Recently, a U.S. court made a landmark ruling on the ongoing legal battle between the U.S. Securities and Exchange Commission and major cryptocurrency Ripple. In a decision that is considered partially in favor of Ripple, the U.S. District Court of the Southern District of New York ruled that the sale of XRP tokens on exchanges and through algorithms are not considered a sale of securities because they did not constitute investment contracts.
In this article, we discuss the impact of the decision on how Web3 companies operate in the future and what other issues remain in need of regulatory clarity.
What The Case Was All About
In December 2020, the SEC sued Ripple and its executives CEO Brad Garlinghouse and co-founder Christian Larsen. The lawsuit claimed that Ripple failed to register XRP as security with the SEC before offering around $1.3 billion worth of tokens in a series of transactions. The regulator’s case involved three categories of unregistered XRP offerings and sales:
Institutional sales under written contracts for which Ripple received $728 million Programmatic sales on digital asset exchanges for which Ripple received $757 million Other distributions under written contracts, such as issuances and grants to executives, employees, and other parties, for which Ripple recorded $609 million in considerations other than cash.
Basically, what the case is trying to allege is that Ripple’s actions constitute investment contracts under the Howey test. This test, which was established in 1946 by the U.S. Supreme Court, is applied in numerous cases in the U.S. to determine whether various financial arrangements and offerings constitute securities.
The Howey test outlines four elements, or so-called prongs, that are present in a transaction for it to be considered an investment contract subject to U.S. securities laws:
An investment of money In a common enterprise With the expectation of profit To be derived from the efforts of others
In the original 1946 case that spawned the beginnings of the Howey test, the SEC sued W.J. Howey Co. for selling tracts of citrus groves to buyers in Florida without the regulator’s permission. Under the sale terms, the buyers must lease back the land to Howey, the company’s employees will maintain the groves and harvest the fruits, and the company will share the revenues with the buyers. In its ruling, the Supreme Court determined that the transactions are considered investment contracts, because:
The buyers invested money in Howey’s land They invested in Howey with by leasing back the land they bought The buyers received a share of the profit from the deal The labor that was needed to get profit was from Howey’s employees
Fast forward 70+ years, this test is being applied to Ripple’s XRP tokens. The final results from this case will have a huge impact on the Web3 industry due to the involvement of cryptocurrencies in just about every action that the industry undertakes.
What the SEC vs Ripple Ruling Resolved
In her ruling on the SEC vs. Ripple case, Judge Analisa Torres of the Southern District of New York applied the Howey test on the three categories of distributions. The results:
XRP sales on exchanges ARE NOT securities transactions.
The ruling determined that when Ripple and its executives sold XRP on third-party digital asset exchanges, there was a lack of reasonable expectation of profits from the transactions. The court also noted that when Ripple sold its XRP tokens in the open market, the company did not make promises or offers to unknown buyers, mainly because the buyers did not know who sold the tokens they just bought. Furthermore, Ripple was responsible for fewer than 1% of the global XRP trading volume since 2017. In effect, XRP sales on exchanges fail the Howey test on the third prong.
This is a positive ruling from the perspective of cryptocurrency traders and exchanges, as other noteworthy lawsuits by the SEC against several Web3 companies are based on assumptions that the cryptocurrencies being offered on exchanges are considered as securities. In the cases against Binance and Coinbase, the SEC claimed that the exchanges have “made available for trading on them crypto assets that are offered and sold as investment contracts, and thus as securities.” In effect, Judge Torres delivered a rebuke to the SEC on this line of accusation.
As a result of this ruling, many of the exchanges that have delisted XRP following the filing of the SEC lawsuit in 2020 have started re-listing the crypto token.
XRP grants to employees and executives ARE NOT securities transactions.
In this part of the lawsuit, Judge Torres ruled that the distribution of XRP tokens to Ripple’s team members as compensation and grants to incentivize development on the XRP Ledger cannot be considered a securities transaction. This is simply because the recipients did not have to pay for the tokens. Hence, the transaction failed the Howey test on the first prong.
With this decision, airdrops, free mints, social media giveaways, and token claims are likely protected from being considered as securities transactions, as these activities do not involve payments to crypto issuers. Many Web3 companies’ marketing teams rely heavily on these activities, and clearing them from being securities should take away one more cause for concern from these teams.
XRP sales to institutional purchasers ARE securities transactions.
Amid the favorable rulings, SEC managed to win in one part of the lawsuit, the part where they claimed that Ripple received $728 million from institutional sales under written contracts. These transactions passed the Howey test because:
The buyers paid Ripple for XRP tokens Ripple used the assets raised from the institutional sales to “promote and increase the value of XRP by developing uses for XRP and protecting the XRP trading market” The buyers profited in proportion to their XRP holdings as the tokens increased in value, as promised by Ripple The buyers did not work on increasing the value of XRP because they were not part of the Ripple team
In a related matter, the decision has put a halt on the common defense used by Web3 companies to assert that cryptocurrencies can be considered as utilities, especially if they are being used in Web3 solutions connected to them. The ruling found that buyers bought XRP not to use it as a currency but as an investment, citing that some buyers agreed to lockup provisions based on XRP’s trading volume and purchased far more than they would need to transact using Ripple’s enterprise solutions.
In effect, the ruling sets the terms that will turn an institutional purchase of cryptocurrencies into a securities transaction. Moving forward, Web3 companies would be wise to be careful about avoiding explicit contracts similar to what XRP’s institutional buyers had.
“Ripple selling XRP directly pursuant to contracts was an investment contract, and thus a security. Ripple had fair notice that doing this without registration was illegal. And a jury will be needed to decide whether Ripple execs aided and abetted this unregistered issuance,” said ConsenSys lawyer Bill Hughes.
What Remains Unresolved in the Case
Despite the seemingly bullish outcome of the SEC vs. Ripple case for Web3 companies, legal experts have cautioned that the ruling has yet to answer the question on whether digital assets such as crypto tokens and NFTs are considered securities under U.S. law. Neither did the ruling provide clarity on whether secondary market sales of digital assets can be considered securities contracts in general. With several lawsuits taking place against many other Web3 companies, there is a potential for contradicting rulings from different district courts. The call for further regulatory clarity remains strong as ever.
Some lawyers opined that the decision raises more questions than it answers. For instance, Preston Byrne, partner at Brown Rudnick LLP, said in response to the ruling, “The Ripple summary judgment is obviously not the last word on the issue. How can a thing be a security in one transaction, but not in another? I also think that Judge Torres' ruling in Ripple is logically not consistent with Judge Castel's ruling in Telegram, which if applied to Ripple would mandate a different conclusion.”
It’s worth noting that in a separate complaint in 2019, the SEC sought to stop chat app Telegram from offering digital tokens called Grams. In 2020, Judge P. Kevin Castel of the U.S. District Court for the Southern District of New York ruled that the SEC established substantial likelihood of proving that Telegram's sale of Grams broke securities laws. Telegram settled the case and returned $1.2 billion to Grams investors.
Moving forward, with each side of the SEC vs. Ripple fight scoring partial victories of their own, either party can file for an appeal. For the SEC side, they may cite the Telegram case ruling to insist on its accusations regarding Ripple’s transactions. The regulator can also challenge Judge Torres’ ruling in the 2nd U.S. Court of Appeals, with the intent of stopping judges in the other cases from making the same ruling regarding the sale of crypto tokens on exchanges. For Ripple, they may seek reconsiderations on the ruling on XRP sales to institutional investors. There’s also a possibility of both sides coming to a settlement agreement, like what Telegram did.
As for the other Web3 companies that the SEC sued, the largely pro-Ripple ruling has given them a reason to hope that they will also receive a favorable outcome. Paul Grewal, chief legal officer at Coinbase, noted that if XRP is not designated as a security in Judge Torres’ decision, then other cryptocurrencies shouldn’t either. “I think it would be a mistake to assume that, in every instance, and in every transaction, the securities laws do not apply. That’s never been Coinbase’s position, I don’t think it should be anyone’s reasonable position. But if you literally replace the letters XRP with the letters for any other token, in this decision, the logic still holds,” Grewal said.
In the bigger picture, the continued lack of regulatory clarity in the U.S., coupled with the SEC’s hot pursuit of Web3 companies, will likely put the country at a disadvantage in the Web3 scene, especially given that economic rivals have started adopting a more positive and clear regulatory approach towards cryptocurrencies. Whether the Ripple ruling will result to greater freedoms for Web3 in the US or further stagnation and stifling remains to be seen, but this generally pro-Web3 ruling is a step forward for the industry.
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Sources: Bill Hughes, Bryan Cave Leighton Paisner Law, Bryan Jacutot, CNBC, CoinDesk, Cointelegraph, Fenwick Law, GreenbergTraurig Law, Investopedia, Preston Byrne, Reuters [1] [2], U.S. Securities and Exchange Commission