Author: John Reed Stark, Former Director of the SEC’s Office of Internet Enforcement; Translation: Wu Explains Blockchain
Yesterday’s Ripple ruling was extensively reported as a painful defeat for the SEC, and it was endlessly praised on social media as a thrilling and well-deserved failure for the SEC/Gary Gensler. Indeed, this was a defeat for the SEC.
But in my view, this ruling is based on an unstable foundation and is likely (and already prepared) to be appealed, and there is a possibility that it will be overturned, so it may not be worth celebrating.
Ripple Ruling: Category One, “Institutional Sales”
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Regarding the issuance of securities, the court divided Ripple’s issuance into three categories and made separate rulings for each category: 1) “institutional sales”; 2) “programmatic sales”; and 3) “other sales”.
For the first category, Ripple’s institutional sales of XRP to knowledgeable individuals and institutions with written contracts, the court ruled that when XRP was sold to institutional investors, it was a security and thus constituted an illegal sale of securities. Therefore, these investors have the right to rescind and Ripple must pay the price for the misconduct. It is reported that the amount involved in these sales reached $720 million.
Court statement: “Based on all the circumstances, the Court finds that a reasonable investor in the position of an institutional buyer would purchase XRP and expect to profit from Ripple’s efforts. From Ripple’s communications, marketing activities, and the nature of institutional sales, a reasonable investor would understand that Ripple would use the capital obtained from institutional sales to improve the market for XRP and develop uses for the XRP Ledger, thereby increasing the value of XRP.”
The court also ruled that a jury is needed to determine whether Ripple’s senior executives assisted and abetted Ripple’s unregistered offering.
Ripple Ruling: Fair Notice
The court ruled that at least in terms of institutional sales, Ripple was fairly aware that selling without registration was illegal, rejecting Ripple’s due process defense. The court stated:
“The Court rejects Defendants’ fair notice and vague notice defenses concerning institutional sales. First, case law defining investment contracts provides a reasonable opportunity for a layperson to understand the behavior it covers…Howey provides a clear test for determining what constitutes an investment contract, and subsequent case law provides guidance on how to apply this test to a variety of factual scenarios…This is constitutionally sufficient to satisfy due process requirements. See United States v. Zaslavskiy, No. 17 Cr. 647, 2018 WL 4346339, at *9 (E.D.N.Y. Sept. 11, 2018) (‘The rich body of case law interpreting and applying Howey at all levels of the judicial system, as well as the SEC’s relevant guidance regarding its regulatory authority and enforcement jurisdiction, provides all the notice required by the Constitution.’). Second, case law presents sufficiently clear standards to eliminate the risk of arbitrary enforcement. Howey is an objective test that provides the necessary flexibility to assess a wide range of contracts, transactions, and plans. Defendants focus on the SEC’s failure to issue guidance on digital assets and its inconsistent statements and practices regarding sales of digital assets as investment contracts…But at least with respect to institutional sales, the SEC’s enforcement actions are consistent with that agency’s enforcement actions against other digital assets sold to buyers pursuant to written contracts to raise funds. See, e.g., Telegram, 448 F. Supp. 3d at 352; Kik, 492 F. Supp. 3d at 169. Furthermore, the law does not require the SEC to warn all potential violators, whether individuals or industries…”
However, the court also noted in a footnote: “Because the Court finds that only the institutional sales constituted offers and sales of investment contracts, the Court does not address the fair notice defense asserted by Defendants with respect to other transactions and plans. The Court’s ruling is limited to institutional sales because the SEC’s theories regarding other sales may be inconsistent with its enforcement in prior digital asset cases.”
Therefore, the court seems to take seriously the position of the cryptocurrency world, namely that the SEC’s information on how to apply the Howey test to tokens in secondary market transactions is confused and inconsistent.
Ripple’s Decision: “Howey Test” and “Investment of Money”
The court rejected Ripple’s attempt to reshape the Howey test with a new test called the “investment of money” test, stating:
“In fact, in the seventy-five years of securities law cases since Howey, courts have found investment contracts exist despite the absence of the “core element” alleged by Defendants, including in recent digital asset cases in this District. This is sensible because the Howey test was meant to “embod[y] a flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” 328 U.S. at 299. In other words, the purpose of the Howey test is to effectuate a “policy of broad protection for the investing public,” a protection that “should not be frustrated by unrealistic and irrelevant formulae.”
The court also rejected Ripple’s argument that, with respect to the Howey test, “investment of money” is different from “mere payment of money,” stating:
“Defendants argue that there is a distinction between “investment of money” and “mere payment of money” – i.e., that Howey requires not only the payment of money, but also an intent to invest that money… Not so. Defendants’ proposed distinction finds no support in case law. The proper inquiry is whether the institutional buyers “provide[d] the capital,” …or “pa[id] the money.”
Ripple’s Decision: Second Category, “Programmatic Sales”
Regarding the second category of investors, namely the public (whom the judge referred to as “programmatic buyers” of digital asset exchanges) and XRP sales, the court ruled that XRP is no longer a security when institutional investors or Ripple anonymously sell XRP to exchanges because there is no actual relationship between exchange customers and Ripple.
The court seems to presume that programmatic buyers do not expect to profit from the issuer’s efforts but may expect anticipated profits from other factors such as general trends in the cryptocurrency market, especially because the court speculates that programmatic buyers do not know who they are buying tokens from.
The court states: “Considering the economic realities of programmatic sales, the Court concludes that the undisputed record fails to establish the third prong of Howey. While institutional buyers reasonably expected Ripple to use its capital to improve the XRP ecosystem and, thereby, increase the value of XRP…programmatic buyers cannot reasonably expect the same. In fact, Ripple’s programmatic sales are a blind-bid/offer process, and programmatic buyers do not know whether their money is paying Ripple, or any other seller of XRP…An institutional buyer buys XRP directly from Ripple pursuant to a contract, but the economic realities are that a programmatic buyer and a secondary market purchaser who does not know to whom or what it is paying are in the same position…Certainly, some programmatic buyers may purchase XRP anticipating profits from Ripple’s efforts. However, “the investigation is a factual one, concerned with the substance of the underlying transaction and not the exact motivations of each participant”…Here, the record confirms that, with respect to programmatic sales, Ripple has made no promises or provided any offering because Ripple does not know who is buying XRP, and buyers do not know who is selling…Programmatic sales also lack other factors present in institutional sales that favor finding a “reasonable expectation of profits derived from the entrepreneurial or managerial efforts of others”…For example, programmatic sales do not involve contracts containing lock-up provisions, resale restrictions, indemnification provisions, or purpose statements. Likewise, Ripple’s promotional materials, such as the “Ripple Primer” and “Gateways” booklet, circulated widely among potential investors such as institutional buyers. However, there is no evidence that these documents were widely distributed to the general public, such as purchasers of XRP on digital asset exchanges. Nor is there evidence that programmatic buyers understood statements by individuals such as Larsen, Schwartz, Garlinghouse, and others as representations of Ripple and its efforts. Lastly, institutional buyers are sophisticated entities, including institutional investors and hedge funds…A “comprehensive inquiry into the nature of the entire dealings of the parties” including “the totality of the parties’ understandings and expectations” supports the conclusion that a reasonable investor, standing in the shoes of an institutional buyer, would understand Ripple’s marketing activities and public statements as linking the price of XRP to its own efforts…There is no evidence that a reasonable programmatic buyer, who is generally less sophisticated as an investor, would have had similar “understandings and expectations” and would have been able to penetrate multiple documents and statements emphasized by the SEC, including statements made by various Ripple speakers (with varying levels of authority) over an eight-year period on numerous social media platforms and news websites (sometimes with inconsistencies).”
Ripple Decides: Category Three, “Other Sales”
The final category of XRP issuance and sales is based on written contracts for “other distribution.” Ripple recorded $609 million in “non-cash consideration” in its audited financial statements. These other distributions include distributions to employees as compensation and distributions to third parties as part of Ripple’s Xpring program to develop new XRP and XRP ledger applications.
Court statement: “Other distributions do not meet the first condition of Howey, which requires that ‘investment capital’ be involved in the transaction or plan… Howey requires proof that investors ‘provide capital,’ ‘invest their money,’ or ‘provide’ cash… ‘In every case [where an investment contract is found], the purchaser is giving up a consideration of value, defined in terms of tangible or definable considerations,’… Here, the record shows that the recipients of the other distributions did not pay money or ‘some tangible or definable consideration’ to Ripple. Instead, Ripple paid XRP to these employees and companies. Moreover, there is no evidence that ‘Ripple raised funds for its projects by transferring XRP to third parties and then having them sell XRP,’ as Ripple never received any payment from these XRP distributions… The SEC did not develop an argument that the sales on these secondary markets involve offers or sales of investment contracts, particularly where the payments for these XRP sales were never traced back to Ripple, and the Court cannot make such a finding. Therefore, considering the economic reality and the totality of the circumstances, the Court concludes that Ripple’s other distributions do not constitute the offer or sale of investment contracts.”
Is the ruling on Ripple reasonable? No, it is not.
In my personal opinion, the ruling on Ripple is concerning in several aspects.
The SEC’s position is that this is a traditional application of the Howey test. “People paid money or other currencies; the common enterprise is Ripple itself and other cryptocurrency buyers; they expected profits from the sale of tokens—this expectation was fostered by Ripple itself through its statements about the potential of the tokens.” The SEC’s position seems fairly straightforward and consistent with its mission of protecting investors. The ruling on Ripple appears to be at odds with the SEC’s mission and authority.
Firstly, the ruling on Ripple grants institutional investors full SEC protection and all the remedies that come with SEC violations, including rescission, fines, penalties, etc. However, retail investors did not receive any SEC protection. This seems at least inverted.
Secondly, the ruling on Ripple seems to declare that if any cryptocurrency issuer sells their tokens through exchanges, securities regulations do not apply because the customers of the exchanges are deemed to be unaware of the cryptocurrency issuers. But ignorance or unwillingness to do research has never been a valid defense against securities violations.
Moreover, I don’t think retail investors are so ignorant. Buyers may not know that they are providing capital to Ripple, but they probably know the same information about Ripple’s intentions as institutional investors. Retail investors choose XRP for a reason – because they believe that the price of XRP will rise due to Ripple’s influence. Ripple encourages retail investors to buy XRP. This seems to be axiomatic.
The Ripple court seems to think that if the issuer doesn’t know who is buying their tokens and the buyers don’t know who is selling the tokens, then even if the issuer uses the revenue from the token’s original, initial sale to fund its operations, the token is not a security.
Following this line of thought, the Ripple court acknowledges that there may be many programmatic buyers purchasing XRP tokens in anticipation of profiting through Ripple, but it still assumes the opposite.
How could any buyer not know who the issuer is? How is this not considered predetermined? In addition, the lack of contracts between buyers and sellers on exchanges does not in any way deprive stocks of their status as securities. Furthermore, according to Howey, why would knowing who the counterparty is matter? The question is whether investors can expect to profit from the efforts of known or unknown third parties.
Even if a token buyer refuses to read or understand any information about the issuer, it should not render the token “not a security”. Consider why many token buyers purchase tokens in the first place. Unlike traditional investments, token buyers cannot view financial statements (there aren’t any); cannot view balance sheets (there aren’t any); cannot view cash flows (there aren’t any); and so on.
Therefore, the typical basis for purchasing tokens is speculation, i.e., that someone else will be willing to pay a higher price (also known as the “greater fool theory”). Even if retail investors purchase tokens entirely based on the greater fool theory, even if token buyers don’t know who they are buying the tokens from, the investment should still be considered a security.
When tokens are sold to institutional investors, they are securities, and then when these institutional investors or the issuers themselves sell tokens on Coinbase or Binance, how can the tokens miraculously transform and become “not securities”?
Ripple court statement: “Institutional investors have reason to expect that Ripple will use the funds obtained from their sales to improve the XRP ecosystem and thus increase the price of XRP.” But investors using exchanges “cannot reasonably expect the same thing.”
This seems to blatantly contradict the fundamental concept of investment. For example, when purchasing Apple stock (or any other stock) on any registered exchange, the Apple stock never loses its status as a security after its IPO.
In addition, no one directly purchases Apple stock from Apple. Typical investors purchase Apple stock from people they don’t know, and this anonymity does not affect whether Apple stock is a security. The Ripple ruling somehow distinguishes between Apple’s IPO and trading and token ICOs and trading.
When anyone buys a share of Apple stock, they don’t know who they are buying it from, and Apple doesn’t know who the buyer is. However, Apple stock still maintains its characteristics as a security. The analysis of tokens should not be any different.
Employees and Third Parties
The distinction between tokens given to employees and third parties in court also doesn’t make much sense. Employees providing services to the protocol and third parties developing applications for the protocol clearly receive compensation in the form of tokens, just like employees or third parties receiving compensation in the form of restricted stock units or stock options.
How can one say that the grant (“airdrop”) of XRP tokens does not have any contractual consideration? In fact, the consideration required by Howey may be minimal, even symbolic, and this is not usually a controversial issue in the cases related to cryptocurrencies in Section 5.
However, despite the clear “two-way contractual consideration flow” in Ripple’s relationship with employees and third parties, the court still concludes that the necessary contractual consideration does not exist and employees and third parties did not pay Ripple any “tangible or definable consideration.”
SEC “Free Stock” Cases
In fact, there is SEC precedent (although not through trial) that contradicts the Ripple court’s determination of the quantity of consideration required to trigger Howey’s registration requirement.
The token airdrop seems similar to so-called “free stock” enforcement actions, in which the SEC brought such actions in 1999 against four promoters and two Internet companies who offered and distributed free stock through online websites without properly registering their offerings. In these cases, although the stocks given to subscribers were completely free, the nominal consideration involved was enough to trigger the registration requirements of Section 5.
At the time, the SEC’s enforcement director Richard H. Walker said, “In these cases, the term ‘free stock’ is actually a misnomer. While there is no cash transaction, the companies issuing the stock received valuable benefits. In these situations, securities regulations give investors the right to full and fair disclosure, which they did not receive in these cases.”
I distinctly remember these free stock enforcement actions and was involved in the handling of all four cases during my time at the SEC. It seemed like everyone with an email account received someone’s proposal for free stock, so the free stock enforcement actions at the time garnered media attention.
In these four cases, investors had to register and disclose valuable personal information on the issuer’s website in order to receive shares. The recipients of the free stock also, in some cases, received additional shares for referring additional investors or in other cases, linking their own websites to the issuer’s website, or purchasing additional shares through services provided by the issuer. In the free stock cases, just like in Ripple, the issuers obtained value through these marketing techniques by nurturing a primary public market for their shares, increasing their business, generating public interest, increasing traffic to their websites, and in two cases, sparking interest in an anticipated public offering, among other things.
Based on a series of precedents related to Howey, it is not necessary to include fund transfers for the purpose of “money investment” in Howey. See, for example, Capital General Corp., Securities Act Rel. No. 7008, 54 SEC Docket 1714, 1728-29 (July 23, 1993) (Capital General’s “gift” of securities constituted a sale because it was a valuable disposition, “value” “arose from the public market created by the issuer of the securities”). See also SEC v. Harwyn Industries Corp., 326 F. Supp. 943 (S.D.N.Y. 1971).
Therefore, when the purpose of the “gift” is to advance the donor’s economic goals rather than to be generous, the giving of stocks constitutes a “sale” as defined by the Securities Act. This case law may rebut the Ripple court’s refusal to consider the determination of employees and third-party Ripple distributions as securities, on the grounds of lack of consideration.
A quick note on precedents and appeals
The trial order in the Ripple case is a partial summary judgment from a single district court judge. While it is important and worthy of study, it is not binding on other courts.
In addition, just like insider trading cases, cryptocurrency cases are always different, sometimes subtle, sometimes significant, but always different. Some cryptocurrency issuance cases may involve stronger relationships between buyers and sellers, with ongoing obligations and potentially creating more explicit investor expectations of profiting from the promoter’s efforts. Additionally, some courts may make distinctions, as in Ripple, for example, the impact of marketing activities on retail investors. This analysis clearly calls for a case-by-case analysis based on the circumstances of each case.
The ruling in Ripple may also be appealed. In fact, given the unprecedented nature of this ruling, the court is likely to certify an immediate interlocutory appeal, and the Second Circuit Court of Appeals may take action to hear the appeal.
The Ripple case can also be seen as conflicting with the SEC’s case against Telegram, in which the same district court ruled on Ripple. As Preston Byrne correctly points out, in Telegram, Judge Kevin P. Castel “associated the purchasers’ profit expectations with ‘Telegram’s basic entrepreneurial and managerial efforts,’ rather than the entrepreneurial and managerial efforts of the intermediaries who sold Telegram SAFT contracts to everyone and their dog at the time.”
It is “Telegram’s commitment to develop the project,” rather than the resale efforts of the intermediaries, that the court considered as the “other person’s essential efforts” constituting a factor of the Howey test. This appears to be contradictory to the analysis of the Ripple court and creates conflicting decisions within the same district.
Looking ahead
The ruling in Ripple is troubling in several aspects, especially the distinction between private sales and public sales (which I refer to as “public sales”), where the former involves accredited investors directly purchasing XRP in large quantities from the company, while the latter involves the concept of selling tokens to anyone on a cryptocurrency trading platform.
First of all, Ripple’s ruling seems to establish a category of quasi-securities, which are distinguished and varied based on the complexity of the investors who purchase the securities. This seems counterintuitive, inconsistent with the SEC’s case law, and unprecedented in this context. The Ripple court essentially claims that Ripple’s marketing efforts and business operations are too complex for ordinary retail investors, as opposed to institutional investors who would understand what investing in a token really means.
In other words, retail investors are typically considered foolish, so the court refuses to assume that retail investors expect to profit from Ripple’s efforts. This not only appears condescending but also insulting.
Secondly, Ripple’s ruling seems to suggest that if a company sells tokens to a savvy VC firm, then that sale will turn the tokens into securities. However, if a company sells these same tokens to an exchange, which then sells the tokens to a random retail trader, the tokens are no longer securities but become “non-securities.” The transformation of tokens into “non-securities” is based on the assumption that retail traders do not understand what they are purchasing and, like any securities exchange, do not know who the seller is.
This argument seems to contradict the sacred and fundamental principles of investor protection. The level of protection investors receive should not be determined by whether they read or are unable to read materials related to their purchases. In any case, it seems reasonable to assume that investors (whether institutional or retail) purchasing XRP are speculating on Ripple for some reason.
Thirdly, Ripple’s ruling seems to imply that affluent hedge funds and venture capitalists are protected and can seek remedies from the SEC against malicious token issuers, while fewer retail investors are left entirely on their own without any SEC protection. This is a complete reversal and goes against the original intent for which the Securities Act of ’33, the Securities Exchange Act of ’34, and the Investment Company Act of ’40 were enacted.
In sharp contrast to this, securities laws are designed to protect investors, especially retail investors, rather than abandon them (even if they want to be abandoned and left alone). In other words, the wealthy have avenues of support and redress, while the poor can only bear the consequences of their purchases. This seems unfair and contradicts the basic principles of U.S. securities laws.
As famous Bloomberg columnist Matt Levine said, “In the 1920s, many people formed very shady companies and raised a lot of money by selling stocks with terrible and misleading disclosures, so securities laws were created to stop them. This did not eliminate stock issuances in the United States. On the contrary! The U.S. stock market benefited from disclosure rules and protection for retail investors. The basic rule of the U.S. stock market is ‘you can do whatever you want to savvy investors, but there are strict rules about how much you must disclose to retail investors,’ and this approach works well. The opposite rule in this case – ‘you can do whatever you want to retail investors, but stay away from savvy investors’ – seems likely to lead to bad outcomes. If the law encourages crypto companies to take advantage of the least savvy investors, who would want to invest in crypto?”
The Securities Law is specifically designed to protect individual investors, based on the idea that they are unable to protect themselves and that fraudulent investors can lead to catastrophic market events (such as the crash of 1929). Ripple’s ruling has overturned this concept.
As Professor Ann Lipton sarcastically points out, “Let’s just say it: calling sales to institutions securities because institutions are savvy is perverse. It’s a step backwards; it undermines the purpose of securities laws (protecting the less savvy investors) and conflicts with other tests for whether an asset is a security (the Reves test often balances the investor’s sophistication against the presence of a security).”
Ultimately, Ripple’s ruling seems to suggest that when tokens are purchased by institutional buyers in exchange for cash, then the token is considered a security. However, Ripple’s court also seems to believe that when tokens are given to employees in exchange for work, the token is not a security. This notion seems to contradict established principles of contract law.
Whether the consideration is in the form of cash or work should not have any impact on the analysis of contractual relationships and other contract law issues. Even if a token is gifted to an employee, the company still benefits from it, and that should be the only important thing – and should trigger SEC registration.
The bottom line is: stocks are always stocks – they cannot transform into “non-stocks”. Therefore, my view is that the SEC will appeal Ripple’s decision to the Second Circuit Court of Appeals, and the Second Circuit will overturn the district court’s ruling on “programmatic” and “other sales”.
Otherwise, be prepared for a new iteration of the crypto industry – PBTs – Programmatic Buyer Tokens, which can be found on (unregistered and unregulated) crypto trading platforms near you.
According to Ripple’s ruling, PBTs will be exempt from securities regulations because programmatic buyers are unaware of PBTs, do not know who they are buying PBTs from, and do not know who is issuing PBTs.
Ripple’s ruling suggests that the same token can sometimes be a security, but other times it is not. The more ignorant and willfully blind retail investors are, the less protection they receive. The less disclosure there is about tokens, the less responsibility there is for token issuers. This is absolutely not acceptable.
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