Split Court Decision on Whether a Token Is a Security in SEC v. Ripple Labs

Key Points

• A judge in the Southern District of New York recently held that (i) the crypto asset XRP is not, on its own, a security and, (ii) as a result, the determination of whether an offer or sale of XRP required SEC registration hinges on the circumstances of the transaction.
• The decision is being viewed as a partial win for both sides. Applying the Howey test, the court issued a bifurcated order finding that (i) “institutional” sales of XRP to individual investors pursuant to written contracts constituted investment contracts requiring registration and (ii) “programmatic” sales of XRP on digital asset exchanges or through trading algorithms, and “other distributions” of XRP as a form of payment for services, did not constitute investment contracts and therefore no registration was required.
• While the court expressly did not address whether secondary market sales would constitute offers and sales of investment contracts, the court’s analysis of the “programmatic sales” provides a framework for how courts consider secondary market sales and may prompt market makers to begin trading in XRP, as well as other crypto tokens such as Solana and MATIC.

The Litigation

Ripple Labs Inc. promotes a blockchain payment protocol to process international money transfers using the XRP cryptocurrency. In 2020, the U.S. Securities and Exchange Commission (SEC) sued Ripple and two of its most senior executives for offering XRP as an unregistered security in violation of section 5 of the Securities Act of 1933. Both sides moved for summary judgment, and on July 13, 2023, the Honorable Analisa Torres ruled on both motions.

The key question was whether the defendants’ offers and sales of XRP were offers and sales of a security.¹ The court applied the three-pronged Howey test, under which to determine whether something is an investment contract, “[t]he test is whether the scheme involves [1] an investment of money [2] in a common enterprise [3] with profits to come solely from the efforts of others.”²

Applying the Howey test, the court held 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. Rather, the Court examines the totality of circumstances surrounding [d]efendants’ different transactions and schemes involving the sale and distribution of XRP.”³

The court then applied the Howey test to the different types of transactions at issue:

• Institutional Sales. According to the SEC’s complaint, Ripple sold approximately $728.9 million of XRP directly to institutional buyers (including hedge funds) pursuant to written contracts. For these sales, the court found that all three prongs of the Howey test were satisfied, citing “horizontal commonality” and an expectation that investors would “derive profits from Ripple’s efforts” to market and promote XRP. The court focused on provisions common to the agreements with sophisticated institutional investors, such as lock-up requirements, resale restrictions and indemnification clauses, and cited them as evidence of intent to participate in a profit-sharing enterprise with Ripple.⁴
• Programmatic Sales. However, the court reached a different conclusion on the (alleged) sales of $757.6 million of XRP through “programmatic sales,” which were sales of XRP tokens on digital asset exchanges and through trading algorithms, finding that the third prong of Howey was not satisfied. This conclusion hinged on the “blind” or clearinghouse structure of the on-exchange sales, which eliminated any notion of buyers investing directly in Ripple or sharing in a common enterprise.⁵
• Other Distributions. The court also concluded that the defendants’ alleged distributions of XRP to employees and third parties as compensation did not satisfy the third prong of Howey because the recipients did not pay money to Ripple.⁶

Importantly, the court expressly did not address “whether secondary market sales of XRP constitute offers and sales of investment contracts,” stating, however, that “[w]hether 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.”⁷

Takeaways

Both parties can appeal the decision, and other courts may reach different conclusions. The immediate favorable price reaction in XRP suggests traders of digital assets in the secondary markets are viewing the opinion as supporting the lawfulness of their activities. Conversely, the court’s decision highlights risks associated with more traditional issuances of digital assets, especially at their earliest phases. Institutional investors—including private funds investing in tokens—that acquire digital asset exposure through written agreements that include traditional securities offering concepts (e.g., lock-ups and resale restrictions) should continue to treat the legal landscape as unsettled and thus uncertain.

^{1 Order at 10, SEC v. Ripple Labs, Inc., No. 20-10832 (S.D.N.Y. July 13, 2023), ECF 874.}

^{2 SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946). The court rejected Ripple’s arguments that the relevant analysis is the “essential ingredients” test, under which investment contracts must include post-sale obligations on the promoter and grant the investor a right to share in profits from the promoter’s efforts. Order at 13, SEC v. Ripple. The court instead embraced a plain-language interpretation of the Howey test. Id.}

^{3 Order at 15, SEC v. Ripple (emphasis added).}

^{4 Id. at 16-22 (emphasis added).}

^{5 Id. at 22-25, 27-28.}

^{6 Id. at 26-27.}

^{7 Id. at 23, n.16.}