SDNY Issues Split Decision in SEC v Ripple Labs, Potentially Complicating Analysis of When Crypto-Tokens Will Be Treated as Securities

On July 13, 2023, Judge Analisa Torres in the Southern District of New York issued the much-anticipated summary judgment order in the Securities and Exchange Commission’s (SEC) case against Ripple Labs and two senior leaders, Bradley Garlinghouse and Christian Larsen.[1] The decision granted and denied in part both the SEC’s and Ripple’s cross-motions for summary judgment, leaving only the relatively narrow question of the individual defendants’ alleged role in Ripple’s violations unresolved. 

Judge Torres’s decision is the latest in a recent line of district court opinions examining, in the context of actions brought by the SEC, when digital assets should be treated as securities under the Supreme Court’s “Howey test,” as articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Indeed, Ripple relied on language from each of SEC v. Telegram Group, Inc.; SEC v. LBRY, Inc.; and SEC v. Kik Interactive Inc. in explaining how Ripple’s XRP tokens should be treated under the Howey test.[2]

Ripple is not a clean victory for the SEC or the crypto-industry, and may very well be appealed by either or both sides. Indeed, much of Judge Torres’ opinion leaves considerable room for interpretation, not only as to what tokens might be deemed to be securities subjecting certain transactions to registration requirements, but also regarding in what contexts such token transactions will constitute investment contracts. As such, market participants should be cautious in relying solely on the Ripple decision when contemplating future transactions. Nevertheless, Ripple is an important addition to the caselaw interpreting Howey in the crypto asset context and warrants close attention.  

Background

As described by Judge Torres, Ripple is a company that “seeks to modernize international payments by developing a global payments network for international currency transfers.” The XRP Ledger Ripple utilizes aims to be a “faster, cheaper, and more energy-efficient alternative to the bitcoin blockchain.” XRP is the digital token of the XRP Ledger. Pursuant to the XRP source code, there is a fixed supply of 100 billion XRP—each of which is divisible into one million sub-units called “drops.” Ripple itself held 80 billion of the 100 billion XRP at launch. 

The SEC’s case against Ripple focuses on three categories of XRP sales Ripple conducted over the years. First, Ripple sold XRP “directly” to “institutional buyers, hedge funds,” and “on demand liquidity” customers (“Institutional Sales”). Second, Ripple sold XRP on “digital asset exchanges” through trading algorithms “programmatically” (“Programmatic Sales”). Third, Ripple used XRP as payment for certain services (“Other Distributions”). These services included employee compensation and software developers to build new applications for XRP and the XRP Ledger. 

Decision

Judge Torres’ ruling focused on several key issues: (1) whether Ripple’s XRP token was inherently a security; (2) whether Ripple’s Institutional Sales of the XRP token constituted securities transactions; and (3) whether Ripple’s Programmatic Sales of XRP on exchanges and Other Distributions for employees and service providers constituted securities transactions. 

A. First, the Court ruled that XRP Tokens are not inherently securities.

To determine whether XRP tokens are securities—defined under the Securities Act as including any “investment contract”—the Court applied the Supreme Court’s test in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), which defines an investment contract as a contract, transaction, or scheme whereby a person (1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party. As a threshold matter, the Court explained that the relevant question is not simply whether XRP tokens are securities for all purposes, but whether they can serve as the subject of an investment contract under the Howey test in the specific contexts presented to the Court. Judge Torres noted that many cases applying the Howey test have found that both tangible and intangible assets can serve as the subject of an investment contract even when that asset was “not itself inherently an investment contract.” Gold, silver, and sugar, for instance, are considered “ordinary assets,” but in certain contexts, they may be serve as the asset underlying investment contracts.

Here, the Court found XRP “is not in and of itself a contract, transaction, or scheme,” but rather just a “digital token,” that was not in and of itself an investment contract. That does not mean, however, that certain XRP transactions could not constitute investment contracts—and therefore, under Howey, securities. The Court thus embarked on a fact‑specific analysis of whether the Institutional Sales, Programmatic Sales, and Other Distributions of XRP constituted investment contracts subject to the Securities Act’s registration requirements.

B. Second, the Court found that Ripple’s Institutional Sales constituted investment contracts.

The Court granted the SEC’s summary judgment motion regarding Ripple’s Institutional Sales, holding that those direct institutional XRP sales to investors constituted an unregistered offer and sale of investment contracts. This ruling continued the trend in Telegram, Kik, and LBRY, holding that certain sales of digital tokens can constitute securities transactions, and again highlighted that such determinations are highly dependent on the specific facts and circumstances of the token sales at issue.  

Howey analysis. Per the Court, Ripple’s Institutional Sales met each Howey prong. As to whether the transaction included an “investment of money,” the Court found that the “payment of money” to Ripple for XRP established this element. Regarding the second prong, the “existence of a common enterprise,” the Court ruled that there was “horizontal commonality” between Ripple and investors, as Ripple “pooled the proceeds” together and used them to “finance its operations.” Each institutional buyer’s “ability to profit was tied to Ripple’s fortunes” (and the fortunes of other buyers) because all “received the same fungible XRP.” 

The Court held that these sales met the third Howey prong as well, reasoning that sophisticated institutional buyers purchased XRP “with the expectation that they would derive profits from Ripple’s efforts.” In support of that finding, the Court catalogued Ripple’s “many” statements and messaging about “the investment potential of XRP and its relationship” to Ripple’s efforts. As we noted following the LBRY decision, such statements appear to attract considerable attention from the SEC and, the caselaw suggests, from courts.

Notably, Judge Torres refused to apply the “essential ingredients” test Ripple had advanced to avoid the impact of the Howey test (at least as the Court interpreted the Howey test). The Court described the essential ingredients test as focusing on post-sale obligations for the seller to generate a return and a right for the investor to share in profits, but called it a “novel” test that no court had ever applied. In other words, Howey’s focus on expectation of profits from the efforts of others was enough; one need not inquire into post-sale obligations.

Despite ruling against Ripple Labs as to Institutional Sales, it found the record did not support granting the SEC summary judgment on its aiding and abetting claims against the individual defendants, claims that require proof that the individuals “knew, or recklessly disregarded, the facts that made Ripple’s transactions and schemes illegal under statutory and case law” and that they substantially assisted those violations. This underscores the challenges the SEC faces in charging individuals whose knowledge and assistance of underlying violations will often be more difficult to resolve at the summary judgment stage.

Due process objections. The Court similarly declined to endorse Ripple’s or the individuals’ defenses of “fair notice” and “vagueness” based on due process principles. The Court explained that any evaluation of a fair notice defense is objective, not specific to whether Ripple or the individual actually received a warning alerting them to the danger of being held to account for their behavior. It then held that Howey “sets forth a clear test” for determining what constitutes an investment contract, and that its “progeny provides guidance on how to apply that test to a variety of factual scenarios.” The Court further found that the SEC’s “approach to enforcement, at least as to” the institutional sales, was “consistent[.]”

C. Third, the Court found that Ripple’s Programmatic Sales on exchanges and Other Distributions (to employees and service providers) were not securities transactions. 

Programmatic sales on exchanges. Judge Torres held that Ripple’s Programmatic Sales of XRP through “digital asset exchanges” did not establish the third Howey prong—i.e., that a reasonable expectation of profits be derived from the entrepreneurial or managerial efforts of others. The Court, finding these programmatic buyers did not know to whom or what they were paying money, held that Ripple’s transactions with them did not constitute offers and sales of investment contracts. The SEC argued that Ripple “explicitly targeted speculators,” but this failed. Per the Court, “a speculative motive” from the purchaser or seller was not sufficient to “evidence the existence of an ‘investment contract’[.]” Even if purchasers expected profit, this expectation was not derived from “Ripple’s efforts.” 

In reaching its conclusion, the Court explained that Ripple’s Programmatic Sales did not include contracts with “lockup provisions, resale restrictions, indemnification clauses, or statements of purpose,” and noted the “less sophisticated” nature of programmatic buyers, who were less likely to have an understanding and expectation that XRP would grow in value based on Ripple’s efforts.[3] The Court also noted the relatively small proportion of global XRP trading volume found to be Ripple’s programmatic sales. Here again, the Court’s fact‑specific analysis should give observers pause before drawing broad conclusions about what this or other courts might find rises to the level of an investment contract for transactions in other crypto assets. 

In a related holding, the Court also found that Larsen’s and Garlinghouse’s sales on digital asset exchanges also were not securities transactions for largely the same reasons.

Other Distributions of XRP as compensation and payment for services. The Court also found that XRP token distributions to employees and third parties to develop software for the XRP ecosystem were not offers and sales of investment contracts. Here, the Court held that the SEC could not meet its burden as to the first Howey prong because recipients of Other Distributions did not pay money to Ripple. The Court noted that Howey requires a showing that investors “provided the capital” or “put up their money.” Judge Torres’ decision rejects the proposition that labor—from employees or third parties who developed applications for XRP and the XRP Ledger—constituted tangible and definable consideration to Ripple.

D. Where does the industry go from here? 

On the heels of SEC victories in Telegram, Kik, and LBRY, the Ripple decision offers some reasons for optimism for crypto market participants that, under certain circumstances, transactions in crypto tokens will not be subject to federal registration requirements. Observers should be cautious to avoid treating any pronouncements in Ripple as gospel, however, as the decision (which is still subject to appeal) was careful to emphasize the specific facts driving its conclusions, leaving ample room for different holdings where token issuers present different factual contexts.

• Tokens as inherent securities. Regarding whether digital assets are in and of themselves securities, the Court’s factual analysis suggests that not every digital asset transaction may be a securities offering. Like gold, silver, and sugar, tokens may sometimes be ordinary assets. As such, they may be the subject of investment contracts in some contexts and fail the Howey test in others, leaving many unanswered questions about how a market in such tokens can function under current securities laws and SEC interpretations of those laws. 
• Institutional sales. The Court’s grant of the SEC’s summary judgment motion as to Ripple’s institutional sales, while also fact dependent, may raise questions about how token issuers, startups, and projects approach institutional investors. Some, like Ripple, do engage with sophisticated institutional investors to sell tokens in exchange for money. Depending on how this ruling plays out in the appeals process and is applied by other courts, regulators are likely to continue scrutinizing these practices.
• Alternatives to Howey and due process defenses. Perhaps the biggest “winner” in Ripple is the Howey test itself. Often criticized as a poor fit to apply to digital assets, Judge Torres reaffirmed the test’s applicability to the current digital landscape in rejecting the “essential ingredients” test and in holding that Howey sets forth a clear test for what constitutes an investment contract—and its progeny provide guidance as to how to apply the Howey test—in a manner that is sufficient to satisfy due process. Those looking for new rules to apply to determine what constitutes an investment contract may need to rely on Congressional action.
• Programmatic sales on exchanges. It is difficult to view this portion of the ruling as providing a clear opening for token issuers and projects to make their tokens available via exchanges in every instance, given the fact-intensive nature of the Court’s analysis. Further, the Court expressly declined to address the question of whether indirect secondary sales constitute securities transactions. Many eyes are on this issue—something both the Judge Torres here and the court in the recent LBRY case declined to reach.   
• Token compensation and services payments. Many projects compensate their employees with tokens. It is also common practice in the industry for crypto projects to compensate engineers with tokens for developing software for a particular blockchain ecosystem. The Court’s ruling on this issue appears favorable to the industry, though the decision left ample room for a different result where facts relating to such compensation may differ. Individual projects and organizations will need to do a careful analysis of their own compensation and payment approaches while keeping a close eye on subsequent rulings.

In sum, although Ripple breaks new ground in several areas, clarity is still lacking for industry, regulators, and courts navigating the fast-changing tides of crypto and blockchain technology. As this and other cases progress through the pleadings, merits, and appeals stages, the market must continue to be ready to adapt to new developments as it seeks more clarity from regulators and the courts.

[1] Sec. & Exch. Comm’n v. Ripple Labs, Inc. (“Ripple”), No. 20 CIV. 10832 (AT), 2023 WL 4507900, at *1 (S.D.N.Y. July 13, 2023).

[2] SEC v. Telegram Grp. Inc., 448 F. Supp. 3d 352 (S.D.N.Y. 2020); SEC v. LBRY, Inc., No. 21 Civ. 260, 2022 WL 16744741, at *7 (D.N.H. Nov. 7, 2022); SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169, 175–80 (S.D.N.Y. 2020).

[3] Although many would have liked it to do so, the Court did not address the issue of whether secondary XRP sales constitute offers and sales of investment contracts. It noted that the outcome of such an analysis would “depend on the totality of circumstances and economic reality of t[he] specific contract, transaction, or scheme.” Id. at *23.