that the vast majority of cryptocurrencies are securities and the rules of the road are clear,¹⁵ that road is no simple highway. Judge Torres’ ruling demonstrates that applying existing law to specific token distributions is not a straightforward exercise. The ruling has also received the attention of U.S. lawmakers. Following the ruling, Senator Cynthia Lummis, co-author of the Lummis-Gillibrand Responsible Financial Innovation Act, said, “The decision confirms the need for Congress to deliver a clear regulatory structure for the crypto asset industry….”¹⁶ In a letter to Chair Gensler following the Ripple decision, another U.S. lawmaker, Rep. Ritchie Torres, urged the SEC to focus its enforcement efforts on “bonafide bad actors” and to otherwise reassess its regulation by enforcement approach.¹⁷ While action from Congress on cryptocurrency has been slow, the Ripple ruling may put pressure on lawmakers to provide much needed clarity to the crypto industry. The ruling could also influence Congress’ views in the ongoing power struggle between the SEC and the CFTC for authority to regulate crypto. In recent months, both agencies have appealed to Congress for increased funding and authority over the crypto space. This ruling, if upheld, could create a gap in the SEC’s purported authority and undermine the SEC’s push to remain the dominant regulator in the crypto space.

6. Proceed with Caution

   Although the decision currently stands as a partial victory for the cryptocurrency industry that could slow some of the SEC’s enforcement momentum, issuers should still remain cautious when conducting token sales of any kind. Judge Torres’ ruling was based solely on the specific facts and circumstances before the Court, and the decision emphasizes the need to examine the economic realities of a token sale based on the totality of circumstances, on a case-by-case basis. An issuer’s specific actions, including statements and public marketing, could potentially shift the Howey analysis. Further, it remains to be seen if the SEC will attempt to appeal Judge Torres’ ruling. In a speech on July 17, 2023, Chair Gensler said that the SEC is “still looking at” the opinion.¹⁸ Moreover, the ruling is not binding on any other court, and other judges may or may not find its reasoning to be persuasive.¹⁹ However, if courts continue to analyze whether tokens are the subject of an investment contract, rather than whether tokens themselves constitute investment contracts, the crypto industry may see a favorable shift in the outcome of future litigation and enforcement actions.