Written by John Basilios In a highly anticipated decision between Ripple Labs, Inc. (ripple) and the U.S. Securities and Exchange Commission (SEC), a US federal judge ruled that the XRP token will only be considered as security when it is sold to institutional investors but not when it is sold to the general public. In this article, we examine the resolution at Securities and Exchange Commission v. Ripple Labs Inc. 1: 20-cv-10832 (SDNY).
background
The SEC initiated this action in December 2020 and alleged that Ripple engaged in three categories of unregistered XRP offerings and sales:
- “Institutional sales” under written contracts during which it received $728 million;
- “automated sales” on digital asset exchanges for which it received $757 million; And
- “Other distributions” under written contracts recorded $609 million in “non-cash consideration”.
In February 2012, prior to publicly launching the XRP ledger, Ripple’s founders took advice from law firm Perkins Coie LLP, which sought to ‘review the proposed product and business structure, and analyze the legal risks associated with [Ripple]and recommending steps to mitigate these risks.
The advice note reads as follows:[a]Although we think a convincing argument can be made [XRP tokens] does not constitute “securities” under the federal securities laws. Because there is no applicable case law, we believe there is some risk, albeit small, that [SEC] inconsistent with our analysis.
resolutions and Howey Exam
Under section 5 of Securities law 1933 (United States) (Securities law), it is illegal to offer or sell a “security” without filing a registration statement with the Securities and Exchange Commission. To prove the infringement, the SEC would have to prove the failure to file a registration statement, and the defendant’s offer or sale of securities through interstate trading.
In this case, Ripple admitted offering and selling XRP through interstate commerce without filing a registration statement. The question before the court was whether XRP was offered or sold as collateral.
The Securities and Exchange Commission (SEC) argued that XRP was being sold as an “investment contract,” which falls under the definition of a security. Ripple argued that XRP was not sold as an investment contract and therefore did not require a registration statement.
in SEC v. W.J. Howey Co., 328 US 293 (1946) (Howey), the Supreme Court held that under securities law, an “investment contract” is a contract, transaction or scheme by which a person:
- invest their money
- in a joint venture; And
- Leads to expect profits only from the efforts of the promoter or a third party.
The court analyzed the “economic reality” and “the totality of the circumstances” to determine whether XRP qualifies as an investment contract under Securities lawfollowing the Supreme Court’s precedent Howey.
Institutional sales
The court first dealt with Ripple’s institutional sales of XRP to sophisticated individuals and entities pursuant to written contracts. The court found that elements Howey The test, including “Investment of money”, “Joint venture”, and “Expect profits from the efforts of others”, are adequately met.
Based on the test of the totality of circumstances, the court found that reasonable investors, who are in the position of institutional buyers, would have bought XRP with the expectation that they would reap profits from Ripple’s efforts. With Ripple’s communications, marketing campaign, and nature of institutional sales, reasonable investors will understand that Ripple will use the capital received from its institutional sales to improve the XRP market and develop uses for the XRP Ledger. This will increase the value of XRP.
Therefore, the court found that Ripple’s institutional sales of XRP constituted an unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act.
Automated sales
The court then examined Ripple’s automated sales of XRP, as Ripple allegedly understood that people were speculating on XRP as an investment that clearly targeted speculators, and made the increasing speculative volume a “target.”
In contrast to institutional sales, the economic reality of automated sales has not met the third element of Howey Exam. Automated buyers could not reasonably expect profits from Ripple’s efforts because they were involved in blind bid/ask transactions and did not know if their payments went to Ripple or other XRP sellers. The court stressed that the investigation focuses on the promises and offers made to the investors and not on individual motives. Therefore, the court held that Ripple’s automated XRP sales did not involve an investment contract.
other distributions
The court examined other distributions of XRP by Ripple, including distributions to employees, executives, and third parties as part of Ripple’s initiatives.
The SEC alleged that Ripple funded its projects by transferring XRP to third parties and making them sell it. However, the court decided that these distributions did not meet the first element of the Howey A test, where recipients have not paid money or tangible consideration to Ripple. Additionally, there is no evidence that Ripple received payments from these XRP distributions. Therefore, the court ruled that other distributions of Ripple did not include the offering and sale of investment contracts.
Further, the Court concluded its findings by determining that, for the same reasons discussed above, executives who offered and sold XRP on digital asset exchanges did not measure up to the offers and sales of the investment contracts.
Ramifications
The Ripple case could influence the future regulatory landscape in Australia. Regulators and policymakers can examine the court’s rationale and implications for the determination of securities and investment contracts in the context of cryptocurrency. This could lead to further guidance, clarifications, or even new legislation addressing specific issues related to cryptocurrency, token sales, and digital asset exchanges.
While the preferential value of the case may be limited, its implications for regulatory clarity, investor protection and market confidence are relevant around the world. By staying informed about emerging regulatory frameworks, technology developments, and market trends, Hall & Wilcox puts its customers first when contributing to industry best practices and facilitating responsible and compliant innovation.
This article was written with the assistance of Ali Al-Ansari, seasonal writer.
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