WAGMI! At Last, a Legal Victory for Cryptocurrency
After a seemingly endless wave of legal defeats, the Web3 world rejoiced as the Southern District of New York ruled partially in favor of Ripple Labs, Inc. (“Ripple”), representing the first major victory for a cryptocurrency issuer in a case brought by the Securities and Exchange Commission (“SEC”). For all the hand-wringing over whether cryptocurrency tokens are “securities” under the Howey Test, for now, the decision holds that XRP tokens (the native token of Ripple’s payment protocol, the XRP Ledger) are not securities, and programmatic sales of XRP tokens on cryptocurrency exchanges are not securities.
What does this mean for token issuers in the future? While it’s difficult to predict exactly how the SEC will respond (or how Congress will react), this is a watershed moment for the nascent industry seeking clearly defined rules for token issuances. Specifically, it’s promising that Judge Analisa Torres of the S.D.N.Y., a court of significant prominence, ruled largely in favor of Ripple after years of the SEC indiscriminately targeting cryptocurrency companies without providing real guidance as to how these companies are supposed to operate within the confines of decades-old precedent. While the SEC is likely to appeal this decision, this is an enormous step towards the knee-capping of the SEC’s tyrannical attacks on the world of Web3.
Background:
Since its inception in 2012, Ripple has sought to “modernize international payments by developing a global payments network for international currency transfers.” In furtherance of its business, the original founders developed the source code for its blockchain known as the XRP Ledger. When launched, the XRP Ledger generated a fixed supply of 100 billion XRP tokens. Of these tokens, per the SEC’s complaint, Ripple (ii) sold XRP directly to institutional buyers (“Institutional Sales”), (ii) sold XRP on exchanges through the use of trading algorithms (“Programmatic Sales”), and (iii) distributed XRP as a form of payment for services to employees and other service providers (“Other Distributions”). Through these sales and distributions, the SEC had alleged that Ripple had conducted a $1.3 billion unregistered securities offering in violation of Section 5 of the Securities Act of 1933, as amended (the “Securities Act”).
Under Section 5 of the Securities Act, it is unlawful for any person to directly or indirectly sell, or offer to sell, a “security” unless a registration statement has been filed with the SEC, or such sale falls within one of the various available exemptions. The first step in the analysis is determining whether the tokens in question are actually securities. As with the vast majority of these cases, Judge Torres utilized the Howey Test to determine whether or not the XRP tokens are securities. The Howey Test was borne out of SEC v. W.J. Howey Co., 328 U.S. 293 (1946), where the Supreme Court held that under the Securities Act, a security is an investment contract “whereby a person (i) invests money, (ii) in a common enterprise, (iii) with an expectation of profit derived solely from the efforts of a promoter or other third party.” In making this determination, the Court subsequently held that “form should be disregarded for substance and the emphasis should be on an economic reality and the totality of the circumstances.” Tcherepnin v. Knight, 389 U.S. 332, 336 (1967).
The Decision:
Institutional Sales: Of the three types of sales of XRP tokens, this one didn’t go in Ripple’s favor. In applying the Howey Test, Judge Torres found that all three prongs of the test were satisfied, and that these particular investors (primarily institutional buyers and hedge funds), knowing that they were purchasing XRP directly from Ripple through written contracts, could reasonably be expected that such capital would be used to improve upon the XRP ecosystem and thus increase the price of the tokens.
Programmatic Sales: So-called “programmatic” transactions are automated and there is no direct communication between a buyer and seller (or blind bid/ask transactions). Here, purchasers of XRP tokens acquired them on an exchange, meaning they didn’t know if they were purchasing the tokens from Ripple directly, or from another seller of XRP. Contrasting this to Institutional Sales, the Court ruled that the “economic reality” is that a programmatic buyer didn’t know to whom or what is paying its money, and could not reasonably expect that Ripple “would use the capital received from such sales to improve the XRP ecosystem and thereby increase the price of XRP.” While the SEC argued that such buyers purchased XRP with an expectation of profit, none of these buyers were aware that they were buying from Ripple, and such profit wasn’t necessarily going to be due to Ripple’s efforts. Indeed, the Court found that less than 1% of the global XRP trading volume was sold by Ripple, and reasoned that “the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all.” The court similarly rejected the SEC’s argument that Ripple “explicitly targeted speculators,” finding that the mere “speculative motive” on the part of a purchaser or seller did not evidence an investment contract, or an expected investment return “contingent upon the continuing efforts of another.” Accordingly, the court found that the third prong of Howey was not satisfied.
Other Distributions: In the simplest portion of its analysis, the Court here ruled that recipient of Other Distributions (primarily to employees as compensation, or commercial partners for development work) didn’t pay any money or “some tangible and definable consideration” to Ripple. Having failed the first prong of the Howey Test (and thus obviating the need to consider the other two prongs once that first prong failed), the Court ruled such distributions did not constitute an offer and sale of securities.
The Case Against Key Personnel:
Another aspect of this case worthy of attention is how the Court ruled in favor of the other two defendants - Bradley Garlinghouse, Ripple’s Chief Operating Officer (“Garlinghouse”) and Christian Larsen, the Chairman of Ripple’s Board of Directors and former Chief Executive Officer (“Larsen”). In its complaint, the SEC argued that Garlinghouse and Larsen engaged in an “extensive, years-long marketing effort” as a means of promoting XRP, and accused them of aiding and abetting a securities violation. In order to establish such liability, the SEC must show: “(i) the existence of a securities law violation, (ii) knowledge of this violation on the part of the aider and abettor, and (iii) substantial assistance by the aider and abettor in the achievement of the violation.”
The Institutional Sales were determined to be securities, thus satisfying the first requirement. As to the second requirement, however, the SEC had to show that Garlinghouse and Larsen either knew, or at least recklessly disregarded, the alleged facts that Ripple’s sales were illegal. Garlinghouse and Larsen both testified that they didn’t believe XRP was a security given the fact that multiple foreign regulators (including Japan, Singapore, and the United Kingdom) had determined that XRP was not a security. Larsen further testified that he had followed the words of Bill Hinman, the former Director of the SEC Division of Corporate Finance who stated in a 2018 speech that neither bitcoin nor ether were securities. Ripple also received a law firm memorandum which concluded that the XRP tokens were not “securities” under the federal securities laws, and thereafter took specific steps to ensure compliance with the advice contained within the memorandum. Accordingly, the Court denied the SEC’s motion for summary judgment as to the aiding and abetting claim against Larsen and Garlinghouse, leaving the issue as one to be decided by the jury.
This aspect of the decision is a revelation for digital asset issuers given the SEC’s contradictory position over the past few years. Specifically, the SEC has repeatedly maintained that the rules governing cryptocurrencies have been in place for decades (“the law is clear,” stated SEC Chairman Gary Gensler in April, 2023), and all issuers need to do is “come in and register.” Of course, anybody participating in the U.S. digital asset market has been well aware of minimal regulatory clarity, and approaching the SEC for regulatory clearance is a fool's errand.
The Court’s ruling here is a check and balance on the SEC’s bad faith targeting of digital asset issuers when it has provided little to no guidance as to how issuers should act, let alone actual regulation.
Implications:
Following this ruling, issuers should be more comfortable knowing that there is a pathway to issuing and selling tokens on exchanges, in a way in which such assets will not be deemed securities. This isn’t a panacea for the industry given the Court’s stance on the Institutional Sales (i.e., direct sales by issuers to recipients), but this is an enormous step in the right direction.
Further, with the Court’s ruling towards Garlinghouse and Larsen, the principals of a cryptocurrency issuer should sleep better at night if they engage competent counsel to help them navigate these now slightly less treacherous waters. In other words, acting in good faith should cause judges to give you the benefit of the doubt.
We strongly recommend you read the full decision: HERE.
If you would like to discuss this decision, or if you are concerned as to how best to launch your token or govern your project in the wake of this decision, please feel free to contact me at KLawrence@FRBLaw.com or by calling (516) 599-0888.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.