The US District Court of the Southern District of New York has appeared to hand digital asset sellers their first victory, albeit partial, amidst a flurry of enforcement actions by the US Securities and Exchange Commission (SEC), including suits against Coinbase and Binance.

In a highly anticipated decision, Judge Torres ruled that programmatic sales of XRP on digital asset exchanges did not constitute the offer and sale of investment contracts, but that sales of XRP to sophisticated investors via written agreement did.  Claims against Ripple’s senior executives for aiding and abetting Ripple’s violations of the Securities Act survived summary judgement.

SEC Enforcement Actions & The Howey Test

At a fundamental level, each SEC enforcement action asserts that crypto assets are investment contracts. Under the Howey test, a transaction involving a digital asset that involves (1) an investment of money, (2) in a common enterprise, (3) with the expectation of profit from the essential entrepreneurial or managerial efforts of others, is considered the offer and sale of an investment contract, bringing it under the registration requirements of the Securities Act.  The Howey test prioritizes function over form, embodying a flexible approach adaptable to various schemes under which alleged investment contracts may arise; overall, courts consider the “totality of circumstances.”[1]

The Ripple Decision

On July 13, 2023, Judge Analisa Torres of the US District Court for the Southern District of New York issued a decision granting in part and denying in part parties’ cross-motions for summary judgment ultimately holding that (1) Ripples’ Institutional Sales of XRP, for which it received $728 million, constituted the unregistered offer and sale of investment contracts in violation the Securities Act, and (2) Programmatic Sales by Ripple and senior executives resulting in over $1 billion in proceeds and the Other Distributions of XRP did not constitute the offer and sale of investment contracts (i.e., securities), thus were not in violation of the Securities Act.

Ripple Labs, Inc. is a technology company that developed the source code for a cryptographically secured ledger, currently known as the XRP Ledger. The XRP Ledger is based on open-source software and can be used by anyone to, inter alia, submit transactions, host a node to contribute to the validation of transactions, propose changes to the source code, or develop applications that run on the ledger. Crucially, XRP is the native digital token of XRP Ledger, and XRP Ledger cannot operate without the XRP token.

Saliently, the court clarified at the outset 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. Rather, it is the totality of circumstances surrounding the different transactions and schemes involving the sale and distribution of XRP that is the subject of examination by the court.

Institutional Sales of XRP

Institutional Sales engaged in by Ripple were those consummated in accordance with written contracts, typically with sophisticated buyers, such as hedge funds and institutional investors. The court performed a Howey test analysis in assessing whether the Institutional Sales of XRP constituted unregistered sales of securities.

First, the court found an investment of money as Institutional Buyers provided capital in exchange for XRP.

Next, the court considered and found the existence of a common enterprise by way of horizontal commonality, which exists where investor assets are pooled, and the fortunes of each investor are tied to the fortunes of other investors and the success of the overall enterprise. Here, Ripple pooled the Institutional Sales proceeds into a network of bank accounts under the names of its various subsidiaries, exercised control over these accounts, and used these funds to finance Ripple’s operations and, issued the same fungible XRP to all Institutional Buyers. The abilities of Institutional Buyers to profit off of their investments were tied to Ripple’s success and fortunes of other Institutional Buyers.

Finally, considering Ripple’s communication efforts, marketing campaign, and the nature of Institutional Sales, the court concluded that reasonable investors situated in the position of the Institutional Buyers would have purchased XRP expecting to derive profits from Ripple’s managerial efforts and expecting that Ripple would utilize capital received from Institutional Sales to improve the market for XRP and develop more uses for XRP Ledger, thus increasing the value of XRP.

The court concluded that Institutional Sales of XRP satisfied each element of the Howey test and qualified as the sale of investment contracts and unregistered securities.

Programmatic Sales of XRP and Other Distributions

The court’s analysis of Programmatic Sales of XRP was abbreviated, including only an examination of the third prong of the Howey test. Upon considering the economic realities surrounding these Programmatic Sales, the court found that buyers in such blind bid/ask transactions could not know who the seller was and, as a result, could not reasonably expect that Ripple would use the capital received to improve the XRP ecosystem, thereby increasing the price of XRP. The court articulated that in contrast to Institutional Buyers, a buyer in a Programmatic Sale stood largely in the same shoes as a secondary market purchaser that was not aware to whom it was paying money. Thus, Programmatic Sales of XRP were held not to be investment contracts.

With respect to the Other Distributions, which includes payment of XRP to employees and third parties (e.g., as part of an initiative to develop new application for XRP and the XRP Ledger), the court found that the first prong of the Howey test was not satisfied.  Consequently, the court concluded that these Other Distributions did not qualify as investment contract offers or sales. As the first prong was not satisfied, the remaining prongs of the Howey test were not examined.

What’s Next?

With appeals likely to drag out for some time, it remains to be seen how big of a ripple this case will have on the enforcement actions already brought by and those to be filed by the SEC related to the sale and offer of digital assets.

[1] SEC v. W.J. Howey, 328 U.S. 293 (1946).