Actions in the Federal Courts

July 31, 2023

WHAT’S NEW AND NOTEWORTHY IN THE FEDERAL COURTS

CRYPTOCURRENCY ENFORCEMENT – SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y., July 13, 2023) – A federal district court rules that Ripple’s XRP cryptocurrency is both a security and not a security, depending on who purchases the digital asset, thus affording protections to “sophisticated” institutional investors but not to individual retail investors purchasing crypto on a public exchange. This turns 90 years of securities investor protection priorities upside down.

The Issue. Cryptocurrency offerings continue to draw huge attention, as a steady stream of enforcement actions and criminal cases against crypto firms and their principals make headlines while the industry swarms Congress in an effort to secure light-touch regulation at the hands of the underfunded, understaffed, and industry-friendly CFTC. The SEC (under Republican and Democratic leadership) has consistently taken the position that most crypto offerings are securities in the form of investment contracts, and an enforcement action filed in December of 2020 (by Trump’s SEC) illustrates the agency’s approach. The SEC filed its case in federal district court against Ripple Labs, Inc. and two of its principals, alleging that since 2013, the defendants had been selling digital assets (known as “XRP”) that were unregistered securities under the Howey investment contract test. The SEC sought an injunction, disgorgement, and civil monetary penalties.

The SEC’s complaint explained that under the Supreme Court’s landmark decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), investment contracts are instruments through which a person invests money in a common enterprise and is led to expect profits or returns derived from the entrepreneurial or managerial efforts of others. The theory advanced in this case is that investors are being asked to speculate on the value of XRP and that its value hinges on the “efforts of others,” i.e., the success of the promoters who are trying to generate demand for XRP as a medium for financial firms to effect money transfers. In its complaint, the SEC highlighted the risk of harm to investors and the informational vacuum created when promoters fail to register their securities offerings:

Because Ripple never filed a registration statement, it never provided investors with the material information that every year hundreds of other issuers include in such statements when soliciting public investment. Instead, Ripple created an information vacuum such that Ripple and the two insiders with the most control over it—Larsen and Garlinghouse—could sell XRP into a market that possessed only the information Defendants chose to share about Ripple and XRP.

The Decision. Following years of intense litigation dominated by discovery disputes (reportedly costing Ripple hundreds of millions of dollars in attorneys’ fees and costs), the case was ready for a much-anticipated ruling on cross-motions for summary judgment—arguments from each party claiming that based on the undisputed facts and the law, they were entitled to a judgment in their favor. On July 13, Judge Analisa Torres of the U.S. District Court for the Southern District of New York issued a 34-page ruling that is already being heralded as a victory by the crypto industry, even though it produced decidedly mixed results, some clearly in the SEC’s favor.

The court ruled that XRP was a security under the SEC’s jurisdiction when Ripple sold the digital asset specifically to institutional investors. However, it also ruled that the same investment product was not a security when it was sold on public exchanges to individual retail investors through so-called “programmatic sales.” So, according to this district court, XRP is both a security and not a security, depending on who is purchasing it and how.

The court’s decision ultimately came down to its conviction that institutional investors have more knowledge about XRP and its value in relation to Ripple’s entrepreneurial efforts than retail investors have. As the court explained, “A reasonable investor, situated in the position of the Institutional Buyers, would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts.” In other words, these institutional investors purchased the asset with the expectation that they would derive profits from Ripple’s efforts. As a result, under the standard set forth in the Howey case, these transactions constituted the purchase of a security. Conversely, reasoned Judge Torres, individual retail investors are “generally less sophisticated” and should thus not be expected to have “similar ‘understandings and expectations’” of Ripple and XRP. Thus, for these “less sophisticated” investors, who purchased XRP on digital asset exchanges, the purchase of XRP “did not constitute the offer and sale of investment contracts” with the expectation of profits derived from the efforts of others.

The court was certainly correct in holding that XRP offerings were investment contracts from the standpoint of the institutional investors. However, the court erred in finding that XRP tokens were not securities as to the retail investors who acquired XRP via exchange trading. On this issue, the court’s analysis was internally contradictory, based on erroneous assumptions about retail investors, and at odds with the remedial purposes that underlie the Howey test and the securities laws.

First, while generally insisting that retail investors did not understand to whom or for what they were investing their money, the court conceded that at least some of those investors may have purchased XRP “with the expectation of profits to be derived from Ripple’s efforts” to support and develop its token. Yet the court held fast to its view that none of the “programmatic” investors purchased securities.

In addition, the court relied on assumptions about the supposedly limited knowledge of retail investors regarding Ripple and XRP that were inconsistent with the record. It claimed that the Howey test involves an objective assessment of the promises and offers made to investors, not a search for subjective motives. But the court’s “objective assessment” was wrong based on the extensive evidence. The court itself recounted “Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts,” which appeared through a variety of social media platforms and news sites over several years. Based on this “objective” evidence, it is far more reasonable to conclude that even the programmatic retail investors trading via the exchange had a good grip on what Ripple was up to and in fact were counting on returns derived from Ripple’s efforts. In short, the court failed to persuasively explain how XRP could be a security in one context but lose its fundamental character simply because it was traded in a secondary market—which is a common feature in today’s securities markets.

Finally, the decision is equally troubling from a policy standpoint, as it turns the remedial purposes of the securities laws on their head. Under the court’s holding, those who need protection the least — like the “sophisticated” hedge funds who purchased XRP — are afforded the many protections provided by the securities laws, while those who need protection the most — the retail investors who buy cryptocurrency on a public exchange — are denied those very same protections. And here too the court was inconsistent. It recited with approval the familiar attributes of the Howey test, pointing out it was intended to be a flexible, not static principle, capable of adapting to the countless schemes devised by those seeking investors’ money. It further noted that the Howey test was intended to effectuate the statutory policy of broad investor protection, a goal not to be “thwarted by unrealistic and irrelevant formulae.” Yet the court arrived at a decision that at least in part conflicted with these principles.

There was certainly some comfort in the court’s decision, not only as to the status of XRP as a security with respect to the institutional investors but also as to a number of other issues presented in the case. For example, the court acknowledged that a wide variety of ordinary assets—including crypto tokens—can be packaged and sold as investment contracts, depending on the circumstances. It also rejected Ripple’s attempt to graft an elaborate assortment of new requirements onto the investment contract test, including a requirement that there be a contract conferring specific rights and obligations. And it firmly rejected the defendants’ due process arguments, holding that they had ample notice of the Howey test based on the Supreme Court’s decision and subsequent cases. Finally, as to whether the individual defendants aided and abetted Ripple’s violations, the court held there were genuine issues of material fact surrounding those claims that would have to be resolved at trial.

Why It Matters. The ultimate impact of the decision will hinge on whether the SEC eventually lodges a successful appeal and has the court’s ruling reversed on the status of the XRP tokens sold via the programmatic trading. Meanwhile, the crypto industry will not only tout its win but also adapt its offerings and trading platforms to gain maximal protection from the court’s holding that secondary trading by retail investors can strip a digital asset of its character as an investment contract. That will energize the crypto industry, likely protect at least some of their offerings from securities regulation, and spawn new platforms, all adding to the already massive harm inflicted on investors by this lawless and predatory industry.

Other Notable Cases We’re Tracking

(For more detailed descriptions of the cases reviewed below, click here.)