SEC v.s. Ripple Labs & Co – what does it mean for XRP and the exchanges? Not Much.

The recent Summary Judgment handed down in SEC v.s. Ripple Labs Inc. and Co has sparked significant interest with many headlines ultimately reporting that XRP is not a security and/or all tokens are not a security if they have been bought and sold on a digital assets exchange. These are not the answers that have been provided by this decision.

In summary, the Court held that buyers who bought XRP via a digital assets exchange were not relying upon Ripple’s efforts to increase the value of XRP (most did not even know that Ripple existed), and, as such, these were not investment contracts (i.e. securities transactions). Importantly, Judge Torres clearly states that this decision is only applicable to the specific XRP transactions considered in this case and it is not applicable to all secondary market sales, including all other XRP secondary market sales.

Ripple’s XRP Transactions

Prior to the year 2020, Ripple owned between 50 and 80 billion XRP.

Under Section 5 of the Securities Act, it is “unlawful for any person, directly or indirectly…to offer to sell, offer to buy or purchase….or sell” a “security” unless a registration statement is in effect or has been filed with the SEC as to the offer and sale of such security.

To determine if there has been a breach of Section 5 (as alleged by the SEC), the Court must determine whether or not Ripple had sold XRP as a security.

Ripple engaged in three different types of transactions in respect of XRP:

1. Ripple sold XRP to institutional investors; hedge funds and On-Demand-Liquidity customers by way of written contracts (“Institutional Sales”). The total value of these sales amounted to approximately 728m USD. The proceeds were used to fund Ripple’s operations.
2. Ripple sold XRP on digital asset exchanges or through trading algorithms (“Programmatic Sales”). The total value of these sales amounted to approximately 757m USD. Again, the proceeds were used to fund Ripple’s operations.
3. Ripple distributed XRP to its employees (i.e. by way of employee compensation) and to third parties to fund third party Ripple related projects (“Other Distributions”). The total value of these distributions amounted to approximately 609m USD.

What is an investment contract?

The question as to whether XRP is a security was not put to the Court or answered in this case. However, the judgment explains that even if XRP was considered to be a commodity, it is possible for a commodity to be the subject of an investment contract, and, therefore, an offer and sale of securities. The Court stated: “Plenty of items that can be consumed or used….have been the subject of transactions determined to be securities because they had the attributes of an investment”. As such, even if XRP exhibits certain characteristics of a commodity or currency, it may nonetheless be offered or sold as an investment contract.

In this case, the SEC has alleged that Ripple sold XRP as a security by way of an investment contract (in all three types of transactions set out above), and, therefore, breached Section 5 of the Securities Act by failing to register the offers and sales with the SEC.

The Howey test defines an investment contract as follows:

1. a contract, transaction or scheme whereby a person invests his money;
2. in a common enterprise; and
3. is led to expect profits solely from the efforts of the promoter or a third party.

The Court looked at the transactions concerning XRP and whether there was an expectation of profits (income or returns) deriving from the efforts of others. In other words, Howey looks at “the use of the money of others on the promise of profits”. To assess this, the Court also looks at the substance and “economic reality and totality of the circumstances”.

In light of the above, the Court reviewed each category of XRP transactions (as set out above).

XRP’s Institutional Sales

The first two limbs of the Howey test are quickly satisfied in respect of the Institutional Sales. It is clear that: 1) money was invested by investors; and 2) the money was invested in a common enterprise.

Both arguments denying the above (as presented by Ripple) were swiftly dismissed by the Court. Rippled pooled the proceeds from investors into bank accounts of its subsidiaries and used the funds raised to finance its operations. In particular, it used the funds to promote and increase the value of XRP by developing the use for XRP and protecting the XRP trading market. Importantly, when the value of XRP increased, all of the institutional buyers profited in proportion to their XRP holdings.

The third limb of the test requires an analysis of whether the institutional buyers were led to expect profits solely from the efforts of the promoter (i.e. Ripple) or a third party. This limb of the test requires an objective analysis of whether or not the promises of Ripple to its investors resulted in investors expected to derive profits from Ripple’s efforts. This does not need to be the investors’ sole motivation, but it needs to be one of the motivations.

The judgment reviews in relatively significant detail the level and type of communications and marketing materials that were shared with institutional buyers by Ripple. The Court held that the marketing efforts shows that Ripple was pitching a speculative proposition for XRP with potential profits to be derived from Ripple’s entrepreneurial and managerial efforts. This was not a simple purchase of “currency”, and this was only further emphasised by the lockup provisions and restrictions set out in the investment contracts.

Based on the three limbs of the Howey test, the Court ruled that the Institutional Sales were an offer and sale of investment contracts (i.e. securities), without registration with the SEC, in violation of Section 5 of the Securities Act.

XRP’s Programmatic Sales

The Court in this judgment only looks at the third limb of the Howey test in respect of Programmatic Sales and ultimately found that these transactions were not securities transactions because these buyers were not led to expect profits solely from the efforts of Ripple. As such, there is no evidence of an investment contract between Ripple and these buyers within the meaning of the Securities Act.

The judgment states that these purchases from digital asset exchanges were blind bid/ask transactions where Ripple did not know who the buyers were, and the buyers could not have known that the money went to Ripple. The Court adds that many of these buyers were not even aware of Ripple’s existence. As such, even if these buyers had an expectation of profit, because of the distance between the two parties, the expectation of profit could not have been derived from Ripple or in reliance of the continuing efforts of Ripple (as opposed to market trends).

The Court admits that some of these buyers may have had an expectation of profits derived from Ripple’s efforts, but the Court has stated that this is not about specific motivations of each buyer, it is about the promises made to the buyers. No promises were made by Ripple to these buyers. There was no marketing from Ripple or direct contract from Ripple.

The Court also added that there is no evidence to suggest that the buyers in the Programmatic Sales were as sophisticated as the buyers in the Institutional Sales so as to have similar understandings and expectations in respect of their purchase.

In addition, the Programmatic Sales represented less than 1% of the global XRP trading volume. The Court then goes on to state that, as a result, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. The reference to the 1% goes to the assessment of the “economic reality and totality of the circumstances”, with these Programmatic Sales ultimately being relatively insignificant in context.

XRP’s Other Distributions

The SEC alleged that Ripple transferred XRP to employees and third parties to fund projects relating to Ripple. The Other Distributions were not deemed to be investment contracts on the basis that the first limb of the Howey test fails – third parties and employees did not pay any money or consideration to Ripple for XRP.

Ultimately, this judgment is only about the 1%

This judgment is focused on a specific set of circumstances – whether or not the specific XRP transactions referred to above are securities transactions.

The Court does not assess whether XRP is a security. In fact, it draws analogies from commodities cases more so in an effort to cite that regardless of whether or not XRP is a security, it is the transaction to which XRP relates which has been assessed to determine if there has been an offer or sale of securities.

It is unsurprising that the Institutional Sales have been deemed to be an offer and sale of securities. However, in respect of the Programmatic Sales (i.e. the sale of XRP on digital asset exchanges), on the basis that there was no reliance on the efforts of Ripple (at least not documented on paper), regardless of whether there was an expectation of profit, and where these sales only amounted to 1% of XRP trading volume, these transactions have not been deemed to be an offer and sale of securities in breach of the Securities Act.

Does this case mean that all tokens traded on digital asset exchanges are not securities transactions? In the judgment, the Court within the footnotes states: “The Court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court. Whether 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.”

The SEC has 10 days to appeal the decision. If the SEC doesn’t appeal, this decision means that these specific Programmatic Sales are not securities transactions. This decision does not go so far as to be applicable universally - the judgment itself states that not every XRP transaction (let alone every other digital asset) on a digital asset exchange may be deemed to not be an offer and sale of securities – that is not what the Court has opined on in this judgment. So, is every token traded on a digital asset exchange a securities transaction or not? According to District Judge Torres, it depends on the transaction.