On July 31, U.S. District Judge Jed Rakoff in New York decided a case with significant implications for how and even whether the Securities and Exchange Commission can regulate cryptocurrencies as a security. His decision contrasts sharply with a ruling just two weeks before by one of his colleagues on the court and brings at least a little clarity – and common sense – to the issue for regulators, investors, companies, and the public at large.
In ruling on a motion to dismiss, Rakoff held that the cryptocurrencies at issue may be securities and refused to draw a distinction based on whether they were sold directly to institutional investors or on the secondary market. His decision in SEC v. Terraform Labs. Pte. Ltd. rejected the approach in a separate case, Securities and Exchange Commission v. Ripple, et.al., where Judge Analisa Torres did make such a distinction, mangling the so-called Howey Test, which for almost 70 years has determined what is a security or, more specifically, an investment contract. The judges’ conflicting rulings means the Second Circuit will almost certainly decide on appeal one of the most important and confusing securities-law issues to arise in decades.
Back to Basics
When the Securities Act of 1933 was enacted, it allowed the SEC to regulate a variety of securities, including the ill-defined “investment contracts.” In 1946, the Supreme Court handed down a landmark case, Securities and Exchange Commission v. W.J. Howey Co., which laid out a four-part test to determine whether the transaction would be classified as the sale of a security. In short, it required 1) an investment of money 2) in a common enterprise 3) with the expectations of a profit 4) to be derived from the efforts of others.
A Ripple in the Water
In December 2020, the SEC brought an action against the Ripple Labs and several affiliated individuals for the sale of unregistered securities in violation of Section 5 of the Securities Act. The action centered on a token issued by Ripple known as “XRP.” After extensive discovery and a series of initial motions, the Ripple court agreed to hear cross-motions for summary judgment on September 13, 2022.
The Ripple court considered three questions, one with several subparts. The first asked whether XRP is an investment contract defined as a security. The second focused on whether certain transactions involving XRP constituted breaches of the Section 5 registration requirements. The final question asked whether executives at Ripple aided and abetted the company in violating securities laws.
As to the first question, the Ripple court ruled that “XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract.” Many commentators stopped reading at this point and argued that this was a win for Ripple. However, the court went on to say that a totality of the circumstances surrounding the differing transactions by the different defendants must be examined.
Sometimes a Security, Other Times Not?
To answer the second question, the Ripple court examined four broad categories of transactions involving XRP. The first was sales to institutional investors. The second involved so-called “programmatic sales” on digital asset exchanges. The third involved “other distributions” under written contracts. The fourth was sales by individual executives, specifically Chris Larsen, one of the founders and a former CEO of the company, and Brad Garlinghouse, the current CEO of Ripple.
Judge Torres found that the sales to institutional investors constituted a sale of unregistered securities because those investors were “situated in the position of Institutional Buyers.” Such buyers could reasonably understand that Ripple would use the money to improve the XRP Ledger and thus increase the value of the token. The repeated public statements by the company and its executives all seemed to indicate a plan to increase the value of the token. Finally, the buyers were required to comply with lockup provisions and resale restrictions based on the trading volume of XRP – thus they were not purchasing with the intent to resell or otherwise distribute.
In answering the second question, Judge Torres focused on the buyers’ inability to know who they were purchasing the tokens from in programmatic sales. Each sale was a blind bid/ask transaction. Purchasers might be buying in a secondary market or might be purchasing from Ripple directly. As a result, the Ripple court found that those buyers had no reasonable expectation of profit from the purchase of the tokens based on the efforts of others, specifically Ripple. This contradicts what we know about who purchases cryptocurrency in the United States and why. In its annual survey of US households, the Federal Reserve has repeatedly found that the overwhelming majority of households that hold cryptocurrency in the United States do so for investment purposes. In 2021, 12 percent of Americans used crypto, with 11 percent buying and holding for investment purposes. Regardless, it’s unclear why a distinction was drawn based on who was selling the token. Its extraordinarily rare for companies to sell their own securities directly to the public.
More confusing was the court’s finding that, because the company failed to publicly circulate the material that institutional investors received, retail buyers could not consider whether this was an investment contract. Even if they had received that material, these types of investors were, according to the court, “generally less sophisticated” than the institutional investors and, therefore, did not have a reasonable chance to have the same “understandings and expectations.” The court goes on to rule that there is no evidence that buyers “understood that statements made by Larsen, Schwartz, Garlinghouse, and others were representations of Ripple and its efforts.” In other words, retail investors were not protected by federal securities laws because they were too uninformed to understand that statements by the founder, the chief technology officer, and the CEO were not representations by the company they worked for. That’s astounding.
As for the other distributions, the court found that, because Ripple gave the tokens to third parties, the tokens could not be securities as the company received no “investment of money.” The court even admits that Ripple funded other projects by paying in XRP. The company gave XRP to employees as it would give stock grants and options. But because it cannot be considered “money,” XRP cannot be a security. This is misreading of long-standing Howey-related precedent.
As for the sales by various executives and individuals within the company, Judge Torres never addressed the question of whether the individuals were affiliates. Because they sold through programmatic sales, Judge Torres ruled that she need not consider the question because the buyers had no way of knowing who they were buying from. This would imply that secondary-market transactions are not securities transactions because their proceeds do not directly benefit Ripple. That’s not an element of the Howey test.
In Terraform, Judge Rakoff thoroughly analyzes Howey Test precedent in examining facts very similar to those in Ripple. He correctly points out that there is no need to differentiate between types of purchasers, institutional or retail. The core test of Howey focuses on the actions of the issuer in trying to attract a range of investors. The difference in purchasers that was the basis for Judge Torres’s decision in Ripple has no bearing on the expectation of profit, according to Judge Rakoff. Nor should it: If an investor purchases a share of, say, Apple on the open market rather than from the company directly, the investor still expects Apple to turn a profit and generate a positive return.
Reading Between the Ripples in the Water
Unfortunately, the Ripple ruling opens the door to considerable mischief. It invites issuers to sell all sorts of things to potential retail investors by designing blind transactions, offering no disclosure, and avoiding securities laws. That is a dangerous precedent to set early in the debate over how to regulate cryptocurrences.
More clarity may be coming soon, as the SEC has decided to appeal Judge Torres’s ruling in light of its sharp differences from Rakoff’s decision. While the latter decision seems correct, continuing uncertainty risks moving us further from where we need to be on cryptocurrency: better protections for investors based on a clear, well structured, and enforceable regulatory regime.
This post comes to us from John Livingstone and Anat Alon-Beck at Case Western Reserve School of Law and Nizan Packin at Baruch College’s Zicklin School of Business.