Changing Tides Or A Ripple In Still Water? Examining The SEC v. Ripple Ruling

• Published date: 26 July 2023
• Subject Matter: Corporate/Commercial Law, Technology, Corporate and Company Law, Contracts and Commercial Law, Securities, Fin Tech
• Law Firm: Ropes & Gray LLP
• Author: Ropes & Gray LLP

On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York issued her highly anticipated ruling¹ on the parties' cross-motions for summary judgment in the Securities and Exchange Commission's ("SEC") action against Ripple Labs, Inc. ("Ripple") and two of its executives, alleging the unregistered offer and sale of XRP, a digital token, as a security. In the decision, Judge Torres rejected the theory that the XRP digital token itself embodied a security, and instead examined the different facts and circumstances by which the tokens were sold. In doing so, Judge Torres handed a rare (partial) victory to a cryptocurrency issuer in an action brought by the SEC, finding that offers and sales of XRP to institutions and sophisticated individuals constituted securities transactions, but that offers and sales of XRP on crypto exchanges, distributions to employees, and other distributions to third-party developers were not securities transactions. While the ruling is being celebrated by crypto market participants, the broader effect of the decision has yet to be seen. In this Alert, we examine the Court's ruling and discuss the potential impacts it could have on future cases and the broader regulation of digital assets.

1. Procedural and Factual Background

The SEC's action against Ripple began in December 2020, when the SEC filed its initial complaint against Ripple, alleging that Ripple and two of its executives, Bradley Garlinghouse and Christian Larsen, engaged in the unlawful offer and sale of securities in violations of Sections 5(a) and 5(c) of the Securities Act of 1933 ("Securities Act") and that Garlinghouse and Larsen aided and abetted Ripple's violations. Following discovery and various hearings, the parties filed cross-motions for summary judgment in September 2022.

The XRP Ledger, an open-source blockchain protocol, was launched in 2012 with a fixed supply of 100 billion XRP, the native token of the XRP Ledger. The founders, including Larsen, retained 20 billion XRP and provided 80 billion to Ripple. From 2013 through the end of 2020, Ripple engaged in various sales and distributions of XRP, including direct sales to certain institutional buyers and hedge funds pursuant to written contracts raising approximately $728 million ("Institutional Sales"), approximately $757 million in sales on crypto exchanges through trading algorithms ("Programmatic Sales"), and $600 million in distributions of XRP to employees as payment for services and to fund certain third parties developing new applications on the XRP Ledger ("Other Distributions"). Larsen and Garlinghouse also sold XRP on crypto exchanges in their individual capacities. At no time was a registration statement filed for any offers or sales of XRP, nor did Ripple make any public filings with the SEC.

The SEC alleged that, since at least 2013, Ripple engaged in extensive marketing efforts related to the utility and value of XRP, including through informational brochures, blog posts, social media, videos, and interviews with Ripple employees. Marketing materials were distributed to prospective and existing XRP investors and described, in part, the connection between XRP and Ripple's business.

2. Court's Findings

The SEC's claims against Ripple, Garlinghouse, and Larsen under Section 5 of the Securities Act turned on whether Defendants unlawfully offered and/or sold an unregistered security. The Defendants did not dispute that they offered and sold XRP without filing a registration statement with the SEC. Therefore, the question before the Court was whether XRP was a security for purposes of the challenged transactions. Determining if XRP was offered and sold in securities transactions turned on whether XRP was sold in an "investment contract" under SEC v. W.J. Howey Co., 328 U.S. 293 (1946). Under Howey, an investment contract is generally characterized by (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit from the efforts of others.² In answering this question, the Court grouped offers and sales of XRP into distinct categories and analyzed the economic realities of each category of sales independently.

1. Institutional Sales The Court examined Institutional Sales of XRP to sophisticated individuals and entities made pursuant to written contracts between Ripple and the investors, and determined that Institutional Sales were unregistered offers and sales of securities in violation of Section 5 of the Securities Act. First the Court determined that these sophisticated individuals and entities invested money by providing capital to Ripple in exchange for XRP. Second, the Court found that a common enterprise existed between Ripple and the institutional investors because (1) Ripple pooled the proceeds from Institutional Sales and (2) each institutional investor's ability to profit was tied to the profitability of other institutional investors, because they all received the same fungible XRP.³ Third, the Court determined...