As the great American philosopher and baseball legend Yogi Berra once said, "The future ain't what it used to be."
Yogi was prescient (as usual) as this observation has been fulfilled by the decision of a federal court on July 13, 2023, in the Securities and Exchange Commission’s enforcement action against Ripple Labs, Inc. and two of its senior leaders (collectively, the Ripple Defendants). This is because, in this decision, the court agreed with often-repeated comments by the current Chair of the SEC that the determination of whether a crypto asset is an investment contract is all about the 1946 landmark Supreme Court decision in SEC v. WJ Howey; however, the court determined, when applying this ruling to the facts in Ripple, transactions in XRP were not always investment contracts. This result potentially portends quite a different future than the future anticipated by the SEC’s Chair’s frequent statement that most crypto assets are securities and that the crypto industry already has clear rules regarding transactions in most crypto assets.
Specifically, the court – the US District Court for the Southern District of New York (before the Hon. Analisa Torres) – noted that crypto assets in and of themselves may not be securities. However, this is not the relevant consideration. For purposes of Howey, transactions in crypto assets – whether the crypto assets themselves are tangible or intangible assets constituting commodities or securities – can be investment contracts and thus, securities. Transactions have to be assessed considering whether (1) there was an investment of money by investors; (2) in a common enterprise; (3) with the reasonable expectation of profits by the investors through the managerial or entrepreneurial efforts of others.
This decision was rendered in connection with offsetting motions for summary judgment by the SEC and the Ripple Defendants.
Howey Standards Applicable
In requiring analysis under Howey, the court rejected the Ripple Defendants’ argument that the relevant standard was not Howey, but the “essential ingredients” test. This test, claimed defendants, requires (1) a contract between the promoter and an investor that demonstrates the investor’s rights to an investment; (2) obligations assumed by the promoter to “take specific actions for the investor’s benefit;” and (3) the provision to the investor of a right to participate in profits derived from the promoter’s efforts using the investor’s funds. The Court noted that “in the more than seventy-five years of securities law jurisprudence after Howey, courts have found the existence of an investment contract even in the absence of Defendants’ ‘essential ingredients,’ including in recent digital asset cases in this district.”
Turing then to the Howey analysis, the court considered three distinct types of sale transactions: those to institutional purchasers pursuant to written contracts (Institutional Sales); those sold by Ripple on trading platforms “programmatically” or through the use of trading algorithms (Programmatic Sales); and those provided as a form of payment for services to employees or to third parties that developed applications for XRP and the XRP blockchain (Other Distributions).
While the court found all Howey elements satisfied in Ripple’s Institutional Sales, it did not do so in connection with its Programmatic Sales or the Other Distributions. Whereas the institutional purchasers “reasonably expected” that Ripple would use their capital to enhance the XRP network and hopefully increase the price of XRP, this was not the case for the programmatic buyers, said the court. According to the court, while “[a]n Institutional Buyer knowingly purchased the XRP directly from Ripple pursuant to a contract, … the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.”
Finally, the court held the Other Distributions also did not satisfy Howey because there was no investment of money by recipients of payment from Ripple. According to the court, “Ripple paid XRP to these employees and companies,” not the other way around.
Additionally, in its decision, the court rejected Ripple Defendants’ “fair notice defense” in connection with the Institutional Sales, claiming that Howey provided “sufficiently clear standards to eliminate the risk of arbitrary enforcement.” The court did not address the “fair notice defense” for the sales that the court concluded did not meet Howey. The court also determined that there were sufficient factual disputes to disallow both sides' motion for summary judgment in connection with the aiding and abetting charges against the individual defendants.
As a result of the Ripple decision, some trading platforms that had delisted XRP since the SEC’s filing of its action against the Ripple Defendants in 2020, relisted the cryptoasset. Although such action appears entirely defensible after this decision, traders and platforms who utilize a systematic means to assess whether a cryptoasset is likely a security or not should incorporate any new news into their systematic analysis, and then utilize their revised holistic review to determine whether to trade or delist a cryptoasset. This is likely preferable to solely relying on the new news alone.
The Future of Crypto Legislation
Additionally, it should be the case that the Ripple decision accelerates debate on Capitol Hill regarding potential legislation to clearly delineate the existing jurisdiction of the SEC and potentially grant new jurisdiction to the Commodity Futures Trading Commission over spot cryptoasset transactions and industry participants. Both recent proposals by Senators Gillibrand and Lummis and members of the House Committees on Financial Services and Agriculture provide holistic paths to legislation that address the myriad of jurisdictional issues; time will tell whether the Ripple decision helps to speed up relevant debate and processing.
In any case, the SEC’s cryptoasset enforcement armor has now sustained its first material dent, raising questions regarding the SEC’s Chair’s frequent public pronouncements that the crypto industry already has clear rules to govern its conduct. The SEC Chair has made such statements relying on Howey. Although the court hearing the offsetting Ripple summary judgment motions agreed with the SEC Chair regarding the importance of Howey, it took a very different view than the SEC regarding its applicability to the undisputed facts in this case.