On July 13, Judge Analisa Torres handed down a long-awaited decision in SEC v. Ripple. Crypto enthusiasts immediately began celebrating the opinion as holding that XRP, the Ripple token, was not a security. Others welcomed the finding that certain XRP sales violated the securities laws but lamented that other sales were exempted. However, careful review of the decision leads to the conclusion that neither side should welcome this decision, which misconstrues basic principles underlying our markets and securities regulations.

Section 5 of the Securities Act prohibits the “offer or sale” of any “security” unless it is registered with the Securities and Exchange Commission or otherwise qualifies for an exemption. In other words, a securities offering is either registered, exempted, or illegal. The analysis requires two steps. The threshold question, which Judge Torres decided in the affirmative in the first part of the analysis, was that sales of XRP were securities transactions. Since no one has argued that there is an applicable registration exemption here, the next question ought to be whether there was an illegal unregistered offering.

The opinion answered the first question by analyzing the term “investment contract” found throughout the securities laws under the Howey doctrine.^[1] Investment contracts do not require a literal contract, and instead apply to transactions or schemes where there is an “investment of money” in a “common enterprise” with the “expectation of profits,” “solely through the efforts of another.” Because investment contracts are definitionally a security, that should have been the end of the first step.

Instead of moving on to the transaction analysis, the opinion re-analyzes the threshold question based on the manner of sale – effectively combining the two steps into one. This is strange not only because it conflicts with the structure of securities laws, but in the immediate case leads to puzzling results.^[2] Specifically, the opinion held that only institutional sales, not “programmatic sales” or “other distributions,” met the Howey test. The opinion does this by attempting to draw a distinction between sales of XRP through literal investment contracts and sales not involving actual contracts.^[3] For example, the opinion held that the “efforts of another” part of the test was missing because some programmatic buyers, as opposed to the institutional buyers, could not have known whether their funds would go directly to fund Ripple’s efforts.

But the law has no such requirement, and by holding that it does the opinion creates a dangerous new loophole. If I buy Apple stock on the NASDAQ, it is still a security even though I have not entered into a contract with Apple and none of my funds go directly to Apple. The relevant question is whether that transaction was an illegal public offering – which it is not. Such transactions are exempt from the registration requirements because they do not involve the issuer or their underwriters.^[4] However, if I buy stock from a pre-IPO company and immediately resell it to the public without registration, then my transaction will not be exempt, as I am merely serving as a conduit for an illegal public offering. Without this distinction the securities laws would have no effect as companies could avoid the registration requirements simply by having someone else do the selling.

A plausible argument could be that some digital assets such as Ether might become sufficiently decentralized such that there are no longer sufficient “efforts of another” to satisfy the Howey test. But notably the opinion had nothing to say about this line of reasoning. To the contrary, the opinion noted the centrality of the efforts of Ripple’s “entrepreneurial and managerial efforts” to the financial success of XRP. Without these efforts, XRP likely would be worth nothing, regardless of who the buyer bought the tokens from. Securities do not stop being securities because of how they are sold, but how they are sold can determine whether their public offering is illegal.

To make matters worse, an analysis of the nature of the transactions should have led to exactly the opposite outcomes. It is likely that the initial sales to institutions qualified for an exemption from the definition of a “public offering” because the buyers were sophisticated enough that they did not need the protections of the securities laws.^[5] But the programmatic sales to retail investors would likely be public offerings because they involved the issuer but did not qualify for any exemptions. The conventional wisdom is that because the value of the security depends on the efforts of another, there is some degree of information asymmetry. Institutional investors presumably have access to issuers to obtain the necessary information to overcome these information asymmetries and have the financial sophistication to protect themselves with additional contractual rights. But retail investors almost certainly lack the financial sophistication and access to information and therefore benefit from the protections of securities laws. Yet the opinion essentially holds that sophisticated institutions get the protections of the securities laws, while ordinary investors do not.

Under the Ripple decision, many types of transactions would seemingly make nearly all existing securities no longer securities, which would be a big loss for the SEC. Various schemes designed to evade scrutiny of initial coin offerings, such as Initial Decentralized Exchange offerings of security tokens, could arguably not be securities under this view. However, the obvious clash with existing securities laws should lead to a swift review and reversal. And even if this saga drags on, Judge Torres has helpfully made clear that XRP sales satisfy the Howey test. That could mean that any unhappy institutional buyers could seek a remedy of rescission, which would put Ripple on the hook for hundreds of millions of dollars. Given the economic reality that XRP depends on the prospects of Ripple, crypto enthusiasts should not consider this a win either.

ENDNOTES

^[1] The term “security” is defined in Section 2(a)(1) of the Securities Act of 1933 (the “Securities Act”), Section 3(a)(10) of the Securities Exchange Act of 1934, Section 2(a)(36) of the Investment Company Act of 1940, and Section 202(a)(18) of the Investment Advisers Act of 1940. SEC v. W. J. Howey Co., 328 U.S. 293 (1946)

^[2] Section 5 is a transaction prohibition, with exceptions in Section 4. There are also specific exceptions from the definition of a security in Section 2 found in Section 3.

^[3] This could be read as holding that XRP is not itself a security, but that only the literal institutional investment contract is a security. However, as Howey itself says, investment contracts are not limited to actual contracts.

^[4] 4(a)(1) exempts transactions not involving any “issuer, underwriter, or dealer.”  Courts interpret the term “underwriter” liberally to prevent illegal offerings. See SEC v. Chinese Consolidated Benevolent Ass’n, Inc., 120 F.2d 738 (2d Cir. 1941).

^[5] 4(a)(2) transactions by an issuer not involving any public offering. The Supreme Court has held that the relevant test is not about the nature of the offering, but whether the investors can “fend for themselves”—meaning that they are sophisticated and they have access to the kind of information that might be found in a prospectus. SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

This post comes to us from Edwin Hu, a research fellow at NYU Law School’s Institute for Corporate Governance and Finance. Previously he worked as commissioner counsel and economist at the Securities and Exchange Commission.