A big Ripple in the regulatory waters with judgment finding token is NOT a security under US law
In a highly-anticipated decision between Ripple Labs, Inc. (Ripple) and the US Securities and Enforcement Commission (SEC), Ripple has achieved what is being called a historical win with a summary judgment decision that the token XRP "is not in and of itself a"contract, transaction[,] or scheme" that embodies the Howey requirements of an investment contract." and as a result the token itself is not a security under US law.
The judgement was handed down by the US District Court of the Southern District of New York on 13 July 2023. The Court ruled that Ripple did not violate US Federal securities laws by selling its XRP token on public exchanges. This is the first victory for a cryptocurrency company in a case brought by the SEC, however it is not quite as simple as Ripple wins! As the SEC also had success in relation to a claim that the sale of XRP to institutional investors was an investment contract.
The SEC alleged that Ripple sold over USD$1.38 billion in XRP over a six year period to fund Ripple's operations, which sale was an unregistered securities offering. The crux of the case is whether the XRP is a security. The matter of whether there was in fact any way for Ripple to register the offering under US law is a matter which has also been the subject of debate.
When cryptocurrency is not a security
The Court applied the (now famous in crypto circles) Howey test to determine whether XRP was a security, being an "investment contract", noting the test is:
a contract, transaction[,] or scheme whereby a person [(1)] invests his 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 previous cases brought by the SEC, findings have been made that the cryptocurrencies at issue were securities for the purposes of jurisdiction and most enforcement actions brought by the SEC to date in the US have been settled by the parties targeted.
However, in Ripple's case, the Court decides that Ripple's XRP sales on public cryptocurrency exchanges - which the Court called "Programmatic Sales" - were not offers of securities under US law, because purchasers did not have a reasonable expectation of profit tied to Ripple's efforts.
Specifically, the Court said those "Programmatic Sales" were
blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP.
This means XRP sales on public cryptocurrency exchanges failed the meet the third prong of the Howey test. Further, the Court found that XRP sales by Ripple Chief Executive Brad Garlinghouse and co-founder and former CEO Chris Larsen, and other distributions including compensation to employees also did not involve securities under US law.
Partial win for the SEC
The Court granted a partial and smaller win to the SEC, by finding that Ripple's USD$728.9 million of XRP sales to hedge funds and other institutional investors did amount to unregistered sales of securities, with the securities being offered being a promise to deliver future tokens to those investors. Specifically the Court said:
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. From Ripples communications, marketing campaign and the nature of the Institutional Sales, reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for XRP Ledger, thereby increasing the value of XRP
This was ultimately:
pitching a speculative value proposition for XRP with potential profits to be derived from Ripple’s entrepreneurial and managerial efforts
The Court also knocked back Ripple's defence that the SEC did not provide them a "fair notice" for potentially breaching the law. The Court said,
The law does not require the SEC to warn all potential violators on an individual or industry level
Tokens for Employees and Founders
Interestingly, the Court found that tokens granted to employees could not have been securities as there was no "investment of money" as part of the transaction.
The ripple effect of the ruling
Despite not being a complete win for Ripple, the decision is important as it considers the status of a digital asset token itself, and leans into the argument that tokens are a kind of property, which may be offered as a security / financial product, in the same way that gold or other property can be offered as a financial product, but that the token in and of itself, is not a security/financial product.
This is precisely what was argued by a number of leading crypto-legal minds, including Mr Lewis Cohen and others in The Ineluctable Modality of Securities Law: Why Fungible Crypto Assets Are not Securities and also supports what the UK has been suggesting for years be the case with most crypto-assets.
The ruling will be no doubt cited by other crypto firms who have been fighting for an end to regulation by enforcement and sensible rule setting to take place. The 2022 SEC v LBRY case was heavily cited in this judgement and builds on the growing jurisprudence in the field.
It will also help crypto projects engaging with regulators recalibrate their submissions, based on what worked and what didn't work in Ripple's submission.
Ripple Chief Executive Garlinghouse in an interview called the ruling was:
a huge win for Ripple but more importantly for the industry overall in the U.S.
Coinbase said it would allow trading of XRP on its platform again. Its Chief Legal Officer Paul Grewal said on Twitter:
We’ve read Judge Torres’ thoughtful decision. We’ve carefully reviewed our analysis. It’s time to relist.
This case may also assist Coinbase in their SEC case, which focuses on similar issues. It is important to note that the ruling is a summary judgement, with a full trial remaining on issues between the SEC and Ripple, and while it may be appealed including once a final judgment is issued.
The authors are not US lawyers (and of course none of this is legal advice), and for an Australian audience it should be noted that the Howey decision is markedly different to the test for a managed investment scheme or financial investment offering in Australia, but some of the underlying principles, particularly that tokens may not in and of themselves be financial products/securities, are likely to prove relevant as the law develops here. We should note that some tokens could be designed to expressly be, or represent, financial products and naturally adding a blockchain to a financial product does not move the issuer outside the regulatory perimeter laws, but neither does adding a blockchain render a digital token within the perimeter.
The key take-aways remain:
Increasingly tokens are being recognised as property, just as the UK has been suggesting for years;
Facts and circumstances of each sale still matter very much and are an area of significant risk;
Marketing and offering a product as a financial investment is likely to be treated by regulators and the Courts as a financial investment (which can include secondary sales); and
The need for fit-for-purpose regulation which addresses the technological peculiarities of blockchain technology and provides a clear path to compliant token sales and offerings is only going to increase as time passes.
Only Parliaments / Congress can properly set a policy framework to support innovation while tackling and reducing the ever rising tide of scams and fraud to protect investors and users of tokens.