Last month’s decision by a court in the U.S. District Court for the Southern District of New York on the SEC’s claims against Ripple Labs has been generally hailed as a victory for the token issuers and exchanges. However, the actual impact of the decision on the future of cryptocurrencies in the U.S. is not so clear.
By highlighting the principle that the SEC’s jurisdiction over digital assets depends on the nature of the offer or sale of such assets rather than the intrinsic qualities of the asset itself, the decision is indeed a positive development for the industry. But other favorable aspects of the decision for Ripple seem ripe for a reversal on appeal. Ironically, that could strengthen the SEC’s hand going forward.
An unusual decision
The SEC’s claims against Ripple hinged on whether Ripple’s distribution of its cryptocurrency, XRP, was a “security” for the purposes of the Securities Act. More specifically, the question was whether these transactions satisfied a three-pronged test for an “investment-contract” security devised by the Supreme Court over seven decades ago in SEC v. W.J. Howey Co.
Under the Howey test, transactions involving the (1) investment of money in (2) a common enterprise with (3) an expectation of profit from the efforts of others, are securities. If these transactions were securities, Ripple was required to make certain public disclosures (which it concededly did not make), along with observing other compliance obligations.
The court concluded that certain negotiated sales of large blocks of XRP institutional purchasers satisfied the Howey test (sales the court called “institutional sales”)–but that anonymous sales by Ripple on cryptocurrency exchanges (so-called “programmatic sales”) did not, nor did Ripple’s transfer or XRP to vendors or employees in exchange for services (termed “other distributions”). Thus, the SEC prevailed on its claim as to the institutional sales, but not as to other types of distributions of XRP. The SEC’s related claims against Ripple's founder, former CEO, and current chairman of the board Christian Larson and the former COO and current CEO, Bradley Garlinghouse over Ripple’s institutional sales will continue to trial. Larson and Garlinghouse deny any wrongdoing.
The most striking feature of the decision is that the court applied the “expectation” element of the “expectation of profit from the efforts of others” differently to different groups of purchasers.
Normally, courts focus their analysis of this prong of the Howey test on whether a person with knowledge of all public information about the role of the people offering an investment (typically called “promoters”) in the future success of the investment would expect that the promoters’ ongoing efforts are key to profits. Instead, the court focused on the actual information available to different sets of purchasers. The court reasoned that since the institutional purchasers knew they were buying XRP from Ripple, and were provided marketing materials from Ripple, they would expect the value of the XRP to be affected by Ripple’s efforts. By contrast, the programmatic buyers’ assumed relative ignorance of Ripple’s role in developing, marketing, and distributing XRP led the court to conclude that these buyers would not reasonably expect Ripple’s activities to affect XRP.
As for the other distributions, the court concluded these transfers lacked the necessary “investment of money” to satisfy the Howey test. The ruling is in contrast to the SEC’s longstanding position that nearly any benefit to the promoter has value and can be considered an investment of money.
What it means for the industry
The cryptocurrency industry has long advocated for a more transaction-focused approach to Howey. By distinguishing among groups of XRP purchasers, the Ripple decision delivers one.
Animating the industry’s goal in this respect is a desire to exclude secondary market transactions from the SEC’s jurisdiction, among other motivations. The question is existential for many market intermediaries, particularly cryptocurrency exchanges, whose subjection to SEC jurisdiction turns on whether they deal, broker, clear, or operate an exchange for trading securities.
Here, the Ripple decision delivers for the industry again. By holding that knowing one’s privity with the promoter is key to the expectation of profit from the efforts of others, the court comes close to carving out secondary market transactions per se, and even (as was the case with the programmatic sales) immunizes anonymized direct sales from promoters like Ripple.
Similarly, if it stands, the court’s formalistic interpretation of the investment-of-money prong of Howey would seem to open the door to more extensive use of digital assets in employee compensation, developer grants, and promotional giveaways (eg. airdrops, a popular if controversial tool for the distribution of crypto tokens).
How an appeal could make things worse
Before the cryptocurrency industry spends too heavily on champagne, it should remember that the Ripple decision is not a precedential opinion, nor is it necessarily the last word on the case. The SEC has the right to appeal–and is expected to use it.
Beyond its novelty, the court’s focus on XRP purchasers’ specific access to information about Ripple yields a perverse result. The sale of XRP to the most sophisticated investors, who by virtue of the bespoke nature of the transaction were privy to the most information about how Ripple’s activities may affect the value of XRP, is a security, subject to the investor protections and restrictions mandated by the securities laws. Whereas, the offer and sale of XRP to retail investors, who dealt with Ripple in anonymous transactions through exchanges and otherwise, is not a security and does not require disclosure or offer those same investor protections. Those people who already have the most information are given a right to more, while those people with the least information go without.
The court’s ruling on the “other distributions” seems on similarly shaky ground. In addition to running up against precedent that “sales” of securities need not involve the transfer of tangible items of value, this interpretation appears to open loopholes in Howey for various non-traditional forms of financing. Indeed, it is even difficult to square with the established concept of “sweat equity.”
Should the Second Circuit Court of Appeals reverse either or both of the industry‑favorable elements of the Ripple decision, the SEC will be finally armed with precedential case law applying Howey to a cryptocurrency–a weapon of no small importance for its fights with the cryptocurrency exchanges Coinbase and Binance over whether the tokens they listed are securities.
Longer-term effects and benefits
Even if significant pieces of the Ripple decision are reversed on appeal, one aspect of the case is likely to provide lasting benefit to the cryptocurrency industry. The court was almost certainly correct to focus its Howey analysis on the transactions in question, rather than the underlying assets. Courts in the past have occasionally missed this subtle distinction–most likely because other parts of the definition of the term “security” in the Securities Act are tied to financial instruments themselves, such as stocks and bonds. But Howey addresses investment contracts, which is why its test focuses on the parties’ actions and expectations, which are driven by the facts and circumstances surrounding the relevant transactions.
Although the court’s distinction between groups of purchasers’ access to information is unlikely to survive appeal as meaningful for Howey test purposes, other purchaser differences might one day be dispositive. Most obviously, courts could draw lines between groups of purchasers over time. As decentralized token projects progress, it is plausible to imagine that the expected effect of the efforts of promoters on profits will change. These efforts might be relevant to profits for an early group of purchasers, but not for a later group after control of the project becomes fully decentralized. Similarly, as such projects mature, the motive for buying a cryptocurrency may change. A reasonable early purchaser might be drawn to financial returns (investment profits) while the primary motive for a later purchaser might be to use the token within a particular network or protocol (consumption).
If future courts take account of these distinctions between purchasers, defendants may have the Ripple court’s attention to differentiated transactional details to thank.
Peter Fox is a partner at Scoolidge, Peters, Russotti & Fox LLP.
The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
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