In a closely watched case, a federal judge in New York has granted partial victories to both the Securities and Exchange Commission and Ripple Labs Inc. in ruling on cross-motions for summary judgment regarding whether sales of Ripple's digital token XRP violated the federal securities laws.
On the one hand, Judge Analisa Torres in the United States District Court for the Southern District of New York held that sales of XRP to institutional investors involved securities under the test articulated by the Supreme Court in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The sale of securities that are not registered with the SEC violates Section 5 of the Securities Act of 1933 unless there is an applicable exemption. To determine if the sale of an asset constituted a securities transaction, courts look at the underlying economic reality and the totality of the circumstances. In Ripple, the court held that the institutional XRP sales satisfied the three prongs of the Howey test: there was the investment of money, in a common enterprise, with the reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others.
However, the court ruled that so-called Programmatic Sales on crypto exchanges did not involve securities because the purchasers were not buying directly from Ripple, and therefore could not reasonably expect a profit derived from Ripple's efforts (the third prong of the Howey test). The court also held that Ripple’s other distributions of XRP to employees and third parties were not securities because there was no payment of money (the first prong of Howey), and there was no illegal underwriting of the tokens. Further, XRP sales allegedly totaling $600 million by two officer-defendants did not meet the Howey test because they were Programmatic Sales on digital asset exchanges in "blind" bid/ask transactions where the buyers did not know who they were purchasing from, and therefore could not have expected profits derived from Ripple's efforts. The court also held that a genuine dispute of material facts precluded summary judgment for the SEC on whether the officer-defendants aided and abetted the company's Section 5 violations. The court rejected the defendants' argument that the SEC violated their due process rights because they lacked fair notice that XRP sales may violate the securities laws.
The court’s ruling in the SEC’s action against Ripple, filed in late 2020, was widely anticipated by the crypto community as a significant test of the SEC’s position that most sales of digital assets constitute securities transactions. It will be interesting to see whether either side appeals the decision, given that both the SEC and Ripple can claim some measure of victory.
It may seem odd that the determination of whether an asset is a security depends on the nature of the transaction in the asset. It would be as if GM stock were a security if purchased directly from GM, but not a security if purchased on the New York Stock Exchange. In either case, the purchaser presumably would be relying on the managerial and entrepreneurial efforts of GM to make a profit. But the Ripple court stated that the purchasers of XRP on crypto exchanges were less sophisticated than institutional investors; likely did not see the representations and statements of Ripple; may not even had known of Ripple's existence; and likely were expecting a profit based on cryptocurrency trends rather than any action by Ripple. Therefore, the economic reality and the totality of the circumstances meant that the Programmatic Sales did not constitute the offer and sale of investment contracts. While the court stated that a Programmatic Buyer stood in the same shoes as a secondary market purchaser, it also noted that it was not addressing whether secondary market sales of XRP constituted investment contracts, because the question was not properly before the court.
For more information regarding Alto Litigation’s litigation practice, please contact one of Alto Litigation’s partners: Bahram Seyedin-Noor, Bryan Ketroser, or Joshua Korr.
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