“Schrödinger’s Token”: Takeaways from SEC v Ripple Labs, et al.
On July 13, 2023 the trial court in SEC v Ripple Labs, et al. granted (and denied) various motions for summary judgment from each of the parties. Generally, the court grants summary judgment if the party seeking that quick decision shows that there is no genuine dispute as to any material fact and therefore they are entitled to judgment as a matter of law. In this case, both parties moved for summary judgment and the court rendered a split decision from which each party can claim a “victory”.
While the court’s ruling was not a clean sweep, there are important lessons to be learned from this decision.
Let’s start with a word of warning. This decision by the district court is subject to appeal to a higher court and likely will be appealed by the SEC (and perhaps Ripple Labs as well). Appellate courts are free to reverse any portion of the decision that is appealed to them and can take years before an appellate decision is rendered. Accordingly, caution should be used when taking any action in reliance on this court decision as the matter has not been adjudicated to finality. Additionally, other courts (specifically those in other federal judicial districts) are not required to follow this decision so this decision is not the “law of the land” quite yet.
Initial Reactions
So, what can we take away from this decision?
First, for those assets that are not specifically deemed to be securities under relevant federal legislation and regulation, the district court reaffirmed that the investment contract test set forth in SEC v W.J. Howey Co. controls the analysis. The court specifically rejected Ripple’s “essential ingredients” test which would have expanded the Howey test in ways not mandated by the Supreme Court.
Second, the court held that even where a token “exhibits characteristics of a commodity or a currency it may nonetheless be offered and sold as an investment contract.” The court focused on the “totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP.” This is an important point to emphasize. The court focused more on the circumstances of the sales and less on the underlying nature or characteristics of the token itself.
Current marketplace discourse regarding whether a specific token is a security has tended to focus primarily on the decentralized nature of the project in an attempt to eliminate a prong of the Howey test (the third prong, “expect profits solely from the efforts of the promoter or a third party”) with little to no effort being spent analyzing the method of sale; however, this court looked at the sale process instead and ultimately, and perhaps curiously, arrived at its decisions on that basis. “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 Defendants’ different transactions and schemes involving the sale and distribution of XRP.”
Accordingly, the same XRP token can be considered to be a security under some sale circumstances and then not a security when distributed differently. This court’s decision concludes that when an issuer sells a token directly to a buyer pursuant to a written contract, that is a sale of a security and the transaction must either be registered with the SEC or the issuer must comply with an exemption from registration. But is this really anything different than what is widely accepted as current practice?
As the crypto industry has matured and distanced itself from the ICO craze of 2017, we have seen an uptick in privately negotiated sales of tokens (and equity) to institutional investors as the primary fundraising model, with many issuers opting to comply with the Regulation S exemption from registration. If the Ripple decision is informative of how courts will approach this issue generally, i.e., direct sales of tokens to institutional buyers means that the token is a security because the sale represented an investment contract, then it is fair to consider whether this institutional sale activity can be brought back onshore; specifically, whether token issuers can and should avail themselves of other exemptions from registration such as Rule 506(b) of Regulation D, which exempts sales of securities to sophisticated investors from SEC registration requirements. So where Ripple Labs tripped up wasn’t in failing to register its offering to its institutional buyers (although it certainly did fail to do so), rather its liability arose because it failed to comply with the prerequisites of an exemption from such registration.
The court’s decision also examined other distributions made by Ripple and its founders and came to different conclusions about the security status of the very same token. Quite curiously, while the court concluded that sales of tokens to the most sophisticated investors was a securities offering and therefore subject to applicable registration or exemption requirements, the court also found that sales of the very same token, by the very same sellers to unknowable retail investors, were not offerings of securities at all. This seems contra to the very purpose of the securities laws, which err invariably in favor of protection of retail investors and often leave sophisticated investors to fend for themselves, and serves as further proof that a legislative update to account for digital assets is warranted.
Ripple Lab’s “programmatic” sales through digital asset exchanges, in the court’s view, failed to satisfy the third prong of the Howey test, “[w]hereas 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…Programmatic Sales were blind bid/ask transactions and Programmatic Buyers could not have known if their payments of money went to Ripple or any other seller of XRP.” Given that the parties to these programmatic transactions were unknown to one another, the court found that Ripple Labs did not make any promises or offers to programmatic buyers because “Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it.”
Similarly, the court did not find liability for Ripple Labs when it distributed XRP to employees as compensation and as grants to app developers. Here, the nature of the transaction was not of a sale at all, no capital was exchanged by the parties and therefore did not satisfy the first prong of the Howey test (i.e., there is an “investment of money” as part of the transaction or scheme).
Lasting Impressions
Aside from a forthcoming trial to determine the culpability of Ripple Labs’ founders for “aiding and abetting” Ripple Labs’ violations of the securities laws, where does SEC v Ripple Labs, et al. leave us?
Unlike the regulatory clarity the crypto community clearly and vocally craves, this decision muddies the waters a bit as it leaves more questions unanswered than it answered and some of those answers seem askew. Even though this court has rejected Chairman Gensler’s categorical assertion that all tokens aside from Bitcoin (and depending on when he was asked, potentially Ethereum) are securities, how will courts view distributions of tokens in a negotiated transaction where the issuer is materially decentralized (i.e., the third prong of Howey)? Are secondary transactions in tokens exempt from registration requirements when transacted on exchanges or defi protocols? How can a token be a security and not a security simultaneously?
It is hard to recommend reliance on a district court opinion that will almost undoubtedly be challenged and appealed by an aggressive regulator who has relied nearly exclusively on enforcement to regulate a nascent industry. If one were to try to find solace in this decision it would be to assume your token is a security and spend the time needed to focus on the nuts and bolts of how you raise funds utilizing your tokens, i.e., if you sell tokens in a venture capital transaction and take advantage of the exemptions from registration that are available to issuers, you should have a defense when the SEC comes knocking. This decision can also serve as comfort for issuers that airdrop or fork tokens into users’ wallets that they have not engaged in a prohibited issuance as the court’s finding with respect to grants made to employees and app developers have shown that no investment contract can exist without compensation or consideration having been paid by the recipients.
What’s Around the Corner?
If we peek ahead into the future a bit, it will be interesting to see how Coinbase incorporates this court’s decision into its defense. Will they extend the “programmatic sales are not securities offerings’’ rationale by latching on to that portion of the court’s decision which states “the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money” as demonstrative evidence that tokens are never securities in the secondary market? How will that court view this court’s decision?
Regardless of the outcome of any specific enforcement action, if the courts continue to send mixed signals to the crypto community and its regulators, the message it is sending to Congress should be clear: the courts will not solve this regulatory uncertainty for you. It is up to you to come to the table, reach across the aisle and work together to provide the clarity needed to save this industry in the United States, an industry which has the power and potential to bring transformation and transparency to markets, bank the unbanked and preserve the United States as the preeminent global financial power and home of innovation. That much is clear and unlike Schrödinger’s cat, the choice is binary.
The views expressed here are those of the individual CoinFund Management LLC (“CoinFund”) personnel quoted and are not the views of CoinFund or its affiliates. Certain information contained herein has been obtained from third-party sources, which may include portfolio companies of funds managed by CoinFund. While taken from sources believed to be reliable, CoinFund has not independently verified such information and makes no representations about the enduring accuracy of the information or its appropriateness for a given situation.
This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services. Furthermore, this content is not directed at nor intended for use by any investors or prospective investors, and may not under any circumstances be relied upon when making a decision to invest in any fund managed by CoinFund. An offer to invest in a CoinFund fund will be made only by the private placement memorandum, subscription agreement, and other relevant documentation of any such fund and should be read in their entirety. Any investments or portfolio companies mentioned, referred to, or described are not representative of all investments in vehicles managed by CoinFund, and there can be no assurance that the investments will be profitable or that other investments made in the future will have similar characteristics or results. A list of investments made by funds managed by CoinFund (excluding investments for which the issuer has not provided permission for CoinFund to disclose publicly as well as unannounced investments in publicly traded digital assets) is available at https://www.coinfund.io/portfolio.
Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others. This presentation contains “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may”, “will”, “should”, “expect”, “anticipate”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially and adversely from those reflected or contemplated in the forward-looking statements.
