How the ruling applies the legal precedent set forth in The Chamber’s brief
August 1, 2023 – The Chamber of Digital Commerce & Sidley Austin LLP
On July 13th, the U.S. District Court of the Southern District of New York provided a split decision on cross-motions for summary judgment in the matter of SEC v. Ripple Labs, Inc. et al. The question before the court was whether Ripple and its executives’ distribution of XRP tokens constituted sales of securities in violation of U.S. securities laws and what law applies to such distributions.
The court analyzed the XRP token distributions in three categories described below. For each category, the court examined the relevant undisputed facts and applied the Howey Test, a multi-factor legal test, to determine whether a distribution of tokens is an offer and sale of “investment contracts” and, therefore, securities. This case is the first time that a Court has applied a separate Howey analysis to different types of distributions of the same token with different rulings for each distribution. The court’s ruling for each distribution is as follows:
- Institutional Sales: The Court ruled that the Howey test is satisfied and Ripple’s direct sales of XRP to “certain counterparties (primarily institutional buyers, hedge funds, ODL customers) pursuant to written contracts” constituted securities transactions. SEC win.
- Programmatic Sales: The Court ruled that Ripple and executives’ sales of XRP through the use of trading algorithms, such as on digital asset exchanges, with blind bid/ask transactions were not securities transactions because the purchasers had no expectation of “profits…from the efforts of others”, including Ripple or its executives. Ripple and executives win.
- Other Distributions: The Court ruled that Ripple providing XRP to employees and to other third parties through initiatives were not securities transactions because there was no “investment of money”. Ripple win.
The Chamber has provided a detailed analysis of the case below, including a look ahead as to what may come next. Although this decision is a great first step, The Chamber is eager to collaborate with Congress on legislation to strengthen and clarify these points.
The Chamber’s View
We were pleased to see that the Court’s interpretation of the issues surrounding the legal classification of digital assets is aligned with the arguments outlined in The Chamber’s amicus brief.
“This case is a big milestone in the process of setting clear and consistent sets of rules for our industry, and we are also encouraged by the legislation also in play,” said Perianne Boring, CEO and Founder of The Chamber of Digital Commerce. “The digital asset industry deserves a level playing field and we will continue to advocate for sound policy that promotes U.S. leadership in the digital economy.”
Judge Torres’ ruling establishes an important legal decision by properly distinguishing between an investment contract and the underlying asset.
In our brief, we argued that the subject of an investment contract (i.e. a digital asset) is separate from the investment contract itself. Therefore, the subject of an investment contract is not inherently a security and should not be treated as such for regulatory purposes. Our amicus brief also asserted that “care needs to be taken not to conflate a digital asset with the circumstances of its initial offering”, and this viewpoint is mirrored in the Court’s decision where Judge Torres states 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.”
Citing a variety of cases referenced in our brief where different tangible and intangible assets served as the subject of an investment contract, including orange groves, whiskey casks, payphones, and condominiums, Judge Torres states that “in each of these cases, the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.”
The Court expressly declined to opine on whether secondary market transactions in XRP constituted investment contracts, as that question was not properly before the Court.
However, the court found that purchasers who bought XRP from digital asset exchanges “stood in the same shoes as a secondary market purchaser” and were not offered or sold investment contracts.
The Court stated that, while such purchasers may have purchased XRP with an expectation of profit, “they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the [buyers on digital asset exchanges] were aware that they were buying XRP from Ripple.” This line of reasoning may also be informative, but not binding, on the application of the Howey test in secondary transactions of digital assets in future or ongoing SEC litigation.
“The Court adopted key themes from The Chamber’s Amicus Brief by setting clear legal precedent that a digital asset, like other tangible and intangible assets that is the subject of an investment contract, is separate and apart from the investment contract itself, and does not embody an investment contract. The Court, while not explicitly opining on the secondary resales of digital assets, indicated that some digital asset sales might not satisfy Howey’s “expectations of profits” criterion. The Court even cited the Judge’s opinion in SEC v. Telegram where The Chamber played a critical role as amicus curie,” said Lilya Tessler, Partner and head of Sidley Austin LLP’s Fintech and Blockchain group and representing The Chamber as amicus curie in SEC v. Ripple and SEC v. Telegram.
The Court applied the Howey test to three applicable scenarios:
1) Institutional Sales, 2) Programmatic Sales, and 3) Other Distributions.
Institutional Sales: For the Institutional Sales, which involved direct sales to primarily institutional buyers pursuant to written contracts, Judge Torres held all factors under the Howey Test were satisfied. The court concluded that purchasers invested money by buying XRP directly from Ripple and that there was a common enterprise because purchasers’ funds were used to finance Ripple’s operations and each purchaser received the same fungible XRP. Additionally, the court held that investors had an expectation of profit based on the efforts of Ripple given Ripple’s marketing efforts and public statements about developing use cases and improving the market for XRP. The court therefore found the undisputed facts demonstrated that the nature of the institutional sales of XRP were understood by the parties to be “an investment in Ripple’s efforts,” and thus a security.
Programmatic Sales: For Ripple and its executives’ programmatic sales, which were sales conducted using trading algorithms on digital asset exchanges, the court concluded that the third prong of the Howey test was not satisfied, stating:
“Having considered the economic reality of the Programmatic Sales, the Court concludes that the undisputed record does not establish the third Howey prong. 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.”
Here, the Court’s ruling indicates that the third prong of the Howey test, which examines whether a buyer is led to expect profits predominately from the efforts of a promoter or a third party, was not satisfied because these sales were “blind” and purchasers had no knowledge if their payments went to Ripple, or any other seller of XRP. The court held that this meant the programmatic buyers of XRP tokens were not purchasing them with the expectation that they would profit from the efforts of Ripple or other third parties because they did not intentionally “invest their money in Ripple” and because they did not receive the marketing materials and direct representations that the Institutional Buyers received. Therefore, considering the economic reality of the circumstances of the Programmatic Sales, the court found there was no offer and sale of investment contracts. Because the court found that the third Howey prong was not satisfied, the opinion did not analyze whether the first or second Howey prongs were satisfied in this distribution.
Other distributions: The court held that other distributions of XRP, such as in connection with employee compensation or Ripple’s Xpring initiative to develop new applications for XRP and the XRP ledger, failed to satisfy the first prong of Howey, that requires an “investment of money” as part of the transaction or scheme. Judge Torres mentions “the record shows that recipients of the Other Distributions did not pay money or “some tangible and definable consideration” to Ripple. The Court did not analyze whether the second or third prongs of the Howey test were satisfied for other distributions as the first prong failed to satisfy the test.
What’s Next?
SEC staff has indicated that they are recommending to the Commission that it appeal the decision. Nevertheless, the decision in this case led to major crypto exchanges reintroducing trading of XRP.
While this ruling represents a clear step forward for the industry by providing the applicable law and distinguishing an investment contract from digital assets themselves, The Chamber believes that regulatory clarity still must be achieved through comprehensive and effective legislation. The gears of Congress are encouragingly in motion with several blockchain and digital asset regulatory bills moving before the House and Senate. We are hopeful these bills will continue to move through the legislative process, but chances of enactment remain slim due to constraints of the legislative calendar and lingering partisan opposition to passing digital asset legislation.
The Chamber will continue to advocate for legislation that creates a clear and comprehensive legal framework for these technologies. Just as in our SEC vs. Ripple Brief, we will continue to work toward a clear route for firms to launch digital asset products, prioritizing both investor protection and innovation.
