The Situation: Recently, two judges in Southern District of New York were required to apply the Howey test in separate cases to decide whether sales of certain crypto assets were investment contracts, and thus securities.
The Result: In applying the Howey test to transactions involving the digital asset XRP, the Ripple court found that sales directly from Ripple to institutional buyers via written contracts were investment contracts and therefore, securities; but sales conducted via blind bid/ask transactions through exchanges were not investment contracts. The Terraform Labs court, by contrast, found that the SEC's allegations around the sale of various crypto assets plausibly asserted that sales from Terraform Labs were investment contracts whether offered via written contract or via blind bid/ask transactions through exchanges, declining to follow the Ripple court's position on sales made through exchanges.
Looking Ahead: While Ripple brought a measure of much needed clarity to the application of the federal securities laws to crypto asset transactions, the Terraform Labs decision just a few weeks later appears to challenge whether blind bid/ask transactions on exchanges fit within Howey's confines. While the cases are distinguishable based on their differing facts and stages of litigation, the seemingly dissonant outcomes highlight the challenges courts—let alone market participants—have in applying Howey to crypto assets, which should spur Congress to clarify the law around these assets.
On December 22, 2020, the SEC sued Ripple Labs, Inc. and its senior leaders, Bradley Garlinghouse and Christian Larsen, in the Southern District of New York, alleging that the defendants' sales of the crypto asset XRP through various means were unlawful offers and sales of securities in violation of Section 5 of the Securities Act of 1933 ("Securities Act"). SEC v. Ripple Labs., et al., Case No. 1:20-cv-10832-AT-SN (S.D.N.Y.) Both Ripple and the SEC filed cross-motions for summary judgment on September 13, 2022.
The core issue on summary judgment was whether defendants offered to sell or sold XRP as an investment contract (and thus a security) under the U.S. Supreme Court's seminal decision in SEC v. Howey, 328 U.S. 294 (1946). In Howey, the Supreme Court concluded that an investment contract is "a contract, transaction[,] or scheme whereby a person [(1)] 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."
While the Ripple case was pending, the SEC filed a complaint in the Southern District of New York on February 16, 2023, charging Terraform Labs PTE Ltd. and its founder with orchestrating a multibillion-dollar crypto asset securities fraud involving an algorithmic stablecoin and other crypto asset securities. SEC v. Terraform Labs PTE Ltd., et al., Case No. 1:20-cv-01346 (S.D.N.Y.). The defendants moved to dismiss the complaint on various grounds, including that the SEC should be barred from asserting that the crypto assets at issue are securities by virtue of the Major Questions Doctrine, the Due Process Clause of the U.S. Constitution, and the Administrative Procedures Act ("APA"); and that the crypto assets are not plausibly alleged to be securities under Howey.
The Ripple Court Found That Some XRP Sales Were Investment Contracts While Others Were Not
On July 13, 2023, the Ripple court ruled on the motions, finding first that "XRP, as a digital token, is not in and of itself a 'contract, transaction, or scheme' that embodies the Howey requirements of an investment contract." Instead, the court held, it should look to the totality of the facts and circumstances surrounding each category of defendants' transactions regarding the sale of XRP to determine whether those transactions involved securities.
The court considered three types of XRP sales made by the defendants:
- Sales under written contracts for which Ripple received $728 million, mostly from institutional investors (the "Institutional Sales");
- Sales on digital asset exchanges for which Ripple received $757 million from public buyers (the "Programmatic Sales") and similar sales by Garlinghouse and Larsen; and
- Other distributions to employees or companies under written contracts for which Ripple recorded $609 million in "consideration other than cash" (the "Other Distributions").
The court held that the Institutional Sales were unregistered sales of investment contracts in violation of the Securities Act. The court found that institutional buyers invested money (the first prong under Howey) and that the capital was then pooled for development of the XRP Ledger (the second prong under Howey). The court further found that Ripple's actions showed that "reasonable investors would understand that Ripple would use the capital received from its Institutional Sales to improve the market for XRP and develop uses for the XRP Ledger." The court also looked to the sales contracts and found lockup provisions or resale restrictions based on XRP's trading volume, which supported the conclusion that Ripple sold XRP as an investment rather than for consumptive use. Thus, the court ruled, institutional buyers had a reasonable expectation of profits derived from the efforts of others (the third prong under Howey).
In contrast, the court held that Programmatic Sales, which were blind bid/ask transactions on exchanges, failed to satisfy the third prong of Howey because XRP buyers on crypto exchanges were not aware of the seller's identity. Therefore, even though Ripple was selling XRP directly to the buyers through the exchanges, the buyers could not reasonably expect that "Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP," because a buyer would not have known if their payments for XRP went to Ripple. The court held that many of these buyers were not even aware of Ripple's existence and that Ripple could not have made "any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it."
The court also determined it to be significant that the Programmatic Sales lacked other factors present in the Institutional Sales, such as contracts with lockup provisions, resale restrictions, indemnification clauses, and statements of purpose. And the court concluded that Ripple's promotional materials were widely circulated among the institutional buyers but not among the buyers on exchanges. The court ruled that the sales Larsen and Garlinghouse made on exchanges likewise did not satisfy Howey's third factor for the same reason.
The Court held that Ripple's Other Distributions did not constitute the offer and sale of investment contracts since there was no "investment of money" as part of the transaction or scheme. Ripple simply gave XRP to employees or companies as rewards or incentives and there was no monetary consideration provided to Ripple.
Finally, in response to the defendants' assertion that the SEC's claims should be denied because they had not been given fair notice that XRP could be a security, the court rejected that defense, finding that the law does not require the SEC to warn all potential violators on an individual or industry level and that Howey provides an objective test with a clear standard.
The Terraform Labs Court Refused to Dismiss Any of the SEC's Claims
On July 31, 2023, the Terraform Labs court issued an opinion and order denying the defendants' motion to dismiss the SEC's complaint. Unlike Ripple—a summary judgment case—the court was required in Terraform Labs to accept the SEC's allegations as true in ruling on the motion to dismiss. In rejecting the defendants' arguments, the court found that the SEC had adequately alleged that the crypto assets at issue and the full set of contracts, expectations, and understandings around them were offered as investment contracts under Howey and were therefore securities, whether sold directly through written contracts or via exchange-based sales.
The court first rejected the defendants' argument that the SEC lacked authority to regulate the crypto industry under a principle of statutory construction called the Major Questions Doctrine. As the court described it, the Major Questions Doctrine requires a government agency to point to "clear congressional authorization" when it claims "power to regulate a significant portion of the American economy" that has "vast economic and political significance." In the court's view, the crypto industry "falls far short" of meeting the standard for application of the doctrine.
The court similarly rejected the defendants' argument that the SEC violated the defendants' due process rights by not providing 'fair notice' that their crypto assets would be treated as securities. In so doing, the court pointed out that: (i) the SEC had been consistent in its position that some crypto assets may be securities; (ii) it had brought enforcement actions against others for similar conduct in connection with crypto assets; and (iii) the SEC staff had published the Framework for "Investment Contract" Analysis of Digital Assets in April 2019, providing guidance on the application of the Howey test to crypto assets. Further, because the SEC's interpretation of the federal securities laws and its application to crypto assets was not "new," the defendants' APA argument was rejected. After rejecting those defenses, the court determined that the SEC had asserted a plausible claim that the defendants' crypto assets qualify as securities under Howey.
Specifically, the court found that there is no requirement that there be a formal common-law contract between transacting parties for an "investment contract" to exist, and that the court's job was to evaluate not the crypto assets themselves, but rather whether the crypto assets and the "full set of contracts, expectations, and understandings centered on the sales and distribution of" the tokens amounted to an investment contract. Consequently, the relationship between the defendants' various coins and the numerous alleged statements made by the defendants as to profit potential of the assets led the court to conclude that the SEC had met its pleading burden.
In doing so, the Terraform Labs court expressly declined to follow the Ripple court's ruling based on the record developed in that case that blind bid/ask sales of XRP on exchanges were not investment contracts. The Terraform Labs court concluded that the SEC had sufficiently alleged that, based on the alleged actions and statements of the defendants, all buyers of the crypto assets, no matter where the purchase occurred, including on exchanges, had "reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf."
Implications of the Two Decisions
It is possible that one or both of these decisions ultimately will be appealed to the Second Circuit, which could provide guidance on how to apply Howey to offers and sales of crypto assets, particularly with respect to blind bid/ask sales on crypto exchanges. Any such developments, however, are likely to be far into the future. Nor is it clear that other circuit courts would necessarily follow a ruling from the Second Circuit; as the conflicting decisions here demonstrate, different courts may well reach different conclusions on these issues. Absent congressional action, only potential Supreme Court rulings are likely to settle the scope of the application of the securities laws to digital assets.
In the meantime, interested parties could argue that the Ripple decision has important implications for other cases involving digital assets. First, Ripple supports the SEC's view that most, if not all, sales of digital assets through initial coin offerings (or other similar transactions where the buyers know they are engaging directly with the issuer) are securities offerings subject to the federal securities laws.
Second, Ripple also supports the argument that sales of crypto assets through exchanges likely do not constitute securities transactions, depending on the facts and circumstances. And while the Ripple court stated that it was not considering secondary market exchange-based sales not involving the issuer, its reasoning implies that such sales would not constitute securities transactions. That, in turn, generally would remove crypto exchanges, and those who engage in such transactions on the exchanges, from the scope of the federal securities laws. This could have a significant impact on pending SEC enforcement actions against entities it alleges are unregistered securities exchanges, unregistered broker-dealers, and/or unregistered clearing agencies for facilitating secondary market trades in digital assets.
Third, the Department of Justice ("DOJ") has also adopted the SEC's position on exchange-traded crypto assets as securities, most recently filing criminal charges for market manipulation under the federal securities laws against Celsius and its former CEO in connection with secondary market trading of crypto assets. The Ripple decision, if it stands, could impact the DOJ's ability to bring such cases in the future.
Turning to Terraform Labs, the SEC, of course, is likely to assert that the ruling supports its position that most digital assets are offered and sold as investment contracts, at least when sold by issuers, and that regulation of the crypto industry under the securities laws is appropriate and warranted. And the SEC and DOJ seem likely to rely on Terraform Labs to counter arguments that digital assets sold on exchanges are not securities. A critical distinction for the SEC and DOJ, however, is that, unlike Ripple, the Terraform Labs decision was based solely on the SEC's bare allegations rather than a fully developed factual record.
Time will tell whether the SEC can support its Terraform Labs allegations with evidence; it was unable to do so in Ripple. Moreover, while the SEC may argue that the language in Terraform Labs relating to Howey's "reasonable expectation of profits" prong is broad enough to apply to secondary market exchange-based trades not involving the issuer, the court's analysis of the "common enterprise" prong would not cover such trades, which were not at issue in the case. Therefore, Terraform Labs may provide only limited support, if any, to SEC efforts to apply the securities laws to crypto exchanges and secondary market trading.
Finally, the two rulings may have reinvigorated congressional interest in a bipartisan solution to regulating digital assets and markets. Under current proposals, most oversight would shift to the Commodity Futures Trading Commission, or CFTC, and away from the SEC.
Three Key Takeaways
1. A judge in the Southern District of New York ruled that the undisputed evidence showed that XRP sold by Ripple directly to institutional investors were investment contracts, but XRP sold by Ripple and two of its executives to buyers anonymously via a crypto exchange were not. If this decision stands after appeal, it could be used to argue more broadly that secondary market sales of digital assets are not securities transactions.
2. Another judge in the Southern District of New York ruled that the SEC had adequately pled that several crypto assets sold by Terraform Labs were investment contracts under Howey. That judge declined to follow the Ripple holding that blind bid/ask sales on exchanges are not investment contracts. He also rejected other theories, like the Major Questions Doctrine, that have been asserted to argue that the SEC should not extend its jurisdiction over the crypto industry. The decision did not, however, apply to secondary market exchange-based sales of digital assets; and may provide only limited support to SEC and DOJ efforts to apply the securities laws to such transactions.
3. These decisions—by two judges in the same judicial district issued within weeks of each other—suggest that the courts are unlikely to settle whether and how securities laws apply to digital assets for the foreseeable future. This lack of judicial consensus further highlights the need for Congress to promptly pass sensible laws that effectively balance the risks and rewards of the crypto industry.
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