On July 13, 2023, the United States District Court for the Southern District of New York issued a mixed decision as to whether various sales and issuances of the XRP token (XRP) by Ripple Labs, Inc. (Ripple) and two of its executives (collectively the defendants) constituted the sale of an unregistered security in violation of Section 5 of the Securities Act of 1933 (the Securities Act), holding on cross-motions for summary judgment that some were and some were not. SEC v. Ripple Labs, Inc. et. al., No. 1:2020cv10832 - Document 103 (S.D.N.Y. 2021).
Grounding its decision in the longstanding Howey test, the court (1) rejected the defendants' argument that additional factors beyond the Howey test—so called "essential ingredients"—needed to be applied to determine whether a token is a security, (2) rebuffed the defendants' due process challenge based on claimed lack of fair notice and vagueness and (3) denied the Securities and Exchange Commission's (SEC) motion for summary judgment on its aiding and abetting claim against Ripple's executives, finding a triable issue of material fact.
Howey governs and is not subject to an additional "essential ingredients" test
The SEC alleged that the defendants violated Section 5 of the Securities Act because they sold XRP as an investment contract, a type of security that must be registered. The defendants argued that XRP is not an investment contract, and therefore not a security that must be registered. Under these circumstances, the court held it must use the test set forth in SEC v. WJ Howey Co., 328 US 293 (1946) (the Howey test), which provides that an investment contract is "a 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." Howey, 328 US at 298–99. In analyzing whether a "contract, transaction or scheme" is an investment contract, "form should be disregarded for substance and the emphasis should be on economic reality" and the "totality of circumstances." Tcherepnin v. Knight, 389 US 332, 336 (1967).
The defendants argued that in addition to satisfying the Howey test, all investment contracts must also have three "essential ingredients," based on a survey and analysis of the case law cited in Howey. This "essential ingredients test" would impose additional requirements in determining whether a token was an investment contract, specifically: (1) a contract between a promoter and an investor that establishes the investor's rights as to an investment, which contract (2) imposes post-sale obligations on the promoter to take specific actions for the investor's benefit and (3) grants the investor a right to share in profits from the promoter's efforts to generate a return on the use of investor funds. The court declined to adopt this test because it would go beyond the plain words of Howey, impose additional requirements and stray from Howey's directive to "embod[y] a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits." 328 US at 299.
Therefore, when analyzing whether XRP was an investment contract, the court evaluated the economic reality and totality of circumstances and held that XRP could constitute an investment contract under certain conditions. The court then considered three different contexts in which XRP had been issued.
Institutional sales satisfy Howey
Institutional sales included the sale and distribution of XRP through wholly owned subsidiaries to certain counterparties, such as institutional buyers, hedge funds and on demand liquidity customers pursuant to written contracts. Following the Howey test, the Court determined that Ripple received money for XRP and rejected the defendants' argument that an "investment of money" required some mental state by the payor different from "merely payment of money." The court found the existence of a common enterprise because the record demonstrated that there was a pooling of assets and that the fortunes of the institutional buyers were tied to the success of the enterprise as well as to the success of other institutional buyers. The court found that reasonable investors, situated in the position of the institutional buyers, would have purchased XRP with the expectation that they would derive profits from Ripple's efforts, relying heavily on evidence of Ripple's communications and marketing campaign, and the nature of the institutional sales.
The court specifically pointed to the sales contracts and the inclusion of lockup provisions, resale restrictions, indemnification clauses and recitals that the institutional buyer was purchasing XRP "solely to resell or otherwise distribute" to reject claims that XRP had been purchased for consumptive or utilitarian rather than investment purposes. These provisions, the court reasoned, supported its conclusion that the parties understood the sale of XRP to be an investment in Ripple's efforts.
Holding that a common enterprise existed between Ripple and the institutional buyers, the court did not reach the question of whether the common enterprise extended to "other XRP holders," Ripple's executives or the "XRP ecosystem."
Programmatic sales do not satisfy Howey
XRP was also sold on digital asset exchanges "programmatically" or through trading algorithms as blind bid/ask transactions, where Ripple did not know who was buying the XRP and the purchasers did not know who was selling the XRP. The court held that the anonymity between programmatic buyers and Ripple meant that programmatic sales did not satisfy the Howey test, because these transactions could not lead to an expectation of profits solely from the efforts of the promoter or a third party. With respect to programmatic sales, the court found that Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it. In fact, many programmatic buyers were entirely unaware of Ripple's existence. Because programmatic sales failed this aspect of the Howey test, the court declined to analyze whether or not Howey's other requirements were met.
Similar to programmatic sales, the court held that sales of XRP by the Ripple executives did not satisfy the Howey test because they were made on various digital asset exchanges and through blind bid/ask transactions. The court similarly declined to analyze the other Howey requirements for such sales in light of this determination.
Other distributions do not satisfy Howey
Other distributions included circumstances where Ripple distributed XRP as a form of payment for services, such as employee compensation. The court determined that since the recipients of the other distributions did not pay any money or "some tangible and definable consideration" to Ripple, these distributions did not satisfy the Howey test. The SEC argued that the other distributions could be transferred in exchange for currency, goods or services to another holder and therefore should be considered an investment contract. However, the court concluded there was insufficient evidence to make such a finding, and it declined to analyze the other Howey factors as to these distributions.
Due process challenge fails
The court rejected the defendants' due process challenge to the SEC's enforcement action based on claimed vagueness and a lack of fair notice that institutional sales were subject to Section 5. The defendants argued that the SEC had failed to issue guidance on digital assets and had taken inconsistent approaches to regulating the sale of digital assets as investment contracts. The court determined that the SEC's approach to enforcement, specifically with respect to the institutional sales, was consistent with the enforcement actions that the agency had brought relating to the sale of other digital assets to buyers pursuant to written contracts and for the purpose of fundraising. Moreover, the court observed that the law does not require the SEC to specifically warn all potential violators of the law's application to them on an individual or industry level.
Both sides have hailed the decision as a partial victory. For cryptocurrency companies, the decision marks the first time a US judge has held that a token issuer's sale of digital assets did not constitute a securities offering (at least in some circumstances). For the SEC, the decision supports the Commission's theory of Section 5 liability for the issuer of a token as a matter of law as to certain types of sales.
The decision confirms the staying power of the Howey test nearly eighty years on. Relying on this opinion, future defendants may argue that their particular token should not be considered an "investment contract" based on the "economic reality" and the "totality of circumstances" around the contract or transaction involved in their particular case. Especially important is the court's determination that "blind" transactions in which Ripple was the seller did not satisfy the Howey test. At the same time, the court provided guidance on the types of contractual provisions that may bring a transaction within the scope of Howey, including lockup provisions, resale restrictions and indemnification clauses. These provisions, the court reasoned, are fundamentally inconsistent with the claim that tokens were being sold for a purely consumptive purpose.
The decision is also significant for what it leaves open. In a significant footnote, the court observed that the question as to whether secondary market sales of tokens constituted offers and sales of investment contracts was not before it. Nevertheless, the court signaled that the answer to that question likewise would seem to depend on the totality of circumstances and the economic reality of that specific "contract, transaction or scheme."
It remains to be seen whether other courts will take a similar approach when analyzing investment contracts involving digital assets under Section 5, and how different types of token issuances will be assessed under the Howey test—or other applicable law.