On 13.7.2023 the Crypto markets were in a state of exhilaration as the Ripple payment protocol’s native cryptocurrency XRP almost doubled in value. This surge came as a consequence of a landmark decision by a New York District Court (further, the Court) which declared that the Ripple Labs Inc. did not violate federal securities law by selling its XRP token on public exchanges.
The decision quickly prompted excited proclamations that the XRP token was deemed not to be a security, and the web was swiftly filled with statements congratulating Ripple on their monumental victory over the US Securities and Exchange Commission (SEC). Many have hailed the decision as a turning point for the crypto.
But was XRP actually declared not to be a security? The ruling is a bit more complex than that, and requires a more in-depth analysis.
Source code for the XRP Ledger was developed between 2011 and 2012 with an aim to create faster and more energy-efficient alternative to the bitcoin blockchain which was introduced in 2009 by Satoshi Nakamoto. Ripple Labs was consequently founded in 2012 with a goal of realizing the “Internet of Value” by facilitating the transfer of value across the internet. The newly emerged XRP token was distributed among Ripple, its founders and developers.
For a detailed legal analysis of XRP, please read our previous article, which is a part of our article series on 12 top cryptocurrencies based on their market cap.
During its operations beginning in 2013 Ripple and two of its core executives – co-founder and former CEO Chris Larsen and current CEO Brad Garlinghouse – (Defendants) engaged in a series of sales and distributions of the XRP – some more convoluted than others:
- Institutional Sales
First, Ripple, through wholly owned subsidiaries, sold XRP directly to certain counterparties (primarily institutional buyers, hedge funds, and ODL customers) pursuant to written contracts.
- Programmatic Sales
Second, Ripple sold XRP on digital asset exchanges “programmatically,” or through the use of trading algorithms. These digital asset exchanges were so called “blind bid/ask transactions”: Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it.
- Other Distributions
Thirdly, Ripple also distributed XRP as a form of payment for services. For instance, Ripple distributed XRP to its employees as a form of employee compensation. Ripple also distributed XRP to fund third parties that would develop new applications for XRP and the XRP Ledger.
- Individual Sales
Finally, in addition to Ripple’s sales and distributions, Larsen and Garlinghouse offered and sold XRP in their individual capacities.
These transactions finally caught the attention of SEC, which filed an action against Ripple Labs Inc. and two of its executives in December 2020, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering. The complaint alleged that the Defendants failed to register their offers and sales of XRP or satisfy any exemption from registration, in violation of the registration provisions of the federal securities laws.
According to SEC, by failing to register their offers, sales, and distributions of XRP, Ripple (abetted by its executives) deprived potential purchasers of adequate disclosures about XRP, Ripple's business and other important long-standing protections, that are fundamental to robust public market system.
Specifically, the SEC alleged that Defendants sold XRP as an investment contract – a type of security as defined by the US Securities Act. Defendants defended their actions arguing, that they did not sell XRP as an investment contract and, therefore, no registration statement was required.
As a consequence, the case revolved around the notions of a “security” and an “investment contract” and whether all or any of the sales or offerings of XRP could be deemed to be offers of securities.
Notion of security in the USA and the Howey Test
In US, if one is considering an Initial Coin Offering (ICO), or otherwise engaging in the offer, sale, or distribution of a digital asset, they need to consider whether the U.S. federal securities laws apply. A threshold issue is whether the digital asset is a security under those laws. The term security includes an investment contract, as well as other instruments such as stocks, bonds, and transferable shares.
In order to establish whether something is a security, the US authorities and courts employ the so-called Howey test. The test is based on the U.S. Supreme Court’s case SEC v. W.J. Howey Co. (1946) and its subsequent case law, according to which investment contract exists when:
1. there is the investment of money;
2. in a common enterprise;
3. with a reasonable expectation of profits to be derived from the efforts of others.
These three requirements are sometimes called the three prongs of the Howey analysis.
The Howey test applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities. The focus of the Howey analysis is not only on the form and terms of the instrument itself (in this case, the digital asset) but also on the circumstances surrounding the digital asset and the manner in which it is offered, sold, or resold (which includes secondary market sales). In other words, form should be disregarded for substance and the emphasis should be on economic reality and the totality of circumstances.
This analysis was employed extensively in the SEC v. Ripple case by the New York District Judge Analisa Torres.
In regard to institutional sales of Ripple, the first prong of Howey was established, as the Institutional Buyers invested money by providing fiat or other currency in exchange for XRP. While Ripple argued that mere “payment of money” should be distinguished from “investment of money”, it was found that providing the capital – or in other words “putting up the money” – is enough.
Furthermore, the second prong of Howey – common enterprise – was also established due to existence of horizontal commonality. Horizontal commonality exists where the investors’ assets are pooled and the fortunes of each investor are tied to the fortunes of other investors, as well as to the success of the overall enterprise. In the case, it was found that the proceeds from Ripple's Institutional Sales were indeed pooled, and each Institutional Buyer’s ability to profit was tied to Ripple’s fortunes and the fortunes of other Institutional Buyers because all Institutional Buyers received the same fungible XRP.
Finally, the Court found that Institutional Buyers had a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of Ripple. According to the Court, from Ripple’s communications, marketing campaigns, and the nature of the Institutional Sales, reasonable investors would have understood that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP. As for “the nature” of Institutional Sales, the Court referenced the fact, that in their sales contracts, some Institutional Buyers agreed to lockup provisions or resale restrictions based on XRP’s trading volume. These restrictions were inconsistent with the notion that XRP was used as a currency or for other consumptive use rather than as an investment.
Consequently, all three prongs of Howey analysis were fulfilled. Therefore, Ripple’s Institutional Sales of XRP sales totaling $728 million were found to be offers and sales of investment contracts.
In regard to Ripple’s Programmatic Sales, the Court concluded that the third Howey prong was not established.
According to the Court, Programmatic Buyers could not have reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP. This was due to the fact, that Ripple’s Programmatic Sales represented less than 1% of the global XRP trading volume. Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. In other words, Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP.
Due to these circumstances, the expected return of Programmatic Buyers was not contingent upon the continuing efforts of Ripple, but rather on other factors, such as general cryptocurrency market trends. Other characteristics supporting this conclusion, were the absence of particular contractual restrictions tied to the sales, as well as the fact that Programmatic Buyers were deemed not to be as sophisticated as Institutional Buyers.
As the third prong of the Howey test was not established, the Court did not inspect whether the first or second Howey prongs were satisfied. Therefore, Ripple’s Programmatic Sales of XRP totaling in $757 million did not constitute the offers or sales of investment contracts.
In regard to Ripple’s Other Distributions, the Court found that they did not satisfy Howey’s first prong.
This was due to the fact, that recipients of the Other Distributions did not pay money or “some tangible and definable consideration” to Ripple. Therefore, there was no investment of money as part of the transaction or scheme. Furthermore, when these Other Distributions were eventually sold by the recipients, XRP sales never traced back to Ripple and therefore did not constitute an indirect public offering.
Therefore, Ripple’s Other Distributions of XRP totaling in $609 million did not constitute the offer and sale of investment contracts.
Larsen’s and Garlinghouse’s Offers and Sales
Lastly, the Court addressed Larsen’s and Garlinghouse’s offers and sales of XRP in personal capacity.
While the Securities Act exempts “transactions by any person other than an issuer, underwriter, or dealer”, SEC argued that this exemption did not apply to Larsen and Garlinghouse because they were affiliates of Ripple and an affiliate of the issuer—such as an officer, director, or controlling shareholder—ordinarily may not rely upon the exemption.
The Court, however, decided not to inspect the issue. This was due to the fact that, like Ripple’s Programmatic Sales, Larsen’s and Garlinghouse’s XRP sales were programmatic sales on various digital asset exchanges through blind bid/ask transactions.
Therefore, the Court established, that Larsen’s and Garlinghouse’s Offers and Sales, from which they received at least $450 million and $150 million respectively, did not constitute offers or sales of investment contracts for substantially the same reasons as Ripple’s Programmatic Sales.
In addition, the Court established that Larsen and Garlinghouse did not aid or abet Ripple in their transgressions.
In conclusion, one can derive from the judgement, that what matters is not what you are selling but how you are selling it.
XRP might as well be an ordinary asset like gold, silver, and sugar. However, even these ordinary assets may be sold as investment contracts, depending on the circumstances of those sales. In other words, even if XRP exhibits certain characteristics of a commodity or a currency, it may nonetheless be offered or sold as an investment contract.
According to the New York District Judge Analisa Torres, 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, what matters is the totality of circumstances surrounding different transactions and schemes involving the sale and distribution of XRP.
Therefore, is XRP a security? The answer is - it depends. Under some circumstances the offering, sale or distribution of XRP can be considered as an offer or sale of a security under the U.S. federal securities laws.
Implications of the Decision
The U.S. concept of a security and the Howey test are exclusively domestic approaches, and the U.S. authorities' decisions based on them do not have a direct impact on other countries. However, many practices undertaken by the U.S. often tend to resonate with other countries due to the sheer international economic power of the state. This being the case, it seems likely, that the consequences of this decision will spill over to other regions of the world - both legally and economically.
Nevertheless, it is prudent to take into account, that the District Court's decision can still be appealed, and if SEC is going down - it will go down swinging. The eventual final decision on this matter will not only affect Ripple but also SEC's ongoing legal battles with Coinbase and Binance, as well as the whole crypto scene.
Regardless, it is certain, that the SEC v. Ripple is the first in the future series of landmark decisions at the forefront of crypto.
Our Associate Trainee Savva Kuparinen took part in writing this article.