By Mauro Wolfe, Vincent Nolan and Angela Benoit
On July 13, 2023, the U.S. District Court for the Southern District of New York granted partial summary judgment in favor of Ripple Labs Inc. (Ripple), holding that the company did not violate the Securities Act by selling its XRP token on public exchanges.
Despite this partial win, the Court also held that Ripple’s sale of the XRP tokens to sophisticated individuals and entities including hedge funds and institutional investors did constitute an unregistered securities offering.
Howey Test and Background
The Securities Act regulates the offer and sale of securities and grants broad enforcement authority to the Securities and Exchange Commission (SEC). Under Section 5 of the Securities Act, it is unlawful to sell, offer to buy or purchase a security, including investment contracts, without a registration statement.
In 1947, the U.S. Supreme Court articulated a three-part test for determining whether or not a transaction constitutes an investment contract. In SEC v. W.J. Howey Co., the Supreme Court held that an investment contract 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 recent years, judges have used the Howey Test to find that specific crypto assets are securities or investment contracts. In these rulings, developer statements tying the value of digital assets or profits depending on the “efforts of others” or pooling funds was sufficient to find participation in a “common enterprise” satisfying the Howey Test.
The SEC has brought more than 100 enforcement actions involving crypto assets by asserting that tokens constitute securities. While many actions result in settlements, experts in the crypto space have been closing watching the Ripple litigation.
Filed in 2020, the SEC contended that Ripple violated the Securities Act by selling XRP tokens to investors beginning in 2013. The court walked through the Howey Test but ultimately the decision turned on the third prong, investor knowledge and expectations.
Institutional Buyers
The court determined that the first prong of the Howey Test was easily met because institutional buyers invested money in exchange for XRP.
The second prong was also satisfied because Ripple pooled the money and used it to fund its operations, and profits for XRP investors were tied to Ripple and the investment of other institutional buyers, establishing a common enterprise. Ripple used the invested funds to promote XRP and the success of the token in turn depended on and was tied to the success of other institutional buyers.
In applying the third prong of the Howey Test, the court examined whether similarly situated reasonable institutional investors would have purchased XRP with an expectation of profiting from Ripple’s business efforts. The court particularly focused on marketing materials and statements aimed at institutional investors, which pitched “speculate value” for XRP that directly depended on Ripple’s efforts to develop its blockchain for transactions involving its digital asset. Senior leaders made statements in interviews and online posts highlighting Ripple’s efforts and the speculative value of XRP.
With all three Howey factors satisfied, the court held that the majority of Ripple’s sales to sophisticated individuals and entities including hedge funds and institutional investors were unregistered sales of securities.
Programmatic Sales
When turning to Ripple’s sale of XRP tokens on public crypto exchanges, the court made clear that these circumstances substantially differed from private sales to institutional buyers.
Programmatic buyers did not or could not reasonably expect that their money would profit Ripple or that Ripple’s efforts would generate profits for them. These sales were blind bid or ask transactions where the purchasers did not and could not have known that their payments went to Ripple. These buyers were less sophisticated and had less knowledge than the institutional buyers and may not have been aware they were purchasing XRP from Ripple.
Triable Issues
The court did find that there a genuine issue of material fact existed regarding whether or not two of Ripple’s executives aided and abetted a Securities Act violation. This analysis turns on the scienter of the defendant. To prevail the SEC must prove “general awareness”—either actual knowledge or reckless disregard—of Ripple’s violation. Both executives testified that they believed XRP did not constitute a security and relied on legal analysis from prior counsel.
Takeaways
Given the stakes, it is likely that both sides will appeal the decision. We will wait for the next round of decisions. Structurally, absent registration, capital raises in connection to crypto projects run the risk of securities violations. The crypto markets believe that the Court essentially ruled that XRP tokens are not securities per se, but rather commodities. We are not convinced the Court of Appeals will agree.