While a conclusion to the much-hyped case may be approaching, market participants should be wary of doomsday prognostications.
As a new year begins, the digital assets industry is still enduring a deep and widespread crypto winter. When the story of this crypto winter is written, a chapter will likely be devoted to the impending resolution of a civil enforcement action brought by the Securities and Exchange Commission (SEC) on December 22, 2020, against Ripple Labs Inc. (Ripple), its former CEO, and its former COO and current CEO. The parties have been litigating this case since then in the US District Court for the Southern District of New York.
The court previously denied motions to dismiss filed by the individual defendants, and the parties have engaged in extensive fact and expert discovery for more than 14 months.
On September 13, 2022, all parties filed motions for summary judgment, asking the court to decide the case as a matter of law and without a trial. Briefing of the motions for summary judgment was completed on November 30, 2022. In deciding the parties’ motions for summary judgment, the court may render a judgment for one side or deny both motions and proceed with a trial on the merits. Alternatively, the parties could reach a settlement at any time before (or after) the court renders a decision.
This case has been widely publicized as a lynchpin in the ongoing public discussion about the viability of digital assets and blockchain technology. Claims of such far-reaching impact may, however, be overblown. The SEC’s claims in this case and the parties’ summary judgment arguments are tied to the facts of Ripple’s ongoing XRP token offering over a six-year period, and a win on either side may be more symbolic than consequential for the broader industry.
This post briefly recaps the key facts at issue in the case surrounding Ripple’s XRP offering, discuss the main arguments, and consider what potential outcomes may mean for the industry.
The Underlying Claims
The SEC’s amended complaint begins with the following statement: “From at least 2013 through the present [i.e., December 22, 2020], Defendants sold over 14.6 billion units of a digital asset security called ‘XRP,’ in return for cash or other consideration worth over $1.38 billion … , to fund Ripple’s operations.” The SEC alleges that by issuing and distributing XRP, the defendants engaged in the unlawful offer and sale of unregistered digital securities in violation of the registration provisions of Sections 5 of the Securities Act of 1933 (the Securities Act). The SEC also alleges that Ripple’s CEO and COO aided and abetted Ripple’s alleged violations of those securities provisions.
The Main Arguments
Defendants’ primary argument hinges on statutory interpretation — that XRP is not an “investment contract” (but is rather a digital currency or commodity) and is therefore not a “security” subject to the Securities Act, including the registration requirements of Section 5.
The parties have sparred over the traditional securities test established in the 1946 US Supreme Court decision, SEC v. Howey. Under Howey, a transaction constitutes a security if a purchaser (1) invests money, (2) in a common enterprise, and (3) is led to expect profits solely from the efforts of the promoter or third party. (See this Latham blog post for more information).
In their motion for summary judgment, the defendants claim that cases regarding investment contracts, including Howey, require three “essential ingredients” to an investment contract: (1) a written contract, (2) post-sale obligations on the promoter of the security to take specific actions for the investor’s benefit, and (3) the contractual right of the investor to receive profits. The defendants argue that none of these factors apply to XRP, and that no Supreme Court or Second Circuit Court of Appeals case before or after Howey has found an investment contract without these three characteristics.
According to the defendants, no contracts either impose post-sale obligations on Ripple to work for the benefit of XRP purchasers or entitle XRP purchasers to share in Ripple’s profits. XRP holders do not acquire any claim to Ripple’s assets or hold any ownership interest in Ripple. Ripple’s only obligation was to deliver XRP; it did not promise to undertake efforts to increase the price or value of XRP. Furthermore, the defendants assert that Ripple is not required to pay any share of Ripple’s revenue, profits, or dividends to purchasers. Ripple also had no contracts with many recipients of XRP, and most XRP trading does not involve Ripple at all (i.e., XRP sold on digital asset exchanges create no contract). The defendants further argue that, even setting aside the absence of the three essential ingredients of an investment contract, the SEC has not proven the elements of the Howey test set forth above.
The defendants also raised a fair notice defense, asserting that they did not have fair notice that the SEC considered XRP a security. Until this litigation, the SEC had not publicly stated it considered XRP to be a security. The SEC, the defendants claim, is seeking to use after-the-fact litigation to regulate digital assets after it failed to do so through guidance and rulemaking. The defendants argue that lack of fair notice is a violation of due process rights.
The SEC alleged in its amended complaint that “at all relevant times during the Offering, XRP was an investment contract and therefore a security subject to the registration requirements of the federal securities laws.” In opposition to the defendants and in its own motion for summary judgment, the SEC argues that the defendants have attempted to “deflect controlling precedent with fictional tests” by improperly interpreting Howey to require an “essential ingredients” test. Under its view of a proper application of Howey, the SEC maintains that Ripple offered and sold investment contracts because:
- the majority of XRP sales were in exchange for money;
- XRP purchasers invested in a common enterprise with each other and with Ripple because they all share proportionally in any appreciation of XRP’s value; and
- The defendants led investors to reasonably expect a profit from their XRP purchases based upon Ripple’s managerial or entrepreneurial efforts.
Ultimately, the SEC’s arguments are no different in this case than those it has espoused since 2017, when it stated that raising funds for the issuance of certain cryptocurrencies is a classic securities offering activity. In its July 25, 2017, “Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO” (the DAO Report), the SEC reiterated “fundamental principles of the US federal securities laws and describes their applicability to a new paradigm — virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities.” Furthermore, in its April 3, 2019, “Framework for ‘Investment Contract’ Analysis of Digital Assets,” the SEC stated that a hallmark of the reasonable expectation of profit prong of Howey is whether the offering is marketed with a “promise (implied or explicit) to build a business or operation as opposed to delivering currently available goods or services for use on an existing network.”
In the complaint against Ripple, the SEC alleged that “the overwhelming majority of Ripple’s revenue came from its sales of XRP, and Ripple relied on those sales to fund its operations.” Furthermore, “Ripple pooled the funds it raised in the Offering and used them to fund its operations, including to finance building out potential ‘use’ cases for XRP, paying others to assist it in developing a ‘use’ case, constructing the digital platform it promoted, and compensating executives recruited for these purposes.”
In response to the defendants’ claims that they lacked fair notice, the SEC asserts in its final reply brief that “Howey is a venerable Supreme Court precedent that has been applied by hundreds of federal courts across the country over more than 70 years and provides all of the notice that the Constitution requires” (internal quotations omitted). The SEC contends that the Supreme Court’s guidance under Howey (and the precedent from the SEC’s 35 prior crypto asset cases) is flexible rather than static and does not require the SEC to state publicly or individually notify purveyors of every unique offering that it may involve securities. The SEC also asserts that the evidence shows the defendants did have notice that XRP may have violated securities laws, in the form of warnings by Ripple’s legal counsel.
Furthermore, the SEC argues that the time it took to file its complaint should not be construed to indicate “that the SEC ‘allowed’ conduct to occur while it investigated the conduct.” Responding to the defendants’ counter claims that the SEC has been regulating the digital assets space through enforcement, the SEC stated pithily that “[e]nforcement of well-established laws that Congress enacted is not ‘regulation by enforcement,’ it is simply enforcing the law.”
Potential Impacts of a Ruling
In March 2020, a different judge in the same district court held in another notable digital assets case (SEC v. Telegram Group, Inc.) that “Howey refers to an investment contract, i.e., a security, as ‘a contract, transaction or scheme,’ using the term ‘scheme’ in a descriptive, not pejorative, sense . . . . This case presents a ‘scheme’ to be evaluated under Howey that consists of the full set of contracts, expectations, and understandings centered on the sales and distribution of the [digital asset under consideration]. Howey requires an examination of the entirety of the parties’ understandings and expectations.” (See this Latham blog post for more information).
Given that every case is unique and must be analyzed on the facts at issue, suggesting (as some market participants and commentators have) that the outcome of SEC v. Ripple will produce a be-all and end-all precedent for digital assets may be misguided. The ramifications of a judgment rendered in favor of either party may be limited in scope given the fact-specific nature of the case, dependent on the “economic realities” and contractual terms of the offering (including that it occurred at different points over a multi-year timeframe), the nature of management’s involvement, and the specific representations made by the offerors.
If the SEC prevails, the court’s ruling may provide useful insights for digital asset market participants in determining whether other assets may be securities. However, the ruling would not directly determine the status of any other assets because a judgment for the SEC will likely focus on the key facts that are specific to this case. As to XRP itself, although the value of the token may be affectedc, the SEC notably alleges only that XRP was a security “at all relevant times during the Offering.”
There is also no indication that the SEC is currently seeking a ruling on secondary sales of XRP. In its summary judgment reply brief, the SEC notes that “secondary market transactions” are “not part of the SEC’s claims here.” However, whether the court will issue a ruling that may impact secondary sales or buyers or sellers in the secondary market for XRP remains uncertain.
Notably, the SEC’s recent win on a motion for summary judgment against blockchain-based streaming and publishing firm LBRY, Inc. would appear to support the view that courts may appropriately be reluctant to venture beyond the relief sought in these digital asset matters. The US District Court for the District of New Hampshire concluded that LBRY’s offering of LBC tokens through ongoing sales was a security, but did not discuss whether secondary sales of LBC tokens were thereby implicated. (See this Latham post for more information.)
If Ripple prevails, the ruling may be optically negative for the SEC from an agency perspective, given that Ripple has positioned the defense as one conducted “on behalf of the entire crypto industry.” A loss for the SEC on the fair notice argument could be significantly broader depending on how the court frames it. It could therefore have repercussions for future SEC enforcement efforts beyond this case because it may help defendants in future matters argue that the SEC similarly failed to give them fair notice.
Either way, to the extent that the court clarifies the application of Howey to digital assets in this heavily contested action, a thoughtful ruling may bring additional stability to a market that has suffered from lack of congressional direction. Such guidance could help the industry find its way to a new phase of development and innovation and maybe even help usher in a crypto spring.