By: Owen Finn
Volume IX – Issue I – Fall 2023
I. Introduction to Crypto, Ripple, and XRP
In December 2020, the Securities and Exchange Commission (SEC) filed an action against Ripple Labs, Inc. and two of its executives: Brad Garlinghouse, an officer, and Chris Larson, a director. The Commission alleged they raised over $1.3 billion through XRP, a non-SEC registered digital asset offering. The SEC argues they sold XRP as a security, more specifically an investment contract, but did not file a registration statement. [1] Ripple conceded they sold XRP without registering with the SEC, but argued they did not need to because the crypto-asset is not a security. [2]
Cryptocurrency is a digital asset stored on blockchain-based platforms. Blockchain provides a decentralized database, or "digital ledger," of transactions everyone on the network can see. [3] This network is essentially a chain of computers that must approve an exchange before it can be verified and recorded. A traditional security such as stock processes records by one central administrator like a company or government. However, the data of the crypto-asset is shared with and verified by all of the users in the network. The decentralization of the network allows crypto to be easily transferable to a variety of exchanges without the interference of a third party. [4] There are five categories of cryptocurrency: (a) utility, (b) security, (c) transactional, (d) governance, and (e) platform. Utility tokens provide the purchaser the right to redeem the tokens for future services on the network and are generally considered commodities as opposed to securities. Security tokens provide ownership of an asset, such as tokenized stock, and are classified by the SEC as securities. Governance tokens give the holders governance rights, such as voting. Platform tokens use blockchains to provide holders access to decentralized applications, or dApps. Transactional coins, contested in the Ripple case, are designed to be used as currency in decentralized financial transactions. [5]
A blockchain-based business selling a transactional coin undergoes an initial coin offering, or ICO, where they sell their crypto-asset to fund the development of their network. Most security laws focus on protecting public retail investors; in a sale of stock, a company must provide information on the security offering, annual financial disclosures and reports, and file a registration statement with the SEC. However, a company can avoid many of these requirements by offering stock to investors as a private transaction rather than on public markets. [6]
In 2012, Defendant Larsen co-founded and led Ripple as its chief executive until December 2016. Of the 100 billion units of XRP generated by the XRP Ledger's code, the three founders retained 20 billion for themselves and provided 80 billion XRP to Ripple. [7] Since its founding, Ripple's mission has been to modernize international payments by developing a global payment network for international currency transfers. [8] From 2013 through the end of 2020, Ripple engaged in various sales and distributions of XRP. First, Ripple sold approximately $728.9 million of XRP directly to Qualified Institutional Buyers (QIBs) like hedge funds in a primary market. Second, Ripple sold roughly $757.6 million of XRP to the public on digital asset exchanges programmatically or through trading algorithms. Ripple's XRP sales on these exchanges, such as Coinbase, were blind bid/ask transactions: Ripple did not know who was bidding on XRP, and the purchasers did not know who was offering it. [9]
The issue of this case and at the forefront of securities law is whether or not crypto, specifically XRP, is a security. The Securities Act of 1933 states "... unless the context otherwise requires— (1) The term 'security' means any note, stock,... investment contract,... or, in general, any interest or instrument commonly known as a 'security'..." [10] This ruling has important implications for XRP, other big market players like Bitcoin and Coinbase, and the SEC's regulation power. If categories of cryptocurrency fall under this domain, Ripple and most of the crypto industry must comply with the SEC. This past July, the Hon. Judge Analisa Torres of the Southern District of New York issued a strange ruling on this landmark case.
II. The Securities and Exchange Commission
The Securities and Exchange Commission applies federal securities laws to protect investors, maintain fair and efficient markets, and facilitate capital formation. Federal securities laws have a straightforward concept: Everyone should be treated fairly and have access to certain facts and potential risks about investments and those who sell them. [11] Not all securities offerings require registration with the SEC, including private offerings to a limited number of persons or institutions, offerings of limited size, and securities of municipal, state, and federal governments; these exemptions aim to lower the cost of securities to the public and foster growth. [12]
Stock is the most conventional form of a security. The Supreme Court has held that the five attributes commonly associated with stock are (a) the right to receive dividends contingent upon an apportionment of profits, (b) the ability to be negotiated, (c) the ability to be pledged or hypothecated, (d) having voting rights in proportion to the number of shares owned, and (e) having the capacity to appreciate. [13] When a transaction involves selling an investment labeled stock that bears these five attributes outlined in Forman, the asset is a security. [14]
Notes are another traditional example of a security. To determine which notes constitute a security, the Supreme Court adopted the "family resemblance" test in Reves v. Ernst & Young, 494 U.S. 56 (1990). Courts frequently apply this test when analyzing notes or in complex cases concerning investment contracts. [15] Given the importance of the family resemblance test, it is discussed with the relevant case law in the next section.
Investment contracts are general investments undertaken to make a profit, but not in the form of stock or another traditional security. The lack of meaning in a commercial context makes the term investment contract challenging to interpret. Still, they intend to serve as a catch-all for "(n)ovel, uncommon, or irregular devices." [16] When the SEC brings cases against a crypto-based business like Ripple, they often argue the digital asset is an investment contract using the Howey test. This test is also discussed below.
Within the Division of Enforcement, the SEC has a Crypto Assets and Cyber Unit to investigate crypto exchanges. In 2022, the SEC brought 30 enforcement actions against crypto market participants. [17] In the suit against Ripple and other transactional coins, the SEC claims the defendant failed to meet the registration requirements designed to provide potential investors with necessary disclosures about XRP and the financial condition of the business. The SEC Investor Advisory Committee (IAC), which advises the Commission on regulatory priorities, issued their views on digital assets like crypto in April: "We believe that virtually, if not all, crypto tokens are securities and that they… are subject to regulation." [18] The IAC urged the SEC to enforce securities laws over crypto assets aggressively, oppose legislation creating special exemptions to the laws, and make crypto enforcement a top priority. Supporting this, the U.S. Treasury estimated that $14 billion worth of digital asset-based crime occurred globally in 2021, nearly double the 2020 estimate. The SEC argues the crypto market should comply with the registration, disclosure, anti-fraud, and investor protector provisions of securities laws.
III. Case History
i. Family Resemblance Test
In Reves v. Ernst & Young, the Farmers Cooperative of Arkansas and Oklahoma sold millions of dollars in promissory notes to co-op members and the public; the co-op went bankrupt and left over 1,600 investors holding notes worth a total of $10 million. [19] To determine whether these notes were securities, the Supreme Court adopted the family resemblance test. The Court held that the notes in Reves were securities because the notes do not resemble or have close similarities to any of the exclusive examples of non-security notes under the test. [20]
First, the test assumes every note is a security because of the wording in Section 2(a)(1) in the Securities Act: "... unless the context otherwise requires… the term 'security' means any note, stock,... investment contract,... or, in general, any interest or instrument commonly known as a 'security'..." However, in Reves, the Court recognized some notes as exceptions; for example, notes delivered in consumer financing or secured by a mortgage on a home are "...denominated 'notes' that nonetheless fall without the 'security' category." [21] If the note is on the exclusive list or bears a "strong family resemblance" to one of the identified notes, it is also not a security. To determine whether a family resemblance applies, the Court considers four factors. First, the Court examines the motivations of the buyer and seller; if the note's purpose is to facilitate the purchase of an asset, it is likely not a security. Second, the Court examines the distribution plan or "whether it is an instrument in which there is 'common trading for speculation or investment.'" Third, the Court analyzes the reasonable expectations of the investing public regarding whether the investment is considered a security. Lastly, any other factors surrounding the economic reality of the investment, such as another regulatory scheme reducing the risk of the investment. [22] The Court has held that the family resemblance test is appropriate in determining whether a note or ambiguous investment contract is a security.
ii. Howey Test
If the investment is not a stock, note, or other conventional security, the Howey test may be applied to analyze it as an investment contract. The SEC and the federal courts frequently use the Howey test to analyze digital assets as potential securities. In SEC v. W.J. Howey Co., Howey sold individual rows of orange trees to mostly remote investors. Howey would harvest and market the crop, but investors shared the profits. In 1946, the SEC brought an action against Howey for not registering the citrus grove asset. [23] In SEC v. W.J. Howey Co., the Supreme Court held that under the Securities Act, an investment contract is "(a) a contract, transaction, or scheme whereby a person invests his money (b) in a common enterprise and (c) is led to expect profits solely from the efforts of the promoter or a third party." [24] Under this test, a standalone commodity like an orange grove can be the subject of an investment contract. Howey has held that many different assets can serve as an investment contract depending on the circumstances surrounding the asset and how it is offered and sold.
The first prong of the test requires an investment contract to have an investment of money. As long as the buyer "provides the capital" to purchase the digital asset, either in fiat currency or another digital asset, this element is established, regardless of the intent of the investment. [25]
The second prong of the Howey test establishes a common enterprise, which has two main theories: horizontal commonality and vertical commonality. Horizontal commonality is where the investors share profit on a pro-rata basis, where the financial success of each investor is tied together. The courts recognize this commonality to satisfy the requirement of a common enterprise. Vertical commonality is more general and calls for a profit-sharing agreement between the buyer and seller. [26] Each Court of Appeals has a different view on vertical commonality and whether this indicates a common enterprise. The Fifth Circuit accepts broad vertical commonality alone to satisfy this prong; this entails investors’ fortunes being interwoven with and dependent on the efforts of those making the offering. [27] The Ninth Circuit is stricter and requires the investor’s financial success to be tied inextricably to the success of the promoter. [28] The Second Circuit, the jurisdiction where XRP is being litigated, has not determined whether vertical commonality alone constitutes a common enterprise, but rejects broad vertical commonality on the basis that it combines the second and third prongs of the test. [29]
The third and final prong examines whether the buyer is led to expect profits solely from the efforts of the promoter or a third party. An expectation that the investment will increase in value by any rate of return is an expectation of profits, as the Supreme Court has held that profit refers to "income or return." [30 ]The digital asset may demonstrate a reasonable expectation of profit if it gives the owner rights in the enterprise's profits or the owner expects the seller's efforts will lead to a return on the investment. Additionally, the profit must rely solely on the efforts of others. The seller's efforts should be the sole or most significant to make a profit, and the purchaser should expect to rely on these efforts. [31] If the investment is likely to increase in value predominantly due to the efforts of others, it satisfies the third requirement of the Howey test.
Overall, in analyzing the prospective investment contract, the Court states, "form should be disregarded for substance, and the emphasis should be on 'economic reality' and the 'totality of circumstances.'" [32] Regardless of the name or form, the economic reality of the transaction or scheme is analyzed through the Howey test.
IV. Application to SEC v. Ripple
Hon. Judge Torres used the Howey test to examine the totality of circumstances surrounding the Defendants' different transactions and schemes involving the sale and distribution of XRP. Each transaction is evaluated based on its content, the purposes it intends to serve, and the factual setting as a whole. Therefore, it is necessary to analyze private and public sales separately.
The first prong of the Howey test requires an investment of money. Ripple concedes they received money for XRP through both private and public sales; this requirement is established. [33]
The second prong of the Howey test examines a common enterprise through horizontal or vertical commonality. Ripple pooled the proceeds of its institutional and programmatic sales into a network of bank accounts under the names of its various subsidiaries. [34] Further, each buyer's ability to profit was tied to Ripple's fortunes and the fortunes of other buyers because all investors received the same fungible XRP. [35] Ripple used the funds it received from its sales to promote and increase the value of XRP by developing uses for XRP and protecting the XRP trading market. When the value of XRP rose, all investors profited in proportion to their XRP holdings. Under this premise, the court deemed a common enterprise to exist for private buyers through horizontal commonality.
The third prong examines whether there is an expectation the buyer is led to expect profits solely from the efforts of the promoter or a third party. Ripple mainly distributed XRP in two different contexts: to QIBs privately and to non-QIBs publicly. These different customer bases offer separate circumstances, and the court analyzed them individually.
Ripple offered XRP to institutional investors like hedge funds privately. They marketed XRP to potential QIBs and explained its potential growth using promotional brochures and highlighting the value of XRP on various public channels, connecting their efforts to XRP's price. [36] Ripple sold XRP and raised money from investors to build the network and grow the coin's value. The court ruled this final prong was satisfied because the sophisticated buyers understood Ripple's relationship with XRP and the potential profit from their efforts. [37] The sale of XRP in this context violated Section 5 of the Securities Act.
Ripple also sold XRP programmatically on public exchanges like Coinbase. When Ripple sold XRP through these exchanges, they didn't know who was buying the XRP and the buyers were unaware they were buying from Ripple. The court ruled that unlike selling to an institutional investor privately, the retail investors "could not have known if their payment of money went to Ripple or any other seller of XRP." [38] Buyers may have purchased XRP with an expectation of profit, but because the majority were unaware they were buying XRP from Ripple, this expectation was not due to Ripple's efforts. Similarly, Ripple did not distribute the same informational brochures to the general public because they were unaware of who the retail investors were. Therefore, based on the economic reality and totality of circumstances, the sale of XRP in this context is not a security. [39]
This ruling is confusing: Sometimes XRP is a security, and sometimes it isn't. When Ripple offered XRP to sophisticated investors privately, with due diligence and contracts, it constituted a security offering. When Ripple blind-offered to the public anonymously without disclosure, it was not a security offering. This was the first time a U.S. judge ruled against the SEC when the commission alleged a crypto token is a security. [40]
V. Conclusion and Future Implications
Cryptocurrency is different from stock, but they act similarly. When the common man purchases Meta Platforms Inc. (NASDAQ: META) stock, the money invested goes to whoever owned the share of stock before they did rather than to the company directly. [41] Venture capitalists bought stock from Meta in a primary market before their IPO in 2012; if you buy stock today, it may be from someone who bought it in its earliest years, or at least someone who bought it from someone who bought it from someone…[42] While Meta may not be actively raising money by selling primary shares to VCs today, the shares of secondary stock are still regulated as a Meta security offering.
Many public investors in Meta have never looked at their SEC filings, but if just one shareholder did notice fraudulent transactions in these filings, all of the shareholders have been defrauded and can sue. Institutional investors already receive significant regulatory support and disclosures that retail investors do not. However, the SEC isn’t the one enforcing these protections in private transactions; it is up to the private buyer, through their own due diligence, to protect themselves from a fraudulent investment. These protections are standard rules to protect investors in stock trading, [43] but the Ripple ruling is drastically different from the order of the stock market and the goals of the SEC. Instead of protecting all investors on the idea they cannot fend for themselves, only private traders are protected. With this logic, as long as you sell to retail investors on a public exchange, you don't need to register with the SEC or provide disclosures, so why sell privately?
Institutional investors receive significant regulatory support that retail investors do not. By performing due diligence and receiving disclosure, they may be adequately protected in private transactions. However, it is up to the private buyer to protect themselves from a fraudulent investment through their own analysis. Without the full extent of the regulatory support institutional investors receive, retail investors do not have the same protections.
In October 2023, Judge Torres rejected the SEC's appeal of the decision, and the SEC later dropped the case against Garlinghouse and Larsen as each side shifted focus to Ripple's punishment for unregistered private sales. [44] This decision gives the SEC less jurisdiction over crypto, specifically transactional coins. It is generally considered a win for crypto but may encourage companies to take advantage of less sophisticated investors. If crypto targets mostly uninformed investors, this is clearly problematic; who would invest in the industry, and how long could the scheme last? Coins like XRP share similarities with stock, but the dissimilar tests allow them to be governed drastically differently.
Different crypto-assets involve different companies with different circumstances; if the circumstances surrounding the sale of XRP are incredibly unique, it may be the only transactional crypto-asset to not be considered a security under the Howey test. A possibility is the Howey test isn't appropriate for digital assets. If they aren't investment contracts, then what is crypto? Overall, while XRP and other players in the crypto industry may remain mostly unregulated for now, I expect the issue will continue to be heavily litigated as the SEC continues to regulate the crypto industry.
Endnotes
[1] SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486.
[2] Ibid.
[3] Bernard Marr, “What Is the Difference between Blockchain and Bitcoin?,” Bernard Marr & Co, July 13, 2021, https://bernardmarr.com/what-is-the-difference-between-blockchain-and-bitcoin/.
[4] Ibid.
[5] LexisNexis Securities Practice Guide § 2.03 (2023)
[6] Matt Levine, “Ripple Is a Security and It Isn’t,” Bloomberg.com, July 14, 2023, https://www.bloomberg.com/opinion/articles/2023-07-14/ripple-is-a-security-and-it-isn-t?leadSource=uverify+wall.
[7] SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486.
[8] Ibid.
[9] Ibid.
[10] Securities Act § 2(a)(1) (1933).
[11] “SEC Mission,” U.S. Securities and Exchange Commission, August 9, 2023, https://www.sec.gov/about/mission
[12] “The Laws That Govern the Securities Industry,” SEC.gov, October 1, 2013, https://www.sec.gov/about/about-securities-laws
[13] United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975).
[14] LexisNexis Securities Practice Guide § 2.03 (2023).
[15] Ibid.
[16] SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943).
[17] Investor Advisory Committee to Chair Gensler, SEC, “IAC Views on Crypto Assets,” April 6, 2023.
[18] Ibid, 2.
[19] Reves v. Ernst & Young, 494 U.S. 56 (1990).
[20] Ibid.
[21] Ibid.
[22] Ibid.
[23] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
[24] Ibid.
[25] SEC v. W.J. Howey Co., 328 U.S. 293 (1946)..
[26] LexisNexis Securities Practice Guide § 2.03 (2023).
[27] SEC v. Koscot Interplanetary, Inc., 497 F.2d 473 (5th Cir. 1974).
[28] De Wit v. Firstar Corp., 879 F. Supp. 947, 979 (N.D. Iowa 1995).
[29] LexisNexis Securities Practice Guide § 2.03 (2023).
[30] SEC v. Edwards, 540 U.S. 389, 124 S. Ct. 892 (2004).
[31] SEC Strategic Hub for Innovation and Financial Technology, “Framework for ‘Investment Contract’ Analysis of Digital Assets,” Securities and Exchange Commission, accessed November 3, 2023, https://www.sec.gov/files/dlt-framework.pdf.
[32] SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486.
[33] Ibid.
[34] Ibid.
[35] SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486..
[36] Ibid.
[37] Ibid.
[38] Ibid, 23.
[39] Ibid.
[40] Chibuike Oguh, “Coinbase Leads Crypto Stock Gains after Ripple Labs’ Legal Victory,” Reuters, July 13, 2023, https://www.reuters.com/technology/coinbase-leads-crypto-stock-gains-after-ripple-labs-legal-victory-2023-07-13/.
[41] Matt Levine, “Ripple Is a Security and It Isn’t,” Bloomberg.com, July 14, 2023.
[42] Ibid.
[43] Matt Levine, “Ripple Is a Security and It Isn’t,” Bloomberg.com, July 14, 2023..
[44] Jody Godoy, “US SEC Drops Claims Against Two Ripple Labs Executives,” Reuters, October 19, 2023, https://www.reuters.com/markets/us/sec-dropping-claims-against-ripple-executives-court-filing-2023-10-19/.