Ripple’s Win Against the SEC
The key question in the Ripple case rested on the application of the test that the U.S. Supreme Court enunciated in Securities & Exchange Commission v. W.J. Howey Co., which provides that a “security” is any “contract, transaction or scheme whereby a person  invests his money  in a common enterprise and  is led to expect profits solely from the efforts of the promoter or a third party.” 328 U.S. 293, 298–99 (1946). According to Ripple, the Securities Act simply did not apply because, it argued, XRP is not a “security” under Howey, and Ripple did not otherwise sell XRP pursuant to any “investment contract” under Howey. Id. at 297. In the SEC’s mind, Howey clearly applied because XRP’s value was derived in part through the efforts of Ripple and its leadership, and Ripple used the investors’ capital to increase the value of XRP.
It would be difficult to overstate the SEC’s confidence in its reading of Howey, let alone the effect of the outcome of the litigation with Ripple—the first major suit to raise the question—if the courts were to agree with the SEC’s theory. SEC Chair Gary Gensler has long taken the position that the “vast majority” of cryptocurrencies are securities, warning digital asset issuers who decline to register that they can’t count on “begging for forgiveness.” And when the SEC filed back-to-back lawsuits against crypto exchanges Binance and Coinbase earlier this year, the SEC’s complaints were, in essence, tethered to the theory that virtually all cryptocurrencies that the companies offered for trading were illegally unregistered, meaning that both exchanges were operating in violation of federal law. If the SEC is correct, it would represent a paradigm shift for cryptocurrency and decentralized finance industries, which, with few exceptions, have generally taken the position that they operate outside of the SEC’s jurisdiction.
This July, after both Ripple and the SEC moved for summary judgment, Southern District Judge Analisa Torres issued a decision that partially granted both parties’ motions. Sec. & Exch. Comm’n v. Ripple Labs, Inc., — F. Supp. 3d —, 2023 WL 4507900 (S.D.N.Y July 13, 2023). But despite granting relief to both parties, Torres’s decision represents a clear overall victory for Ripple—and a striking blow to the SEC, not to mention its claims that Coinbase and Binance were running illegal securities exchanges by listing cryptocurrencies like XRP.
As an initial matter—and in a rebuke to the SEC’s long-held view that crypto tokens have no separate identity from an “investment contract”—Torres found that XRP “is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract.” Ripple, supra, at *8. Still, Torres noted that something that is not a security by nature—say, gold or silver—can nevertheless “be sold as investment contracts, depending on the circumstances of those sales.” Id. at *7. The court then analyzed the categories of sales and issuances of XRP—to institutions, through exchanges and “other sales” that yielded “consideration other than cash,” and via Ripple executives’ private sales of XRP—to determine whether such transactions fell under Howey. Id. at *8. Considering the institutional sales, the court noted that Ripple pooled the cash of XRP’s buyers without segregating investor funds or allowing for profits to remain independent, booked all XRP-related proceeds together, used the cash “to promote and increase the value of XRP,” and marketed its business model “‘on a belief that demand for XRP will increase,’” increasing demand for the token. Id. at *9–10 (quoting Ripple court documents). This, to Torres, ticked off all of Howey’s boxes, inasmuch as the institutional investors “would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP.” Id. at *10. Thus, Torres found that such institutional sales constituted an unregistered offer and sale of investment contracts under section 5 of the Securities Act. Id. at *11.
Despite that ruling for the SEC, the court granted Ripple’s motion for summary judgment with respect to the sales of XRP to public buyers through digital asset exchanges—the so-called Programmatic Sales—and issuance of XRP through “other contracts” for noncash consideration. Looking at the Programmatic Sales, Torres noted that the transactions were blind bid/ask sales, meaning such buyers—“many” of whom “were entirely unaware of Ripple’s existence”—“could not have known if their payments of money went to Ripple, or to any other seller of XRP.” Id. at *11–12.
It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but 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 Programmatic Buyers were aware that they were buying XRP from Ripple.
Id. at *12. Based on the “economic reality” of these sales, the court found that the SEC failed to establish Howey’s requirement of a reasonable expectation of profit solely from the efforts of others. Id. at *13. For the same reason, the sales of XRP by the individual defendants—the current and former CEO of Ripple—failed to satisfy Howey because the undisputed record demonstrated that these sales were made “on various digital asset exchanges through blind bid/ask transactions.” Id. at *14. Lastly, considering Ripple’s “Other Distributions” of XRP to employees as compensation and to developers as incentive to develop new applications of XRP and its ledger, the court determined that these distributions did not satisfy Howey’s requirement “that there be an ‘investment of money’ as part of the transaction or scheme.” Id. at *13 (quoting Howey). “Here, the record shows that recipients of the Other Distributions did not pay money or some ‘tangible and definable consideration’ to Ripple. To the contrary, Ripple paid XRP to these employees and companies.” Id. (quoting Int’l Brotherhood of Teamsters v. Daniel, 439 U.S. 551, 560 (1979)).
Critically, however, the court’s rulings on the law as to the various sales of XRP did not resolve the entire case. The SEC had alleged that Ripple executives, both named as defendants, had aided and abetted the unregistered sales to institutional investors, but Torres found that the executives had raised a genuine issue of fact as to whether they “knew or recklessly disregarded the facts” of the sales. Id. at *16. That left the SEC, which made known its view that the case was “wrongly decided,” with the sole appellate option of seeking permission for an interlocutory appeal—a rarity in the U.S. Court of Appeals for the Second Circuit. Just ahead of the deadline to seek that relief, and on the heels of a decision in the Southern District of New York that declined to adopt Ripple’s reasoning with respect to secondary-market purchases in connection with a motion to dismiss the SEC’s claims against Terraform Labs, the SEC filed for permission to appeal Torres’s holdings with respect to the Programmatic Sales and “other sales” of XRP, but not the court’s holding that XRP is not, in itself, a security.
In early October, Torres denied the SEC’s motion and set an April 2024 trial date. Then, the SEC handed Ripple—and, perhaps, the crypto industry in general—another win by agreeing to dismiss its aiding-and-abetting claims against Ripple’s executives, thus avoiding a trial and speeding up any potential appeal of Torres’s July ruling.
Congress: Crypto Legislation
In the wake of the court’s ruling, several lawmakers urged Congress to enact bespoke cryptocurrency regulations. In a joint statement, House Representatives Patrick McHenry (R-N.C.), chair of the House Financial Services Committee, and Glenn Thompson (R-Pa.), chair of the House Agriculture Committee, noted that Torres’s decision “underscores the need for Congress to pass clear rules of the road for the digital asset ecosystem,” while urging their fellow lawmakers to pass their cosponsored draft legislation that would develop a regulatory structure for digital assets.
The bill, known as the Financial Innovation and Technology for the 21st Century Act (FITTCA), attempts to fill perceived gaps in the Securities Act of 1933 and the Commodity Exchange Act in several ways. The law would clarify the jurisdiction of the SEC and the Commodity Futures Trading Commission (CFTC) over digital assets, digital commodities, certain stablecoins, and exchanges, with the CFTC—long thought to be softer on the crypto industry than the SEC—taking the balance of power. To this end, the act specifically exempts “digital commodit[ies]” from the Securities Act’s definition of security, id. § 301, and further provides—in an apparent extension of Ripple’s holding—that a “digital asset sold or transferred or intended to be sold or transferred pursuant to an investment contract is not and does not become a security as a result of being sold or otherwise transferred pursuant to that investment contract,” id. § 101. The law defines digital commodity as “any unit of a digital asset held by a person” other than a digital asset issuer, provided that the digital asset “relates to” a sufficiently decentralized blockchain network. So, what is a “digital asset,” then? The FITTCA defines it as “any fungible digital representation of value that can be exclusively possessed and transferred, person to person, without necessary reliance on an intermediary, and is recorded on a cryptographically secured public distributed ledger”—that is, a public blockchain. Id. Critically, however, the bill would exclude from the definition of digital asset any “note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, or transferable share.” Id. Thus, the SEC could, conceivably, try to grab jurisdiction through this exemption by claiming that an underlying digital asset is, in reality, a “stock,” “debenture,” or some other traditional security. In late July, the bill advanced out of the House Financial Services Committee on a bipartisan vote, marking the first time any digital asset–specific legislation passed a congressional vote.
At the same time, the House Financial Services Committee also voted on, and passed, a related bill—known as the Blockchain Regulatory Certainty Act—which would exempt blockchain developers from certain financial reporting and licensing requirements that the Bank Secrecy Act and related regulations typically impose upon banks and other payment providers. Under the exemption, any “blockchain developer or provider of a blockchain service” cannot be treated as a money transmitter or a money services business unless the entity “has, in the regular course of business, control over digital currency to which a user is entitled under the blockchain service or the software created, maintained, or disseminated by the blockchain developer.” This is a key exemption because money services businesses and money transmitters are typically required to implement anti-money-laundering programs, create know-your-customer rules, monitor customers’ transactions for any suspicious activity, and report any suspicious activity if detected.
The bills now must still pass the full House before heading to the Senate, where they would be taken up by the Senate Banking Committee and its chair, Ohio Democrat Sherrod Brown, who has called for tougher regulations of the crypto industry.
Until Congress acts, the Ripple decision will remain the touchstone for determining when a digital asset is, or is not, a “security.”