SEC v. Ripple Labs Ruling Recap (EN)

On July 13, 2023, the long-awaited summary judgment ruling in SEC v. Ripple was issued by Judge Analisa Torres of the United States District Court for the Southern District of New York. The ruling granted the SEC’s motion regarding institutional sales while ruling in favor of Ripple on all other aspects of the case. The court’s decision stated, “For the foregoing reasons, the SEC’s motion for summary judgment is GRANTED as to the Institutional Sales, and otherwise DENIED.” Given the potential significance of this ruling in establishing a precedent for security tokens, this article will further examine Judge Torres’ ruling in SEC v. Ripple and analyze its implications for the future, building upon the previous article, “Is Crypto a Security (EN).”

SEC v. Ripple Background

• During 2011 and early 2012, Arthur Britto, Jed McCaleb, and David Schwartz collaborated to develop the blockchain source code that is now recognized as the XRP Ledger. 100 billion $XRP has been created and remains in fixed supply to support the functioning of the XRP Ledger.
• Founded in 2012 by Britto, Larsen, and McCaleb, Ripple initially held 20 billion $XRP, while 80 billion $XRP was allocated to the company.
• By the end of 2020, Ripple held 50 to 80 billion $XRP, which was sold and distributed through various channels from 2013 to 2020. These channels included institutional sales, programmatic sales, other distributions, and personal sales by Larsen and Garlinghouse.

$728.9 million of $XRP in these Institutional Sales

$757.6 million of $XRP in Programmatic Sales

Ripple recognized revenue of $609 million from its distributions of $XRP to individuals and entities in exchange for services

Larsen sold $XRP on digital asset exchanges programmatically and made at least $450 million from his sales

• However, Ripple did not submit any EDGAR filings (Form 10-Q, Form-10K, Form 8-K) during these sales processes. Consequently, on December 22, 2020, the SEC filed a complaint in the U.S. District Court for the Southern District of New York, accusing Ripple of violating the Securities Act of 1933.

“Is Crypto a Security (EN)” Recap

To facilitate a better understanding of the SEC v. Ripple judgment, here’s an overview of prior article, “Is Crypto a Security (EN).”

• Cryptocurrencies are distinct from stocks and bonds as they do not fall under explicit securities regulations. To ascertain whether a cryptocurrency qualifies as a security, it must meet the criteria of an “investment contract” as assessed by the Howey Test. This test comprises four criteria, with a primary focus on the second and fourth ones: the expectation of profit derived from the efforts of a third party, which often fuels debates concerning crypto securities.

1. It is an investment of money
2. There is an expectation of profits from the investment
3. The investment of money is in a common enterprise
4. Any profit comes from the efforts of a promoter of third party

• If the underlying asset satisfies the Howey Test, it is deemed an investment contract and falls under the purview of securities laws. For instance, a company selling orange groves and offering a leaseback arrangement to buyers, ensuring rental income and cultivation returns, would be considered an investment contract and subject to securities regulations.
• Contrary to common belief, the previous ruling does not imply that the orange grove itself is considered a security. If the subsequent buyer intends to utilize the orange grove for actual farming purposes, it does not qualify as an investment contract and, as a result, is not subject to securities regulations.
• In the SEC v. LBRY case, the court ruled that buying $LBCs with profit expectations in the primary market is deemed an investment contract under securities laws. However, this doesn’t classify $LBC itself as a security. If $LBC is later bought solely for utility purposes in another transaction, such an act would not violate securities laws.

Analyzing the Judgement

Institutional Sales

Howey Test 1: It is an investment of money

• Ripple admitted to receiving funds through institutional sales but asserted a distinction between an “investment of money” and a “mere payment of money,” emphasizing the underlying intent to invest. Nevertheless, the court, drawing upon established precedents, ruled that even a simple payment of money (“provided the capital” and “put up their money”) fulfills the requirements of Test 1.

Howey Test 2: The investment of money is in a common enterprise

• Ripple effectively retained the funds from institutional sales within its subsidiary entities, utilizing them to support the company’s operations. Furthermore, all institutional investors received compensation in the form of $XRP, establishing a direct link between the revenues of both the investors and Ripple. Consequently, the court determined that this satisfied Test 2.

Howey Test 3: A reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others

• The central dispute in the Ripple lawsuit was regarding Test 3 and its relevance. After reviewing Ripple’s communications, marketing efforts, and institutional investments, the court found that a reasonable investor would believe that the funds from institutional sales would be used to enhance the XRP Ledger and increase the value of $XRP. In support of this, the court cited several interviews and communications, ultimately ruling that Ripple fulfilled Test 3.

Programmatic Buyers

Howey Test 1: It is an investment of money

• Same as Institutional Sales

Howey Test 2: The investment of money is in a common enterprise

• Same as Institutional Sales

Howey Test 3: A reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others

• Unlike institutional sales, programmatic sales were excluded from being subject to Test 3 by the court for specific reasons. Notably, programmatic sales involve blind bid/ask transactions where the buyer remains unaware of the recipient’s identity. Furthermore, the court refuted the SEC’s claim that “Ripple is aware of XRP’s speculative usage,” citing legal precedent to clarify that the presence of speculative intent in one party does not automatically categorize it as an investment contract security. Instead, the classification requires an expectation of profit arising from the efforts of the other party involved.

Other Distributions

Other distributions pertain to the allocation of tokens to third parties, either as incentives for employees or for the purpose of funding new application development.

Howey Test 1: It is an investment of money

• With regard to other distribution methods as discussed in institutional sales, it has been concluded that they do not fall under Test 1. This determination is based on the absence of actions such as “providing the capital” or “putting up their money,” as no investments were made by either employees or third parties.

Larsen’s and Garlinghouse’s Offers and Sales

Howey Test 3: A reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others

• The court determined that Larsen and Garlinghouse’s sales were also categorized as Programmatic Sales. Their sale of XRP on different cryptocurrency exchanges did not meet the criteria for Test 3, as it was not feasible to identify the buyers or sellers of the XRP.

*Numerous investors are predominantly approaching this case from the perspective of institutional vs retail/issuance vs distribution when evaluating securities. Nevertheless, the pivotal aspect lies in the critical examination of the Howey Test, specifically Tests 2 and 4, when assessing the classification of securities based on the anticipation of profit derived from third-party endeavors. In the context of a particular project, if the parties communicate their intention to sell cryptocurrencies on an exchange and utilize the proceeds for the project’s development, such sales could be considered an investment contract due to the expected profit arising from efforts of the third parties. Hence, it is crucial to avoid simplifying this case by categorizing it as non-securities when sold on an exchange and as securities when sold on the primary market.

Other Notable Points

Defendants “Essential Ingredients” Test

The establishment of the Howey Test in the 1940s has prompted a demand for more contemporary standards to effectively assess investment contracts, particularly when evaluating crypto assets where the test was deemed inadequate. In light of this, Ripple introduced a novel approach known as the “Essential Ingredients” during the course of the litigation, encompassing 3 pivotal elements for defining an investment contract. Nonetheless, the court opted to maintain its emphasis on the Howey Test and declined to adopt the Essential Ingredients test.

The Nature of the Institutional Sales

In this ruling, the court determined that the nature of institutional sales supports the notion that Ripple sold $XRP for investment purposes rather than for consumption. Institutional investment contracts were found to have various structures, contingent on the trading volume of $XRP, with provisions for lock-ups and resale. Some contracts explicitly stated, “solely to resell or otherwise distribute… and not to use [XRP] as an [e]nd [u]ser or for any other purpose.” Consequently, the court concluded that such contract structures substantiate the classification of $XRP as an investment contract, intended to generate profits through Ripple’s efforts, rather than considering it as a commodity or currency.

After the Summary Judgement

The SEC v. Ripple lawsuit concluded with a summary judgment, a decision granted when there are no substantial factual disputes, and only legal judgement is required. Should the SEC decide to appeal, the case will progress to the appellate court, where the typical appellate process takes around one and a half years. However, given Ripple’s three-year duration for the summary judgment, it is expected that the appeals process in this particular case might extend even further.

The possibility of an SEC appeal has elicited varying viewpoints. Some argue that the SEC may refrain from appealing due to constraints on presenting additional evidence and the potential impact on other cases. Conversely, others contend that the current ruling contradicts securities law’s intended purpose, increasing the likelihood of the SEC successfully overturning it on appeal and making an appeal more probable.

Key Takeaway

• The possibility of an SEC appeal remains, and drawing definitive conclusions on the securitization of tokens and the industry’s direction solely from SEC v. Ripple is intricate. However, as discussed in “Is Crypto a Security (EN),” the ruling did not classify cryptocurrencies as securities and dismissed the SEC’s embodiment theory. Similar to SEC v. LBRY, the judgment affirmed that acquiring a token with an expectation of profit from third-party efforts meets the criteria for an investment contract, but it does not inherently designate subsequent secondary sales or the token itself as a security.
• The SEC v. Ripple case has brought “blind bid/ask transactions” to the forefront, presenting a crucial factor that might complicate the SEC’s future scrutiny of exchanges. As a result, exchanges could gain greater independence in their determinations of token listings and delistings, especially concerning securities-related aspects. Nevertheless, the ruling also underscores the importance of reevaluating institutional investments and private fundraising strategies, urging token projects to carefully consider their approach to raising initial capital.
• As a distinct asset class with governance, utility, and open-source characteristics, cryptocurrencies demand new regulations. Despite the rejection of Ripple’s “Essential Ingredients” Test in the SEC v. Ripple case, it remains essential for the industry to pursue initiatives that recognize the unique attributes of crypto assets to facilitate continued advancement.
• The SEC v. Ripple case has led investors to categorize institutional sales and primary market sales as securities, while programmatic sales and distribution market sales are seen as non-securities. However, when evaluating the securities status of cryptocurrencies, the assessment should extend beyond institutional/retail or issuance/distribution distinctions and encompass whether there is an expectation of return from third-party efforts to accurately determine the classification of securities.

Disclaimer

All content in this article is intended to communicate and provide information and is not intended as the basis for investment decisions or for recommendations or advice for investment. The contents of the text are not responsible in any shape or form including matters that pertain to investment, law, or tax matters