What some may consider a victory has others trembling in their seats. A recent landmark ruling by the US District Court for the Southern District of New York in the SEC v. Ripple Labs case could make waves for the future of Cryptocurrencies (“Crypto”).
Before getting into the nitty gritty, we should first understand what Crypto is – Crypto is “a digital or virtual currency secured by cryptography and based on a network that is distributed across a large number of computers.” [1] Many cryptocurrencies are decentralized networks based on blockchain technology, which is essentially a distributed ledger enforced by a network of computers.[2] Crypto has introduced a newer and potentially safer way to manage money because it is nearly impossible to counterfeit or double-spend, and they are theoretically immune to government manipulation or interference for the time being. [3]
While some believe Crypto is the future, others are more hesitant to follow suit because of its lack of regulation and because Crypto is not classified as actual legal tender by the United States government. Whether we like it or not, Crypto is sticking around for a while, so we might as well understand it and the role it plays in our economy.
What is a Security?
One of the biggest debates in the regulatory conversation is whether Crypto should be classified as a security, a commodity, a currency, or something else.[4] If Crypto is a security – like stocks and bonds – it would fall under the jurisdiction of the Securities and Exchange Commission (“SEC”). In SEC v. W.J. Howey Co., the court defined a security as including any “investment contract.”[5] The investment contract criteria became known as the “Howey Test.”
Under the Howey Test, a transaction is considered an investment contract (and therefore a security) if it meets the following four criteria: (1) money is invested; (2) the investment is in a common enterprise; (3) there is an expectation the investor will earn a profit; and (4) profits are generated via the efforts of others. [6] SEC Chair Gary Gensler has expressed his belief that most forms of Crypto are securities under the Howey Test, but Judge Analisa Torres of the Southern District of New York disagrees. The third prong of this test is what led to the landmark opinion in SEC v. Ripple Labs.
The Landmark Ruling – SEC v. Ripple Labs
On July 13, 2023, the U.S. District Court for the Southern District of New York, issued its long-awaited opinion in SEC v. Ripple Labs, ruling on the competing summary judgment motions brought by the parties.[7] In 2020, the SEC initiated litigation against Ripple, a giant in the Crypto world, alleging that Ripple’s efforts in raising more than $1.3 billion through an unregistered offering of digital assets (XRP tokens) allegedly violated Section 5 of the Securities Exchange Act of 1933 (the “Act”). Ripple argued their sales of XRP tokens were not in violation of the Act because the XRP tokens were not securities to begin with, under the Howey Test. The crux of the lawsuit revolves around whether Ripple’s token – XRP – is in fact a security under the federal securities laws and whether the transactions involving XRP tokens were securities transactions.
Judge Torres ultimately granted in part and denied in part both summary judgment motions.
First, the Court concluded that Ripple’s sale of XRP tokens to institutional buyers was a security because institutional buyers follow an entirely different process when purchasing XRP tokens and usually for entirely different reasons than programmatic buyers. Institutional buyers are investors like mutual funds, hedge funds, private equity funds, and banks. The Court highlighted that from 2013, Ripple created brochures describing the company’s operations, the XRP trading market, and the XRP ledger, which they marketed to potential investors touting XRP as an investment tied to Ripple’s success. [8] Ripple explains its “business model is predicated on a belief that demand for XRP will increase… if the Ripple protocol becomes widely adopted,” and “[i]f the Ripple protocol becomes the backbone of global value transfer, Ripple… expects the demand for XRP to be considerable.”[9] Thus, institutional investors have a greater expectation of Ripple’s profit as it is tied to their purchase of XRP tokens.
Next, Judge Torres found that XRP, the primary token at issue in the matter, is not a security when it is sold on a public exchange to retail investors due to its failure to meet the third prong of the Howey Test.
Torres explains that these were not offers of securities because purchasers did not have a “reasonable expectation of profit tied to Ripple’s efforts.” Torres states in her opinion, “Whereas the Institutional Buyers 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, Programmatic Buyers could not reasonably expect the same.”[10] Torres found that programmatic investors, who purchased XRP from digital exchanges, did not invest their money in Ripple as the institutional investors did. Institutional investors were sophisticated entities aware of Ripple’s marketing campaigns and public statements connecting XRP’s price to its own efforts.[11]
Unlike the institutional sales, these programmatic sales lacked contracts containing lockup provisions, resale restrictions, indemnification clauses, or statements of purpose. [12] With such a “blind bid/ask” transaction, it is unlikely programmatic investors had the same expectation of profit as the institutional investors. Therefore, programmatic sales of XRP tokens (or possibly any cryptocurrency) are not to be considered a security subject to SEC regulations. This ruling marks the biggest win for a Crypto company in a case brought by the SEC to date. [13]
Rippling Effects
Some think the Ripple decision is on shaky ground and possibly facing appeal. However, at this stage in the litigation, an appeal would be deemed interlocutory, given the Court did not dispose of the case in its entirety. Thus, even if granted, the case will still go on until a final judgment is delivered deciding on all the issues of the case.
Despite being in heated litigation with the largest security market regulator in the world, Ripple remains quite optimistic. Ripple’s general counsel revealed that Ripple believes U.S. banks and other financial institutions may start showing interest in adopting XRP in cross-border payments.[14] Ripple expects to initiate discussions with American financial firms about using its On-Demand Liquidity (ODL) product, which uses XRP for money transfers.[15]
As for the future of all Crypto, this relies heavily on the legislative developments over the coming years, and of course, the legal decisions pertaining to regulatory jurisdiction. If cryptocurrencies become subject to the jurisdiction of the SEC, this may pose a big threat to the decentralized nature that attracted many Crypto investors in the first place and may stifle innovation by placing limits on how Crypto may be used. [16] While some freedoms may be limited, investors might enjoy having some added protection over their assets. Nick Ranga, a senior cryptocurrency analyst, says stricter regulation of cryptocurrencies would certainly protect investors, in instances where an exchange collapses (like the FTX collapse).
John Rizzo, Senior VP at Clyde Group, admits “Far from achieving the end of crypto in America, the SEC’s attempt to cripple crypto in America may eventually lead to a bipartisan regulatory framework that engrains crypto more deeply into the economy than once thought possible – a bad day for those who banked on a strategy of killing crypto assets in America, indeed.”[17]
[1] Jake Frankenfield, Cryptocurrency Explained With Pros and Cons for Investment, Investopedia – Cyrptocurrency (July 24, 2023), available at https://www.investopedia.com/terms/c/cryptocurrency.asp
[2] Id.
[3] Id.
[4] Wayne Duggan, How Does the SEC Regulate Crypto?, Forbes Advisor, Investing (June 30, 2023), available at https://www.forbes.com/advisor/investing/cryptocurrency/sec-crypto-regulation.
[5] SEC v. W.J. Howey Co., 328 U.S. 293 (S. Ct. 1946).
[6] Id.
[7] SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486 (S.D.N.Y.) (unpublished).
[8] Id. at 30.
[9]Id at 30 (citing Defs. 56.1 Resp. ¶ 187; ECF No. 855-14 at 23, 29, 31).
[10] Id. at 35.
[11] Id at 39.
[12]Id at 34, (citing SEC v. Telegram, 448 F. Supp. 3d 352, at 373 (S.D.N.Y. March 24, 2020).
[13] Jody Godoy, Explainer: What makes a crypto asset a security in the US?, Reuters: Future of Money (July 14, 2023), available at https://www.reuters.com/technology/what-makes-crypto-asset-security-us-2023-07-14/.
[14] Ryan Browne, Ripple says U.S. banks will want to use XRP cryptocurrency after partial victory in SEC fight, CNBC CryptoWorld (July 17, 2023), available at https://www.cnbc.com/2023/07/17/ripple-hopes-judge-ruling-in-sec-case-will-lead-to-us-banks-using-xrp.html.
[15] Id.
[16] Wayne Duggan, How Does the SEC Regulate Crypto?, Forbes Advisor, Investing (June 30, 2023), available at https://www.forbes.com/advisor/investing/cryptocurrency/sec-crypto-regulation.
[17] John Rizzo, Could the Ripple Ruling Spell the End of Regulation by Enforcement?, Coin Desk (July 14, 2023). Available at https://www.coindesk.com/consensus-magazine/2023/07/14/could-the-ripple-ruling-spell-the-end-of-regulation-by-enforcement/.
