Last week, Judge Analisa Torres of the United States District Court for the Southern District of New York ruled on cross-motions for summary judgement filed by the SEC and Ripple in relation to ongoing litigation that dates back to December 2020. The following is a short summary of Judge Torres’ ruling and my initial reactions.
Summary
Judge Torres’ ruling argues that a determination of an unlawful offer and sale of securities in violation of Section 5 of the Securities Act of 1933 should hinge on the facts and circumstances by which the sale was made. Judge Torres notes that in the original Howey case and its progeny, which have come to define the term “investment contract”, “the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.” Thus, Judge Torres points to “the plain words of Howey”, which make clear that an investment contract for purposes of the Securities Act means a contract, transaction[,] or scheme.” (emphasis added by Judge Torres). Judge Torres states 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.”
With this analysis established, Judge Torres then assesses the three categories of alleged unregistered XRP offer and sales:
- Institutional Sales under written contracts for which it received $728 million;
- Programmatic Sales on digital asset exchanges for which it received $757 million; and
- Other Distributions under written contracts for which it recorded $609 million in “consideration other than cash.”
Judge Torres finds that only the “Institutional Sales” constituted the unregistered offer and sale of an investment contract, as all three prongs of the Howey Test were satisfied. For the Programmatic Sales, whereby Ripple sold XRP via cryptocurrency exchanges, Judge Torres ruled these did not constitute investment contracts because the third prong of the Howey Test (expect profits solely from the efforts of the promoter or a third party) was not satisfied because buyers were not aware they were buying XRP from Ripple and because Ripple “did not make any promises or offers because Ripple did not know who was buying the XRP.”
A Modest Victory for the Crypto Industry
Judge Torres ruling is largely viewed as a victory for cryptocurrency exchanges because the tokens they list are similar to XRP in that they are not in and of themselves a “contract, transaction, or scheme.” Thus, if they are not listing investment contracts, they cannot be accused of operating an unregistered securities exchange. However, it is important to note that footnote 16 in Judge Torres ruling notes:
“The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court. Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction, or scheme.”
But even with the caveat expressed in footnote 16, Judge Torres’ analysis would seemingly absolve Coinbase of the charges leveled against them by the SEC. Judge Torres rejected the presence of an investment contract in Ripple’s Programmatic Sales largely based upon the fact that XRP purchasers had no idea they were buying XRP from Ripple, therefore they couldn’t reasonably expect Ripple’s efforts to result in profits for them. Given that most secondary trading on crypto exchanges, like Coinbase, does not involve the token issuer, i.e., the issuer DOES NOT receive any proceeds from trading in their token, Judge Torres would likely find that crypto exchanges are not listing investment contracts.
Problems With the Ruling
As has been detailed elsewhere, Judge Torres’ ruling flips securities law on its head. The securities laws were established to protect retail investors in the wake of companies raising money from the public during the 1920s based upon poor, absent, and misleading disclosures, which contributed to the stock market crash of 1929 and the resulting Great Depression. The result of Judge Torres’ ruling is that wealthy and sophisticated institutional token investors get the protections provided by the securities laws while retail investors do not. This outcome is counter to the purpose and intent of securities laws.
In addition, Judge Torres implicitly demeans the intelligence of retail XRP investors by noting that they could not have interpreted Ripple’s, and Ripple executives’, public statements about the Ripple blockchain and XRP to mean that the value of XRP depends on Ripple’s success in building valuable products and services, even though institutional investors had access to the exact same information. Judge Torres found that “Institutional Buyers, would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts” and that “[t]here is no evidence that a reasonable Programmatic Buyer, who was generally less sophisticated as an investor, 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.”
Presumably, Programmatic Buyers purchased XRP because they thought it would increase in value. If these buyers were not relying on information supplied by Ripple, why did they think XRP’s price would increase? Judge Torres does not appear much interested in the answer to this question, and she notes that even if Programmatic Buyers are simply speculating, that “does not evidence the existence of an ‘investment contract’ within the meaning of the [Securities Act].” But it is hard to understand how you can assess the existence of Howey’s third prong (expect profits solely from the efforts of the promoter or a third party) without assessing the reasons why Programmatic Buyers would purchase XRP and why XRP would ever have value. If Ripple sold all its XRP and then decided to stop working on the Ripple Blockchain and instead speculate on luxury real estate, then clearly the value of XRP would plummet. Thus, ANY purchaser of XRP is reliant on Ripple’s efforts to realize their expected profits. However, Judge Torres seems to believe that such an expectation can only be present if the buyer knows that his funds are going directly to Ripple, which is a test that courts have not previously relied on in applying Howey.
For these reasons, and perhaps more that I have not yet thought of, there is a very good chance that the Second Circuit will reverse Judge Torres should the SEC appeal the decision, which I expect they will.
Perhaps the Law is Not so Clear
Judge Torres’ ruling certainly strikes a blow at the SEC’s efforts to bring the crypto industry within the securities regulatory perimeter. SEC Chairman Gary Gensler has long said that most tokens are securities (publicly, he has only conceded that one token, Bitcoin, is a commodity) and that the SEC has the existing legal authority to effectively regulate the crypto sector. Judge Torres’ ruling suggests that the law is not as clear as Chair Gensler, and many others, including myself, thought. While I may disagree with the ruling, it is Judge Torres’ opinion, not mine, that matters. If a federal district court judge can look at the facts around XRP offers and sales and conclude that in some circumstances XRP is an investment contract, and in others, it is not, then the law is not clear.
Absent federal legislation clarifying the regulatory status of cryptocurrency, a growing body of case law will define the contours of the crypto regulatory perimeter, and its shape will not be pretty. A different federal judge looking at the exact same facts and circumstances as Judge Torres could very well come to a different conclusion – and they likely will in similar cases. Of course, the Supreme Court could provide clarity, but that will take years. In the meantime, more courts will find that more tokens are commodities and not securities, and we will find ourselves in the same position we’ve been in for the past decade-plus. While the Commodity Futures Trading Commission (CFTC), regulates commodity derivatives, they do not regulate commodity spot markets. The practical effect of this structure is that cryptocurrency exchanges in the U.S. are presently not regulated at the federal level, and we’ve seen how that has played out over the past year and a half.
This gap must be closed as soon as possible. Even the crypto industry and Congressional sponsors of bills to regulate crypto markets have pointed to the urgency and necessity of this effort in light of Judge Torres’ ruling. I agree with them, although I disagree on how crypto should be regulated and by whom (in Congressional testimony from March 2023, I propose that Congress grant the SEC exclusive oversight over all of crypto).
Conclusion
Until Congress acts, Judge Torres’ ruling opens the door for all kinds of creative methods for crypto developers to raise funds from the public without having to comply with ANY meaningful regulation (beyond general prohibitions against fraud and manipulation in commodity spot markets.) According to Judge Torres’ logic, if token purchasers do not know they are transacting with the token issuer, the securities laws do not apply (even if they do know, securities laws may still not apply provided the token issuer is not marketing the token as an investment opportunity). This is a recipe for investor abuse.
Lee Reiners is a lecturing fellow at the Duke Financial Economics Center
