Landmark win for Ripple Labs in US SEC case over XRP cryptocurrency

By John Bassilios

In a highly anticipated decision between Ripple Labs, Inc. (Ripple) and the United States Securities and Exchange Commission (SEC), a US federal judge ruled that Ripple’s token will only be considered as a security when it was sold to institutional investors but not when sold to the general public. In this article, we examine the decision in Securities and Exchange Commission v. Ripple Labs Inc., 1:20-cv-10832, (S.D.N.Y.).

Background

The SEC commenced this action on December 2020 and alleged that Ripple engaged in three categories of unregistered XRP offers and sales:

1. ‘institutional sales’ under written contracts for which it received $728 million;
2. ‘programmatic sales’ on digital asset exchanges for which it received $757 million; and
3. ‘other distributions’ under written contracts for which it recorded $609 million in ‘consideration other than cash.’

In February 2012, before the XRP ledger was publicly launched, Ripple’s founders received advice from Perkins Coie LLP law firm, which sought to ‘review the proposed product and business structure, analyze the legal risks associated with [Ripple], and recommend steps to mitigate these risks.’

The advice memorandum stated that ‘[a]lthough we believe that a compelling argument can be made that [XRP tokens] do not constitute ‘securities’ under federal securities laws, given the lack of applicable case law, we believe that there is some risk, albeit small, that the [SEC] disagrees with our analysis.’

The decisions and the Howey test

Under Section 5 of the Securities Act 1933 (US) (Securities Act), it is illegal to offer or sell a ‘security’ without a registration statement filed with the SEC. To prove a violation, the SEC needs to show that no registration statement was filed, and the defendant offered or sold the securities through interstate commerce.

In this case, Ripple had admitted to offering and selling XRP through interstate commerce without filing a registration statement. The question before the court was whether XRP was offered or sold as a security.

The SEC argued that XRP was sold as an ‘investment contract’, which falls under the definition of a security. Ripple argued that XRP was not sold as an investment contract and therefore did not require a registration statement.

In SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (Howey), the Supreme Court held that under the Securities Act, an ‘investment contract’ is a contract, transaction or scheme through which a person:

1. invests their money;
2. in a common enterprise; and
3. is led to expect profits solely from the efforts of the promoter or a third party.

The court analysed the ‘economic reality’ and ‘totality of circumstances’ to determine if XRP qualifies as an investment contract under the Securities Act, following the Supreme Court's precedent in Howey.

Institutional sales

The Court first addressed Ripple’s institutional sales of XRP to sophisticated individuals and entities pursuant to written contracts. The Court found that the elements of the Howey test were sufficiently met, including the ‘investment of money’, ‘common enterprise’, and the ‘expectation of profits derived from the efforts of others’.

Based on the totality of circumstances test, 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. From Ripple’s communications, marketing campaign, and the nature of the institutional sales, reasonable 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. This would increase the value of XRP.

Therefore, the Court found that Ripple’s institutional sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act.

Programmatic sales

The Court then examined Ripple’s programmatic sales of XRP, where it was alleged that ‘Ripple understood that people were speculating on XRP as an investment’ ‘explicitly targeted speculators, and made increased speculative volume a “target goal.”’

Unlike the institutional sales, the economic reality of the programmatic sales did not meet the third element of the Howey test. Programmatic buyers could not reasonably expect profits from Ripple's efforts as they engaged in blind bid/ask transactions and did not know if their payments went to Ripple or other sellers of XRP. The Court emphasised that the inquiry focuses on the promises and offers made to investors, rather than individual motivations. Therefore, the Court held that Ripple's programmatic sales of XRP did not involve investment contracts.

Other distributions

The Court examined Ripple’s other distributions of XRP, including distributions to employees, executives and third parties as part of Ripple’s initiatives.

The SEC alleged that Ripple funded its projects by transferring XRP to third parties and having them sell it. However, the Court determined that these distributions do not meet the first element of the Howey test, as recipients did not pay money or tangible consideration to Ripple. Additionally, there is no evidence that Ripple received payments from these XRP distributions. Therefore, the Court held that Ripple's other distributions did not involve the offer and sale of investment contracts.

Moreover, the Court concluded their findings by determining that, for the same reasons discussed above, the executives who offered and sold XRP on digital asset exchanges did not amount to offers and sales of investment contracts.