Author: David, Legal Department of LBank
On July 13, 2023, the Southern District of New York issued a summary judgement [1] in the SEC v. Ripple Labs case. The court ruled that Ripple Labs’ sale of XRP to institutional investors constituted the sale of securities, while the programmatic sales of XRP on cryptocurrency exchanges and the distribution of XRP to employees and third parties did not constitute the sale of securities. This long-awaited judgement may have a significant impact on the cryptocurrency industry.
1. Background
Ripple is an open-source payment protocol that serves as a real-time settlement system, currency exchange, and remittance network. It aims to facilitate secure, instant, and low-cost fund transfers. The protocol utilizes distributed ledger technology, allowing the sending and receiving of any form of currency, whether traditional fiat currencies (such as USD and EUR) or digital currencies (such as XRP), through the Ripple network. Ripple’s goal is to improve payment efficiency in traditional financial systems and help financial institutions achieve faster, cheaper, and more reliable global payments. The predecessor of the Ripple protocol was RippleLianGuaiy, developed by Ryan Fugger in 2004. In 2012, Chris Larsen and Jed McCaleb joined and introduced the concept of cryptocurrency to the protocol. The three of them established OpenCoin in San Francisco, which later became Ripple Labs and is responsible for the development and promotion of the Ripple protocol.
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XRP is the digital currency used in the Ripple protocol. Unlike Bitcoin and Ethereum, XRP is a pre-determined digital asset issued by Ripple Labs, with a total supply of 100 billion. XRP aims to facilitate the flow of funds in the Ripple network as a bridge currency, enabling fast conversions and cheap transactions.
2. Timeline of the Ripple Case
December 21, 2020: SEC files lawsuit against Ripple Labs
The SEC filed a lawsuit against Ripple Labs, CEO Brad Garlinghouse, and co-founder Chris Larsen, alleging that they conducted unregistered securities offerings.
December 28, 2020: XRP delisted by Coinbase
Coinbase announced the delisting of XRPToken from its platform. The ongoing legal disputes and regulatory ambiguity surrounding the classification of XRP likely influenced this decision.
January 29, 2021: Ripple Labs responds to SEC complaint
Ripple Labs filed a formal response to the SEC complaint, denying that XRP is a security and accusing the SEC of harming the interests of XRP holders.
March 3, 2021: Larsen and Garlinghouse question SEC’s lack of fair notice
Larsen and Garlinghouse submitted a letter to the court, alleging that the SEC lacked fair notice regarding the classification of XRP as a security. They expressed concerns about the SEC’s failure to provide clear guidance to market participants.
March 8, 2021: SEC Requests a Hearing
In response to the arguments made by Larsen and Garlinghouse, the SEC has requested an immediate hearing to address the issue of fair notice and other matters related to the case.
March 22, 2021: XRPToken Determined to Have Monetary Value and Utility
Judge Sarah Netburn ruled that XRP has monetary value and utility, distinguishing it from other cryptocurrencies. This preliminary ruling marks a significant development in the case and highlights the distinctions between various digital assets.
April 13, 2021: Token Safe Harbor 2.0 Proposal Released
SEC Commissioner Hester Peirce released the Token Safe Harbor 2.0 proposal. The proposal aims to provide token issuers with a three-year grace period to operate outside of securities laws in order to better understand their participation in decentralized networks.
September 17, 2022: SEC and Ripple Labs File Preliminary Motions for Summary Judgment
Both the SEC and Ripple Labs have filed preliminary motions for summary judgment, signaling an important step forward in the legal proceedings. These motions outline the arguments and positions of the parties involved in the case.
September 21, 2022: Chamber of Digital Commerce Granted Permission to Submit Amicus Brief
The court reviewed and approved the request of the Chamber of Digital Commerce, a U.S. blockchain technology advocacy organization, to submit an amicus brief.
December 22, 2022: SEC Attempts to Block Public Release of Hinman Documents
The SEC has applied to block the release of internal emails from William Hinman, former director of the SEC’s Division of Corporation Finance, including any references to these documents in the court filings submitted by Ripple Labs. Ripple and the SEC have had lengthy discussions regarding the relevance of the Hinman documents and their potential impact on the case.
June 12, 2023: Hinman Documents Unsealed and Made Public
After a lengthy legal process, the Hinman documents have finally been unsealed and made public. These documents hold significant importance in the Ripple v. SEC lawsuit.
July 13, 2023: Court’s Summary Judgment Decision
Judge Torres of the Southern District of New York ruled that Ripple Labs violated securities laws with the institutional sales of XRP, but the programmatic sales, other distributions, and the sales by Larsen and Garlinghouse did not violate securities laws.
III. Court’s Summary Judgment
As the SEC’s lawsuit was based on allegations that the sale and distribution of XRP violated securities laws, Judge Torres did not directly define the nature of XRP. Instead, the court analyzed whether the specific circumstances of providing and selling XRP by Ripple Labs in different contexts constituted the sale of securities.
Of particular importance was the distinction between the subject matter of an investment contract and the investment contract itself. According to the Howey test, an investment contract under securities laws refers to a contract, transaction, or plan. However, the subject matter of a contract, transaction, or plan may not necessarily be a security on its face, and the court must determine its economic substance based on the surrounding offers and sales. For example, gold, silver, and sugar are ordinary assets, but investment contracts for the sale of gold, silver, and sugar may constitute securities.
1. Institutional Sales
Let’s review the four criteria of the Howey Test for the sale of securities: (1) Investment of Money, (2) Common Enterprise, (3) Expectation of Profit, and (4) Derived From The Efforts of Others. The court found that Ripple Labs’ institutional sales fully met the four criteria of the Howey Test.
It is worth noting that Judge Torres considered “horizontal commonality” as the basis for determining “common enterprise”. If investors’ assets are pooled together and each investor’s wealth is linked to the success of the company and shared in its profits and risks, there is horizontal commonality.
The court found that there is horizontal commonality in the Ripple case. Ripple Labs consolidates the proceeds from its institutional sales into a network of bank accounts. Although Ripple Labs has separate bank accounts for each subsidiary, it controls all the accounts and uses the funds raised from institutional sales to fund its operations. Additionally, Ripple Labs’ accountants record all revenue related to XRP together. Furthermore, the profitability of each institutional buyer is closely linked to the fate of Ripple Labs and other institutional buyers because all institutional buyers receive fungible XRP. Ripple Labs uses the funds obtained from institutional sales to promote and enhance the value of XRP by developing its uses and protecting the XRP trading market.
In addition, the court also found that certain terms of the institutional sales contracts indicate that XRP is sold as an investment rather than for consumption. In the sales contracts, some institutional buyers agree to lock-up or resale restriction clauses based on the volume of XRP traded. These restrictions do not align with the concept of XRP being used as a currency or for other consumptive purposes. Because if the buyer’s intention is to acquire a substitute for fiat currency, a rational economic actor would not agree to freeze millions of dollars. Therefore, these lock-up and resale restriction clauses indicate that institutional investors understand the act of purchasing XRP as an investment in the efforts of Ripple Labs.
Therefore, considering the economic realities and the overall circumstances of the institutional sales, the court concluded that Ripple Labs’ institutional sales of XRP constitute unregistered investment contract offers and sales in violation of Section 5 of the Securities Act.
2. Programmatic Sales
The court found that Ripple Labs’ programmatic sales of XRP to public buyers on digital asset exchanges do not constitute investment contract offers and sales because they do not meet the third and fourth criteria of the Howey Test, namely “Expectation of Profit Derived From The Efforts of Others”.
The court pointed out that in fact, Ripple Labs’ programmatic sales are blind buy/sell transactions, and programmatic buyers cannot know whether the funds they pay flow to Ripple Labs or to other sellers of XRP. Although many programmatic buyers expect to profit from their purchase of XRP, their expectations do not derive from the efforts of Ripple Labs but from other factors such as general trends in the cryptocurrency market. In other words, even if some programmatic buyers purchase XRP and expect to profit from the efforts of Ripple Labs, the investigation is objective and focuses on the promises and proposals made to investors, rather than exploring the exact motivations of each participant. Furthermore, the records show that Ripple’s promotional materials, marketing reports, and public statements by its executives were not widely distributed to buyers of XRP on digital asset exchanges, thereby affecting the objective expectations of programmatic sales buyers.
In addition, the court believes that since the sales of XRP by Larsen and Garlinghouse were conducted through the programmatic sales of digital asset exchanges, they do not constitute securities offers and sales, just like Ripple Labs’ programmatic sales.
3. Other distributions
Ripple Labs’ other distributions of XRP include distributions to employees as compensation and distributions to third parties as part of the Xpring program aimed at developing new applications for XRP and XRP Ledger.
The court believes that these other distributions do not meet the first prong of the Howey Test, which is the “investment of money.” According to precedent, in every case recognized as an “investment contract,” the buyer gives up some tangible and identifiable consideration in exchange for a substantially equivalent interest with securities characteristics. In the Ripple case, the recipients of these other distributions did not pay money or any tangible and identifiable consideration to Ripple Labs. Furthermore, as a matter of fact, there is no evidence to suggest that Ripple Labs funded its project by transferring XRP to third parties for them to sell, as Ripple Labs has never received payment from these XRP distributions.
IV. Impact of the Judgment
1. Support and skepticism
The judgment in the Ripple case is generally well received and supported by the industry. Jake Chervinsky, Chief Legal Officer of the cryptocurrency lobbying group Blockchain Association, views it as a huge victory that undermines the SEC’s enforcement theory: If a token was initially sold as an investment contract, then the token itself represents a security.
However, there are also voices of skepticism. Critics argue that while tokens are securities when sold to institutional investors, they cease to be securities when these institutional investors or issuers themselves sell these tokens on cryptocurrency exchanges, which seems to defy common sense. Lawyer Preston Byrne refers to this as “Schrodinger’s Shitcoin.” Former head of the SEC’s Office of Internet Enforcement, John Reed Stark, points out the illogicality of the court’s analytical logic by comparing it to Apple stock: “Apple stock will never cease to be a security after its IPO. Additionally, no one buys Apple stock directly from Apple. Typical investors buy Apple stock from people they don’t know, and this anonymity doesn’t affect whether Apple stock is a security.”
Stark further argues that the simplified judgment in the Ripple case goes against the original intent of securities laws to protect investors, leading to misplaced protection for institutional investors and retail investors, as the judgment “gives institutional investors complete SEC protection and all the remedies that come with SEC violations, including rescission, fines, penalties, etc. However, retail investors have not received any SEC protection. This seems upside down.”
2. SEC response
The importance of the Ripple case ruling has become evident. Terraform’s lawyers have cited the Ripple case ruling in their request to the court to reject the SEC’s motion. On July 21st, the SEC expressed its view on the Ripple case summary judgment in its response. The SEC believes that the court’s judgment on Ripple Labs’ programmatic sales does not conform to the Howey test and subsequent relevant precedents. Firstly, the choice of using intermediaries for sales does not change the reasonable expectation that the profits come from the efforts of others – indirectly purchased individuals also have the same reasonable expectation. These expectations are based on the same public statements and the same investment economic reality of the issuer, rather than how funds mechanically flow to the issuer. Secondly, the Ripple case wrongly created two different “reasonable investor” standards – one for institutional investors and another for retail investors – but creating any such subjective dichotomy contradicts the Howey test. Thirdly, the Ripple case summary judgment incorrectly added certain requirements in the fourth standard of the Howey test, including the seller making direct promises to each investor, each investor knowing that his money will flow directly to the issuer, the investor’s expectations (rather than profits) coming from the issuer’s efforts, and the investor believing that her returns will be directly used for related efforts. Finally, the basic logic of the Ripple case summary judgment deviates from the basic principles of the Howey test and federal securities laws. The Ripple case summary judgment weakens the protection of retail investors under securities laws by distinguishing between investor categories.
In addition, SEC Chairman Gary Gensler expressed disappointment with the outcome of the Ripple case summary judgment in an interview, believing that it did not protect the public investors. However, the Ripple case was initiated by the SEC before Gary Gensler took office. Even if the SEC ultimately wins the expensive and time-consuming legal battle, the fruits of victory do not seem to belong to Gensler’s “political legacy.” Moreover, after Gensler took office, he led the SEC to launch large-scale enforcement and judicial actions against the cryptocurrency industry, so he has every reason to give up the Ripple case and focus on the new battlefield he created. This seems to be a better political choice.
Finally, even if the SEC appeals, the final result will take months or even years to come out.
The US court system consists of the federal court system and the court systems of individual states. The federal court system is composed of the United States District Courts, the United States Courts of Appeals, and the Supreme Court of the United States. The New York Southern District Court, which heard the Ripple case, belongs to the United States District Courts, and its higher court is the United States Court of Appeals for the Second Circuit.
The initial trial of the SEC as the plaintiff generally takes place in the Southern District Court of New York. First, cases brought by the SEC as the plaintiff generally involve federal laws such as the Securities Act and the Securities Exchange Act, and fall under the jurisdiction of federal courts. Second, the Southern District Court of New York is located in the Manhattan area, where many globally renowned financial institutions are headquartered. Third, the judges of the Southern District Court of New York have extensive expertise in securities law and financial markets. The court plays a significant role in the field of securities and financial law. Therefore, the court’s summary judgment is sometimes adopted as a precedent by other district courts or federal appellate courts, influencing similar cases nationwide. Alternatively, the summary judgment of the U.S. federal district court constitutes a district court precedent for subsequent similar cases in the district, with binding effect in that district.
However, such district court precedents are easily overturned by subsequent judgments of the same court, just as the summary judgment in the Ripple case contradicted the precedent set by the Telegram case. In the Telegram case, Judge Kevin P. Castel believed that it was Telegram’s commitment to the development project, not the resale efforts of intermediaries, that satisfied the fourth prong of the Howey test. This analysis is inconsistent with the Ripple case. Similarly, the analysis in the Ripple case is also likely to be overturned by subsequent judgments.
Furthermore, Judge Torres refused to extend her legal analysis to all secondary market sales. In footnote 16 of the summary judgment, the judge wrote: “The court does not address whether the secondary market sales of XRP constitute offers and sales of investment contracts because that issue was not before the court. Whether the secondary market sales of XRP constitute offers or sales of investment contracts depends on the particular facts and circumstances of the overall plan and economic realities.”
In addition, Judge Torres emphasized several specific factors related to XRP and Ripple. For example, Ripple’s programmatic sales accounted for less than 1% of the global trading volume of XRP; promotional materials distributed by Ripple Labs to institutional investors were not widely disseminated; there was no evidence that programmatic buyers understood the statements of individual defendants and others in relation to Ripple Labs and its efforts. These factors, especially the first one, are very specific to the current market environment. Therefore, these factors favorable to the determination that programmatic sales do not constitute securities transactions may not apply widely to other token programmatic sales and lack broad applicability as precedents.
Therefore, even if the SEC does not appeal, the outcome of the Ripple case has limited impact on the entire cryptocurrency industry.
4. Favorable to Exchanges and “Whales”
Although the outcome of the judgment has limited overall impact on the industry, Judge Torres’ summary judgment in the Ripple case regarding XRP’s programmatic sales on cryptocurrency exchanges directly benefits centralized cryptocurrency exchanges, especially Binance and Coinbase, which are embroiled in legal disputes. JPMorgan believes, “If the Ripple case is successful, it will be more difficult for the SEC to prove that these 13 tokens are securities, and Coinbase, an unregistered securities exchange, may be exempt from certain future licensing and regulatory requirements.” On the day the summary judgment in the Ripple case was announced, Coinbase’s stock price skyrocketed by 24.49% to $107, its highest level in the past year.
First of all, the summary judgment of the Ripple case provides favorable arguments for Binance and Coinbase, which are deeply involved in the SEC lawsuit. Just as Terraform’s lawyers cited the summary judgment request of the Ripple case to request the Southern District Court of New York to dismiss the SEC’s lawsuit, it can be foreseen that the lawyers of Binance and Coinbase will do the same. Because the logic of the SEC’s enforcement of cryptocurrency exchanges is that since most cryptocurrency tokens are subject to securities laws, most cryptocurrency intermediaries must also comply with securities laws. For regulators, they cannot act without authorization from the law. The power granted to the SEC by the law is limited to the securities market. Therefore, if it wants to take action against cryptocurrencies, it must define them as securities. The SEC accuses exchanges such as Binance, Coinbase, and Bittrex of violating securities laws and securities trading laws, and this must be based on the prerequisite that the cryptocurrencies traded on their platforms constitute securities. In fact, the primary accusation of the SEC against Binance and Coinbase is that they operate unregistered securities exchanges, brokers, and clearinghouses. For this reason, the SEC devoted a large part of the complaint to argue that a total of 19 tokens listed on these two cryptocurrency exchanges are securities.
More importantly, the summary judgment of the Ripple case further closes the space for projects to raise funds through VC private placements, and seems to open up a way for token sales that rely on cryptocurrency exchanges as intermediaries. This will not only change the development model and financing habits of cryptocurrency projects since 2018, but may also further strengthen the ecological position of cryptocurrency exchanges in the industry, and even create new narratives.
In addition, the summary judgment of the Ripple case on “other distributions” should not be overlooked. The court believes that if the token recipients do not pay money or other tangible and ascertainable consideration to the project party, then this token distribution model does not meet the first criterion of the Howey test, which is “investment of money”, and therefore does not violate securities laws. According to logical reasoning, the industry-common token distribution method of airdrops will not violate securities laws. The “airdrop enthusiasts” are going to win again.
Finally, even if the summary judgment of the Ripple case is overturned in the future, it has at least dealt a blow to the SEC’s established position that tokens are securities under any circumstances, thereby increasing its enforcement costs. In cryptographic terms, this has recharged the industry’s faith.
5. What should cryptocurrency projects do?
1. Regarding the primary market
According to US securities laws, there are only two compliant ways to issue and sell securities: either register the securities with the SEC or apply for an exemption from registration with the SEC. The former is the traditional path for equity listing, namely IPO, which has extremely high compliance costs and is not suitable for token issuance projects. Therefore, for most cryptocurrency projects, there is only one path, which is to apply for an exemption from registration. Specifically, registration exemptions can be based on Regulation D, Regulation S, Regulation A+, and other regulations.
Regulation D is a private placement for qualified investors in the United States, with restrictions on the issuance amount, issuance targets, and issuance methods. The three categories of Rule 504, Rule 506(b), and Rule 506(c) have different requirements, but none of them require prior application to the SEC. Only a sales notice, Form D, needs to be submitted to the SEC within 15 days of the initial sale.
Regulation S is for overseas issuances in the United States, and it must meet two conditions: first, the issuance and trading must take place outside the United States; second, the issuance targets must not be U.S. citizens.
Reg A+ is equivalent to a small-scale IPO and can target the U.S. public. However, compared to Regulation D and Regulation S, it has stricter information disclosure requirements, resulting in higher costs.
Therefore, from the perspective of compliance costs, if the project party wishes to introduce U.S. institutional investors, applying for Regulation D exemption registration is a good choice. If the project party does not care about U.S. investors and the market, then considering applying for exemption registration under Regulation S is an option.
In addition, according to the analysis in Chapter 3 and Chapter 4, based on the judgment logic of the Ripple case, distributing tokens for free through airdrops to users or potential users does not violate U.S. securities laws. Therefore, for project parties that do not need to consider financing issues, attracting potential users to participate in project ecosystem development and construction, and incentivizing them through airdrops is a way that not only conforms to the spirit of Web3 collaboration and sharing but is also relatively compliant in terms of token distribution.
2. For the secondary market
Based on the analysis in Chapter 3 and Chapter 4, we can deduce that if we do not consider the uniqueness of XRP and Ripple (Ripple’s programmatic sales account for less than 1% of the global trading volume of XRP; the promotional materials distributed by Ripple Labs to institutional investors are not widely disseminated), based on the judgment logic of the Ripple case, trading tokens on the secondary market through cryptocurrency exchanges’ order books may not violate U.S. securities laws. This may prompt cryptocurrency project parties to consider adopting token economics different from the mainstream.
6. What kind of future
Bill Hughes, Global Head of Regulatory Affairs at ConsenSys, believes that it is unlikely to see the SEC change its hardline enforcement strategy. As a savvy political operator, Gary Gensler will double down on enforcement efforts and, by doing so, demonstrate strength to anyone who may question his strategy and style. Weakness is political death. Given the SEC’s clear and proactive enforcement stance on cryptocurrencies as securities, it should not be expected to deviate from its long-standing position. On the contrary, the judgment result of the Ripple case may force the SEC to improve its enforcement theory and refine its enforcement tools. For example, the SEC may establish more specific boundaries between “promises and offers made to investors” in the secondary market to narrow the scope of exemption for programmatic sales. It may also develop and present stronger evidence to prove the consideration provided by employees for the exchange of tokens, thereby meeting the Howey test.
Therefore, although the Ripple case ruling is a milestone moment in the legal battle between the crypto industry and the SEC, it does not resolve the key disputes, so it is far from the end of this game. After the ruling, professionals turned their attention back to Capitol Hill, calling for legislation to normalize cryptocurrency investments and incorporate them into a regulatory framework, giving all token transactions clear legal status, requiring an active disclosure system, and abolishing the requirement in securities laws to regulate tokens without contractual commitments in the same way as regulatory contract tools. As Bill Hughes pointed out, “Now is the time to end interagency disputes and market uncertainties and ultimately establish a regulatory framework that is fully aligned with technology.”
[1] A summary judgment is a judgment made by a court without a full trial. If there is no genuine dispute of material fact that would affect the outcome of the case after the process of filing a lawsuit, filing a defense, and disclosing evidence, any party has the right to apply to the court to make a judgment on all or part of the dispute as a matter of law without a trial. A summary judgment means that the court believes there are no disputed material facts and legal issues that require a full trial process, and a conclusion can be reached directly.
References
https://storage.courtlistener.com/recap/gov.uscourts.nysd.551082/gov.uscourts.nysd.551082.874.0_2.pdf
https://storage.courtlistener.com/recap/gov.uscourts.nysd.594150/gov.uscourts.nysd.594150.49.0.pdf
https://www.coindesk.com/consensus-magazine/2023/07/13/ripple-labs-ruling-throws-us-crypto-token-regulation-into-disarray/
https://www.linkedin.com/pulse/ripple-decision-cause-crypto-celebration-momentarily-best-stark/
https://www.coindesk.com/consensus-magazine/2023/07/14/ripples-legal-win-means-its-time-for-crypto-to-stand-up-to-the-sec/
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