At a high level, the Order contains five key holdings:
- XRP, as a digital asset, is not in and of itself an investment contract.
- Selling any asset (including a digital asset) via an investment contract does not automatically make the subject asset a security.
- An arrangement by Ripple to sell XRP directly to institutional investors pursuant to written agreements ("Institutional Sales") is an investment contract.
- An arrangement by Ripple to sell XRP "programmatically" or through trading algorithms anonymously to the public via crypto exchanges ("Programmatic Sales") is not an investment contract.
- An arrangement by Ripple to distribute XRP as a form of payment for services (e.g., employee compensation) ("Other Distributions") is not an investment contract.
- In this Alert, we provide an overview of the key holdings and share some insights on its potential implications to the state of crypto regulation in the US.
In this case, Judge Torres was called upon to determine whether or not Ripple engaged in the unregistered offer and sale of securities in violation of Section 5 of the Securities Act of 1933 ("Securities Act") in connection with its XRP transactions, as alleged by the SEC. The court was obliged to evaluate the transaction under SEC v. W.J. Howey Co., 328 US 293 (1946), the leading precedent under which the US Supreme Court set forth a test for determining how to identify a security. The Howey test generally provides that an "investment contract" is a "contract, scheme or transaction" whereby a person (1) invests money (2) in a common enterprise and (3) is led to expect profits from the essential managerial efforts of others which affect the success or failure of the enterprise. If the contract, scheme or transaction is an investment contract, it is a security and will be governed accordingly under a panoply of the federal and state securities laws.
There has been little debate in recent years that an initial coin offering or other forms of selling digital asset tokens in an initial distribution constitutes an investment contract and therefore a securities offering. However, through consent orders, recent complaints, and informal statements, the SEC has clouded the long understood distinction between investment contracts (a security) and the underlying assets sold pursuant to them.
In speeches and interviews, SEC Chair Gary Gensler has repeatedly taken the view that the "vast majority [of digital asset tokens] are securities." Similarly, as highlighted in a prior alert, the SEC's recent enforcement actions against crypto exchanges effectively argue that once a digital asset token is sold via an investment contract, the token somehow becomes an investment contract itself.
In those complaints, the SEC attempts to tie the initial offering of a token and continued participation of its founders and issuing organizations to the secondary trading of such tokens on crypto trading platforms as an ongoing investment scheme under Howey.
However, as noted in the Securities Clarity Act, a bi-partisan bill reintroduced a few weeks ago, these statements and claims conflate the long settled distinction between an investment contract (a security) and the underlying assets sold pursuant to the investment contract, which may or may not be a security. This distinction also was reflected in the now infamous 2018 speech by former Director of the SEC Division of Corporate Finance, William Hinman — Digital Asset Transactions: When Howey Met Gary (Plastic). Still, somewhere in between, the Chair Gensler and the SEC determined to test that distinction.
Orange groves are not securities and neither is XRP: Back to Howey basics
While the Ripple decision contains other important holdings, for the sake of Howey and the crypto industry, perhaps no holding was as important as returning to the basics: that is, the purpose of the Howey test and the distinction between an investment contract and its subject asset. In assessing the XRP token, Judge Torres recognized that any asset can be the subject of an investment contract, but selling any asset (including a digital asset) via an investment contract does not automatically make that subject asset into a security. Rather, whether the sale and distribution of XRP, orange groves, or any other asset (a non-security) constitutes an investment contract (a security) depends on the totality of the circumstances surrounding each contract, transaction, or scheme through which the asset is sold and distributed (i.e., a transaction-by-transaction analysis).
When looking at XRP, Judge Torres was unequivocal in holding that XRP, the digital asset by itself, is not "a 'contract, transaction, or scheme' that embodies the Howey requirements of an investment contract," and thus it is not a security. In that sense, XRP, the digital asset, is no different than the orange groves in Howey. In Howey, investors purchased ownership interests in parcels of orange groves coupled with a service agreement for another person to cultivate, harvest and market the crops and remit the net proceeds to the passive investors. It was the entirety of that arrangement that constituted the investment contract in Howey, not the orange groves themselves.
Re-establishing the basic Howey analysis framework may be the most important outcome of the Order, and arguably one less likely to be overturned on appeal. Moreover, the Securities Clarity Act and the recently introduced Financial Innovation and Technology (FIT) for the 21st Century Act would further reinforce the distinction between the investment contract and the underlying asset. Indeed, the connection was immediately highlighted by Rep. Emmers in reaction to the Order.
Institutional Sales vs. Programmatic Sales
Applying the Howey transaction-by-transaction analysis, in the Order, Judge Torres assessed each of the Institutional Sales, Programmatic Sales, and Other Distributions based on the totality of the facts and circumstances surrounding each contract, transaction or scheme. Of the three contracts, transactions or schemes involving XRP assessed by the court, only the Institutional Sales were found to meet all of the Howey elements. The court found that both the Programmatic Sales and Other Distributions failed to meet at least one Howey element, and thus were not investment contracts.
The court's divergent conclusions on Institutional and Programmatic Sales stems from the analysis of the third prong of the Howey analysis. With respect to Institutional Sales, Judge Torres quickly dispensed with the first two Howey prongs, finding they were easily met. Because the court found the third prong was not met for Programmatic Sales, discussion of the first two prongs was unnecessary. When assessing the third prong, the court recognized that buyers in both types of sales had or could have had an expectation of profits in purchasing XRP. Thus, the crucial question for Judge Torres was whether that expectation was derived from the efforts of Ripple.
The court found that Institutional Buyers derived their expectation of profits from the efforts of Ripple, but that Programmatic Buyers did not. To reach this conclusion, the court identified several differences, but the key distinction was buyers' knowledge of whether Ripple was on the other side of the transaction.
In particular, Institutional Buyers entered into contracts with Ripple and purchased XRP directly from Ripple. As a result, they knew that Ripple was the seller and Ripple knew the buyer. In contrast, Programmatic Buyers had no contract directly with Ripple and purchased XRP through blind bid/ask transactions on a secondary exchange. As a result, Programmatic Buyers could not have known whether Ripple was the seller, and Ripple could not have known the buyer. As noted in the Order, these Programmatic Buyers largely "did not invest their money in Ripple at all." The court also noted evidence that some of these Programmatic Buyers who purchased XRP were wholly unaware of Ripple.
Additionally, the court also looked at the sophistication of the different types of buyers in determining whether a reasonable, similarly situated person would have connected XRP's price to Ripple's efforts. In this regard, unlike the Institutional Buyers, the court found the evidence lacking that a reasonable person in the shoes of the "generally less sophisticated" Programmatic Buyers could have analyzed the various documents and statements published by Ripple and its personnel over an extended period of time and connected those efforts by Ripple to XRP's price.
As a result, having considered the economic reality and totality of the circumstances, although Judge Torres held Ripple's Institutional Sales constituted an unregistered offer and sale of securities, Ripple's Programmatic Sales did not.
The court took little time in finding that Ripple's Other Distributions did not involve an investment of money and thus failed the first prong of the Howey test. In each distribution cited, Judge Torres noted that it was Ripple who gave up something of value (XRP) and not the recipients. The recipients paid no money, cash or other tangible and definable consideration to Ripple in exchange for the XRP they received.
Congressional action more likely
Although the Ripple decision is likely to be appealed, it stands to complicate the SEC's other ongoing litigation matters in this area while supporting pending Congressional action. Indeed, arguments that crypto regulation in the US must be resolved by Congress and not administrative action have only been bolstered by the Order; and the FIT for the 21st Century Act and other legislative activity may find more support than previously thought. Still, converting expectations of legislation into law may require significant bi-partisan support to avoid a veto threats from the Biden administration, which has shown little receptiveness to the industry.
Impact to ongoing SEC litigation
As briefly noted above, the Order cuts directly at the heart of the SEC's legal arguments in its ongoing litigation matters against crypto exchanges, and one of those cases also happens to be in the SDNY, where Judge Torres's Order will carry more legal weight. The Order is undoubtedly a new litigation risk for the SEC's ongoing and planned enforcement activity. How it may impact the current cases or the SEC's crypto crackdown remains to be seen.
Crypto exchanges and trading platforms
The question of whether secondary market sales of XRP constitute the offer and sale of investment contracts was not properly before the court and thus was not directly addressed. Nonetheless, in footnote 16, the court reiterated that such a question must be assessed under the transaction-by-transaction Howey analysis. As a result, the court reinforced the framework for exchanges to assess their digital asset listing process: (1) assessing each digital asset to determine whether it constitutes an investment contract or some other security by itself, and (2) if not, whether the manner in which the exchange makes the digital asset available for sale on its platform constitutes an investment contract.
Firms should consider how the Order may impact their listing standards, and trading and promotional activities. Of note, US crypto exchanges generally take the position that merely making digital asset tokens available for trading on their platforms, without more, is not the offer and sale of securities. As a result, the Ripple Order was enough to prompt many US crypto exchanges to begin relisting XRP on their platforms.