Ripple Caused A Tidal Wave
Implications from the Ripple Summary Judgment
On Thursday, July 13, 2023 Judge Analisa Torres of the Southern District Court of New York issued a Summary Judgment on the SEC’s case against Ripple Labs and two of its executives. The judgment was met with jubilation by crypto participants. XRP, the token issued by Ripple Labs, catapulted 80% and settled up 50% since the news. Crypto assets that indirectly benefited from the judgment rose as well: ETH +7%, COIN +30% and alt-coins rallied 10-30% led by SOL +30%.
The punchline is that XRP is not a security. The SEC was dealt its first loss in an otherwise perfect record litigating against crypto projects. The SEC’s stance that all crypto assets, except for Bitcoin, are securities was undermined by a federal judge.
This article leverages the insights of many crypto lawyers. It serves as a consolidation of the most prescient legal interpretations and details the Court’s rationale. It explains why the Judgment is a big deal and enumerates the implications.
Why it’s a big deal
1. It’s a win for US crypto in an otherwise dire backdrop
Crypto in the US has been in the doldrums. The wake of FTX, banking clamp downs and SEC enforcement actions set the industry back in the US. The judgment vindicates that crypto has a right to exist in the US. Participants are breathing a sign of relief.
The win shifts the power dynamic. The SEC is not always right. Its views are not the final judgment. The ruling lends support to other cases.
2. A US federal court judge stated that a token is not a security
Specifically, XRP is not a security. That’s a huge deal. Until that statement the overriding rhetoric, vocalized by the SEC, was that all tokens, except for Bitcoin, are a security. The implications was that the entire industry was illegally operating outside of the confines of US securities law. It’s all illegal. The ruling by Judge Torres denounced that notion.
A token, in and of itself, is not an investment contract and therefore not security. If a token is sold as part of a contract, transaction or scheme that “embodies the Howey requirements” then an investment contract is present. Investment contracts need to be registered as securities with the SEC. But that doesn’t make the subject of the investment contract, in this case the token, a security. The judged sided with what the crypto industry has been saying for years.
The SEC had fused together two things: a token and a security. The judge soundly rejected that those two things are necessarily the same.
3. Indication that the tide is turning
Crypto skeptics dominated the US regulatory rhetoric this year. Chairman Gensler, Senator Warren and less vocal but equally poignant regulatory bodies championed banning crypto in the US. That tide is starting to turn. Financial juggernaut BlackRock filed for a Bitcoin spot ETF and heralded the benefits of Bitcoin. Congressmen McHenry and Thompson tabled progressive crypto legislation in the House of Representatives. Senators Lumis and Gillibrand re-introduced their amended legislation in the Senate. All in the last month.
Coinbase was the only defendant of crypto in the US. They are now joined by financial institutions, Congressmen and Senators, and now the courts. A new chapter has opened in US crypto.
The rationale of the judgment
In December 2020, the SEC commenced its action against Ripple and two of its executives. The SEC charged Ripple Labs, the company that issued the XRP token, and two of its executives with engaging in unlawful offer and sale of securities in violations of the Securities Act of 1933. The two named executives were also charged with aiding and abetting Ripple’s violation.
Clarifying context: what’s a summary judgment
Judge Torres issued a Summary Judgement. A Summary Judgment is issued when there is no dispute over the case facts. When both sides agree to the substantive facts, the judge can skip to a judgment. A Summary Judgment is different from a Complete Judgment. There is no trial subsequent to a Complete Judgment. There is a trial subsequent to a Summary Judgement. In this case, there will be a trial pertaining to the charges levied against the executives. However, that pertains exclusively to the individuals. It will not impact the rest of the judgment.
The question at the heart of the matter
The key question the judge opined on is:
“The question before the Court is whether Defendants offered to sell or sold XRP as a security.”
The SEC alleged that Defendants sold XRP as an ‘investment contract,’ which is a type of security defined by the Securities Act. The Defendants argue that they did not. Therefore, no SEC registration statement was required.
How the judge addressed the question
The Summary Judgment made clear that:
“The plain words of Howey make clear that an investment contract for purposes of the Securities Act means a contract, transaction, or scheme. But the subject of a contract, transaction, or scheme is not necessarily a security on its face.”
That means the thing being sold is not necessarily a security, but the way in which it is being sold can turn the sale of it into a securities contract.
The Judgment continued:
“Howey and its progeny have held that a variety of tangible and intangible assets can serve as the subject of an investment contract [orange groves, whiskey casks, payphones, condominiums, beavers, digital tokens]. In each of these cases, the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.”
The famous example is the Howey case itself. The assets being sold were orange groves. The orange groves themselves are not securities. The way in which they were packaged, marketed and sold created an investment contract. The investment contract is bound by securities laws. But that doesn’t morph the actual orange groves into securities. They are still just a bunch of dirt, trees and oranges.
Based on that logic, the judge determined:
“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.”
Rather the court examines the “totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP.” The judge determined there were three different circumstances under which Ripple sold XRP. Each is assessed independently based on the Howey test to determine if a securities contract exists. The three are:
Institutional Sales
Programmatic Sales
Other Distributions
1. Institutional Sales
Ripple sold XRP directly to institutions raising $728 million. The judge ruled in favor of the SEC. These sales were unregistered securities offerings. The judge explained the Howey test rationale. There was:
(i) an ‘investment of money’
Institutional buyers exchanged currency for XRP.
(ii) in a ‘common enterprise’
Investor assets were pooled together. The fortunes of each investor are tied to the others and to the success of the enterprise.
(iii) and a ‘reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others’ exists
Case law stipulates that profit can mean “income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment.” Ripple marketed the merits of the investment directly to institutional buyers. The capital raised was used to advance Ripple technology, which could lead to the appreciation of the XRP token. Institutional buyers were bound by lockup agreements. Restricting the transfer of XRP refutes the notion that institutional buyers acquired XRP for consumptive use.
The ruling in favor of the SEC on Institutional Sales was expected.
The law Ripple broke in conducting the sale of XRP to institutional buyers is not registering with the SEC in advance. Companies do what Ripple did regularly. They just register. Crypto projects do as well. But since the ICO days they’ve gotten more sophisticated. They apply for exemptions to SEC filings and limit the sale of tokens to specific types of investors.
This ruling in no way undermines institutional investors participating in financings of crypto projects that abide by SEC filing exemptions.
2. Programmatic Sales
XRP was also sold through crypto exchanges to unknown buyers. These sales are characterized as ‘Programmatic Sales.’ The court concluded that there was no ‘reasonable expectation of profits from the efforts of others’ in regards to Programmatic Sales.
The judge noted:
“Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, Programmatic Buyers could not reasonably expect the same”
XRP was purchased in open market transactions. Programmatic Buyers did not know who they were buying XRP from. The vast majority of XRP buyers didn’t buy it from Ripple. An estimated 1% of transaction volume came from Ripple sales. Therefore, unlike Institutional Buyers, Programmatic Buyers didn’t directly invest their money in Ripple. Programmatic Buyers are similar to secondary market purchasers.
The judge clarified that a ‘speculative motive’ on the part of the buyer or seller does not evidence an investment contract. Programmatic Buyers may have purchased XRP with the expectation of profit. But the expectation can’t be linked to the efforts of Ripple anymore so then to external factors like the overall market.
The Judgment finds that Programmatic Buyers were not directly marketed like Institutional Buyers were. Programmatic Buyers were “less sophisticated investors” and didn’t share the same “understanding and expectations” as Institutional Buyers. Programmatic Buyers couldn’t be expected to parse through Ripple’s multiple documents and public statements, which occasionally were inconsistent, across several outlets over a period of eight years.
The third prong, the ‘expectation of profits from efforts of others,’ of the Howey test was not satisfied according to the Court. Therefore, the other two don’t need to be analyzed. All three need to be present for an investment contract.
3. Other Distributions
Ripple issued $609 million worth of XRP tokens to employees as compensation and third parties in exchange for services. The judge ruled that these distributions are not securities contracts. They do not satisfy the first prong, the ‘investment of money,’ of the Howey test.
Recipients did not pay money or “some tangible and definable consideration” to Ripple. There is no evidence that Ripple funded itself by issuing XRP to recipients who subsequently sold XRP and distributed the proceeds back to Ripple.
What happens from here
The SEC could appeal the decision. An appeal would take at least a year to play out. The SEC is in a bind as crypto lawyer orlando.btc pointed out:
The SEC will likely appeal, but it may not matter. In the interim the Coinbase case and potentially regulation will surface. Both of which will hold more weight than this judgment.
Ripple is not in the clear. The judge found it guilty of violating securities laws when it raised $780 million from Institutional Investors. Penalties usually include disgorgement of ill gotten gains and fines. Ripple owns an estimated 3.7 billion XRP valued at $2.6 billion. Ripple likely has enough money to cover the penalties. Ripple will probably settle for the violations regarding Institutional Sellers.
Implications
1. Temper expectations, this ain’t precedent setting
The Judgment is a win for XRP and crypto more broadly. But it is not a slam dunk. It is a non-binding and non-precedent setting judgment. The Judgment can persuade other court judges. But other judges are free to disagree with it. For the judgment to set precedent, it would need to be appealed to and reconfirmed by a circuit court. There is a good chance the SEC appeals the decision. Trial court judgements are regularly reversed.
Stephen Palley, partner at Brown Rudnick, put it perfectly:
2. XRP is not a security, so other tokens shouldn’t be a securities either
The judge made it clear XRP, in and of itself, is not a security. The read across for the market was that if XRP is not a security, then other tokens are also not securities. The thinking sent alt tokens up 10-30%.
3. Surprising outcome on questionable logic could be reversed on appeal
The outcome was unexpected. Price movements reflect the magnitude of the surprise. The most surprising things were:
Judge clearly stating that XRP, in and of itself, is not a security
Programmatic Sales are not securities offering
Other Distributions are also not securities offering
The rationale of why XRP, in and of itself, is not a security is strong. It will likely hold up. That alone is a huge win. However, the logic of the latter two is questionable and could be overruled on appeal.
An appeal could argue that the ‘expectation of profit’ of Programmatic Buyers came from Ripple itself. As Preston Byrne, partner at Brown Rudnick, points out, it’s clear to everyone in the industry Ripple was the promoter of XRP. Whether or not Programmatic Buyers bought XRP from Ripple directly or others is irrelevant. The Southern District Court of New York found that, in the case against Telegram, the purchasers ‘expectation of profit’ came from “the essential entrepreneurial and managerial efforts of Telegram,” and not the intermediaries that sold the Telegram securities to the buyers. Buyers in the Telegram case didn’t buy directly from Telegram, but that didn’t matter. So why does it matter in the Ripple case?
Stocks are rarely bought from the issuing company. The buyer of Apple stock is not handing over money to Apple the company when purchasing Apple shares. The transaction occurs on an open market between unknown buyers and sellers. Money transfers from the buyer to the seller. Shares transfer from the seller to the buyer. Apple, the company, plays no role.
The judge applies the securities laws, which apply to stocks, to crypto. Yet for some reason delineates that in crypto, it matters who the buyer bought the token from, yet in stocks it does not. That’s bizarre. If it’s the same securities laws being applied to both, why does it matter in one venue who the buyer is buying from yet not in another?
An appeal will highlight that the ‘investment of money’ per Howey, does not actually need to be money. Byrne describes that precedents make it clear that the purchaser only needs to “[give] up some tangible and definable consideration in return for an interest that had substantially the characteristics of the security.” Ripple employees and service providers offered their time and skills and the employer, Ripple, gave them XRP in exchange. Yet, in regards to Other Distributions, the Court found that employees and service providers paid no “tangible and definable consideration” to Ripple. Hours worked and applications built in exchange for XRP seem tangible and measurable.
4. Conflicting views, unexpected judgment outcome and marginalizing SEC will accelerate regulation
The judgment will accelerate regulation. It serves as another example highlighting the conflicting views on what digital assets are. The SEC, CFTC, politicians and now the courts have differing opinions. The argument can not be made that crypto regulation is clear in the US and actors need to conform to existing laws. Regulatory bodies, Congress and the courts need to get on the same page.
Legislation is required to clarify an odd and unexpected result of this judgment. If a seller sells something to ‘sophisticated’ buyers by marketing to them, negotiating directly and structuring a deal, then it's an investment contract. SEC filings and disclosures are required to ensure investor protection. But if that same ‘something’ is sold through exchanges to unknown parties, no disclosure is required. Ironically, the outcome is ‘sophisticated’ investors are more protected than ‘unsophisticated’ retail investors. That’s the opposite of what the SEC aims to achieve.
Matt Levine correctly points out:
“The message of this decision is that crypto companies can freely sell tokens to retail investors as long as those retail investors are uninformed and the companies are secretive about it; only if they sell tokens openly to sophisticated investors will they get in trouble. That’s bad.”
The Judgment implies the SEC has no jurisdiction in crypto. Token sales today are commonly sold to institutional investors under exemptions from securities laws. Armed with this judgment, future sales on exchanges done like XRP’s Programmatic Sales, are not securities offerings. The SEC is circumvented in both cases. No crypto sales will ever require SEC registration. Regulators and politicians won’t like that. The SEC serves purpose; ensuring investors are protected. The SEC achieves that by enforcing disclosure requirements. Marginalizing the SEC from regulating crypto will force the SEC to support legislative action.
5. Mostly a positive read across for Coinbase
The ruling was favorable for crypto exchanges, namely Coinbase. The judgment supported the view that Coinbase is not trading illegal securities. XRP, and perhaps by extension other tokens traded, are not securities. Two unsupportive points were made in the Judgment that were largely missed. The Court did not opine on secondary market sales. The court denied Ripple’s due process claim.
The court buried in a footnote the following:
“The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court. Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme.”
That’s weird. The court essentially says don’t take this judgment and apply to other secondary market sales because the court wasn’t specifically asked about secondary market sales. But the court implicitly opined on secondary market sales in order to rule in favor of Ripple’s Programmatic Sales. That seems like a contradiction.
Ripple claimed that the SEC violated their due process rights. Defendants stated that securities laws are not clear enough regarding crypto assets. The SEC sued Ripple without ‘fair notice.’ The Court rejected this claim. The Judgment states that there is ample case law exemplifying the Howey Test.
Coinbase’s defense partly rests on a similar due process claim. If the judge doesn’t think it has merit, chances are another won’t either. However, due process is one of several of Coinbase’s defenses read SEC v COIN: The Heavyweight Battle for US Crypto.
6. No ICO boom coming and judgment undermines prior ICOs
Contrary to popular belief ICOs are not coming back. The favorable ruling for Programmatic Sales does not legitimize ICOs. The Judgment’s logic does not apply. Unlike XRP Programmatic Buyers, typical ICO buyers know exactly who they are buying from and where the money is going.
The ruling actually further undermines ICOs. The Judgment makes it clear that if tokens were sold in a similar fashion as XRP to institutional buyers with lockups, without requesting an exemption, then that’s an unregistered securities offering. Many ICOs fit that characteristic.
Stay curious.
My thoughts in this article are informed by the many leading crypto lawyers including: Bryan Jacoutot, Gabriel Shapiro, orlando.btc, Brandon Ferrick, Rosenfeld M, Stephen Palley, Jason Gottlieb, Bill Hughes, Preston Byrne. Thank you for your insights.
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The quote from the court opinion is not part of the decision from the case. It is read in as the standard by which to do any Howey analysis. The dependency on this to formulate a legal opinion is incorrect. Additionally, the case finds XRP to be part of an investment contract. Given the fungibility of the token, it is unclear the impact this will have in the market or secondary trading.
Taken as the court's conclusion "Therefore, having considered the economic reality and totality of circumstances surrounding the Institutional Sales, the Court concludes 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 only issue that was decided in this case that is relevant to our industry is how to litigate and prove reliance and expectations in the third prong of Howey, with sufficient facts.
I write this because I have growing concerns that the misinterpretation of this case is going to be very costly to founders and our industry as whole.