SDNY Tests Whether Ripple Constitutes an Investment Contract
Commentary by Steven Lofchie
The District Court of the Southern District of New York issued an Order that partially granted and partially denied summary judgement on the SEC's claim that the various defendants had engaged in unregistered distribution of securities in violation of Securities Act Section 5 ("Prohibitions relating to interstate commerce and the mails"). The SEC's charges against the defendants were premised on its assertion that XRP, the virtual currency driving the Ripple blockchain, is (or is tied to) an "investment contract," and thus a "security" for purposes of the Securities Act.
According to the Order, the controlling persons for Ripple distributed XRP, a digital asset, through three mechanisms: (i) large direct sales to institutional investors, (ii) algorithmic sales of XRP into the broad trading market for XRP, which included significant numbers of retail participants; and (iii) as compensation to Ripple employees and other contributors to the development of XRP. The Court found that XRP was not, on its own, inherently an "investment contract" (or otherwise a "security"). In order for there to be an investment contract to which the recipients of XRP were a party, the Court reasoned that there had to be both (i) an investment of "money" or "capital" by the recipients of XRP and (ii) an "expectation" on the part of the recipients that the developers of XRP would use the proceeds to "improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of the XRP."
In the case of the institutional investors, the Court found both that there was an investment of money and that, based on the communications of the Ripple founders to the institutional investors, the institutional investors believed that the purchase of XRP created "potential profits to be derived from Ripple's entrepreneurial and managerial efforts". As a result, the Court found that there was an investment contract and, therefore, the institutional investors had purchased a "security."
In the case of the employees who received XRP, the Court found that there was no investment contract because the employees "did not pay money or ‘some other tangible and definable consideration’" to Ripple in exchange for the XRP.
In the case of acquisitions through anonymous marketplaces, the Court held that these persons were not purchasing "securities," because they had no expectation that the founders of Ripple were working to create a rise in the value of XRP. In the absence of such an expectation, the Court held that there was no "investment contract," and therefore no "security."
Additionally, the Court held that there was a genuine issue of material fact as to whether the Ripple insiders knew that they were aiding and abetting an illegal sale of the securities to the institutional investors, because they arguably had good cause to doubt that such sales were of "securities," based on the uncertainty of the law.
Commentary
The judge's decision is both dissatisfying and satisfying.
The conclusion that employees have not contributed value in exchange for their non-USD cash consideration (i.e., XRP) is dissatisfying. And plainly wrong. One does not have to be a Marxist or accept the labor theory of value to believe that work is of economic worth and that an asset can be purchased with labor just as it can be purchased with fiat currency. Likewise, the conclusion that the Ripple insiders did not aid and abet because they were not convinced that XRP was a security seems wrong. Their ignorance was of the law, not of the facts, and generally being ignorant of the law is not a defense.
The interesting and important part of the decision is that the investors in the secondary market were found to not have had a reasonable "expectation" of reliance on the efforts of the Ripple founders. In effect, the Court is taking the SEC at its word: Howey governs. XRP in and of itself is not a security, so the sale of XRP is only a sale of a “security” if it is an "investment contract.” The Court then asks, "where is the contract"? As a starting matter, the Court finds that, in most cases, the algorithmic purchasers did not purchase from Ripple and thus there could not have been a contract between the retail investors and the founders. In most cases, the retail investors did not purchase from the founders and their money did not go to the founders, so it would seem hard to demonstrate a contract between the retail investors and the founders. Even where the retail investors purchased from the founders, the transaction was anonymous, so the investors did not know who their counterparty was. Again, this leads to the conclusion that there was not an “investment contract.”
The next question is whether the retail investors might nonetheless have had a contract based on the statements and promises of the Ripple founders that they were working to create value in XRP. But even had the investors known from whom they were purchasing, the Court found that the investors were not made any promises that the Ripple founders were at work building the market for XRP. The Court conceded that the Ripple founders made some public statements in this regard, but the Court decided that they could not form the basis of a contract, in part because the retail investors were insufficiently informed to demonstrate reliance on the statements of the Ripple founders. In this regard, the Court stated: "there is no evidence that a reasonable Programmatic Buyer [retail investor], who was generally less sophisticated as an investor [than the institutional investors], shared similar ‘understandings and expectations’ and could parse through the multiple documents and statements that the SEC highlights, which include statements (sometimes inconsistent) across many social media platforms and news sites from a variety of Ripple speakers (with different levels of authority) over an extended eight-year period."
Thus, the SEC is "hoist by its own petard." It has proclaimed that Howey governs; the Court agreed, performed the Howey test, but could find no investment contract between the sellers and the buyers, and therefore no securities. In this regard, a shout-out to Lewis Cohen of DLx Law is in order. He has been the most learned and persistent challenger to the assertion that every purchaser of a digital asset was necessarily party to an "investment contract." (See his latest here.)
By the terms of Howey, the logic of the decision seems very reasonable. That said, the logic does lead to some unsatisfying results. If the Ripple founders were able to sell XRP into the retail market and not have those XRP assets be deemed “securities,” then the institutional investors should also have been able to sell their XRP into the retail market without any holding period. After all, those sales would also have been anonymous, and the institutional investors clearly made no promises to the sellers. But if the institutional investors could sell into the retail market without the XRP being deemed securities, then there would be no point to imposing any holding period on the institutional investors. The institutional investors should be able to buy restricted securities on the morning of day one and sell XRP that are not securities to retail investors in the afternoon.
That outcome does not seem right or logical. But the Court cannot be blamed for producing a result that leads to dubious policy; determining policy is not, and should not, be the job of the Court. That should be the job of Congress and the regulators. If the law as written leads to a strange result, it's not the Court's job to fix the law. Viewed from the perspective of simply following the law (Howey) as written, the Court's decision as to the algorithmic sales is justifiable. The SEC said all along it was relying on Howey. In that case, the original buyers had a direct relationship with the managers (of the grove) and were clearly relying on their efforts. Purchasers of the oranges in the secondary market had no relationship with the operators of the grove and, therefore, they were just buying oranges, not an investment contract. Accordingly, a strict reading of Howey very reasonably results in the conclusion that the secondary market transactions in the XRP were not securities. After all, the purchasers in the secondary market had no obvious basis for asserting that the Ripple founders had obligations to them.
The discomfort of such a conclusion leads to one simple fact: digital assets are not oranges. Rote application of Howey to digital assets does not work.
SEC Chair Gary Gensler has justified his assertion that virtually all digital assets are "securities" with the mantra that "like must be treated as like"; i.e., oranges and digital assets are similar so they must be regulated in the same way. The mantra is wrong (see here for more on that). While it is true that "identical things should be treated identically,” it does not follow that similar things are required to be treated identically. Digital assets, like XRP, sold in the secondary market, are actually quite different from the oranges that were at issue in Howey. But the SEC simply refuses to acknowledge that. Or, if the SEC is right - that XRP are just like oranges - then purchasers of the XRP/oranges simply have no investment contract with the founders of Ripple or with the operators of the orange grove.
Rather than try to engage with the question of the existence of an investment contract, or to deal with the differences between digital assets and oranges, the SEC effectively asserted that any asset purchased with the hope of an increase in its value is a security. But that also cannot be true. If someone buys a house or a painting or Taylor Swift tickets, they may be hoping to resell at a profit. But that does not make the house, the painting or the tickets "securities." The Court explicitly, and correctly, rejects this argument. (See pages 23-4: "a speculative motive on the part of the purchaser or seller does not evidence the existence of an 'investment contract' with the meaning [of the Securities Act].”) There must also be an "investment contract." The Court asks, "where is the contract; I don't see one." In short, there is no direct relationship between the Ripple founders and the retail investors, and even if there were, no promise was made to them. Because the SEC has refused to engage with the differences between digital assets and oranges, the SEC does not seem to have a ready answer.
That leaves us in a strange place. The SEC is bringing enforcement actions against brokers and exchanges facilitating the trading of digital assets in the secondary market. But if those digital assets are not securities, there is no basis for the SEC's enforcement actions. Likewise, much of the SEC's rulemaking initiatives are, if the decision is correct, without any jurisdictional basis.
Of course, the SEC may appeal and may win on appeal. Courts are generally reluctant to defy the SEC, particularly when ruling against the SEC would leave a regulatory void. It remains arguable that an investment contract was formed by virtue of the Ripple founders' public statements and promises and it may not matter that those statements were not made directly to the retail investors. Where the Ripple founders made the statements to the market, they might have assumed that the market would rely on them, just as someone who trades on inside information may commit a fraud on the market without having lied to the particular counterparty. But this is not an argument that the SEC has asserted because it has simply assumed that Howey could be applied in a wholly mechanical fashion.
Even if the SEC now wins on appeal, that will not resolve the question of how digital assets should be regulated. That resolution can only come through Congressional action. Until there is legislation, it is hard to be confident that the SEC has much to offer beyond repeating that like must be regulated as like. As to what Congress should do now, there are lots of ideas, even if not generated by the SEC. See, e.g. By Whom Should Digital Assets Be Regulated? The Solomonic Solution.