SDNY Tests Whether Ripple Constitutes an Investment Contract
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.
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