You may have seen recent news about an important case involving Ripple Labs that could impact how federal regulators can treat cryptocurrencies in the context of federal securities laws. This post will give you a rundown of the essential facts of this case and its potential implications for the future.

On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York (“SDNY”) ruled against the Securities and Exchange Commission (SEC) on most of its claims. The question the court was tasked with answering was whether Ripple Lab’s XRP digital token was a “security” subject to the SEC’s enforcement jurisdiction when the token was bought and sold in a variety of contexts. 

The Court needed to answer this question because the SEC brought an action in December 2020 against Ripple and two of its senior executives, alleging that Ripple engaged in the sale of unregistered securities in violation of Section 5 of the Securities Act of 1933.  The SEC can impose severe penalties where it can prove that a company issued and sold investments that should have been, but were not, registered as securities with federal government. The question before Judge Torres of whether certain purchases and sales of XRP were securities turned on application of the Supreme Court’s 1946 decision regarding the meaning of investment contracts in S.E.C. v. W.J. Howey & Company—a Supreme Court case you may have heard about if you have followed the SEC’s efforts to regulate cryptocurrencies in recent years.  Sales of “investment contracts” are one type of “security” covered by the federal securities laws.

The purchases and sales of XRP at issue took a variety of transactional forms, and Judge Torres addressed each form separately in her opinion.

First, in what turned out to be the SEC’s sole win, Judge Torres found that Ripple and its affiliates’ sale of $728.9 million worth of XRP to institutional investors pursuant to written contracts were securities under federal securities laws.  The court found that this form of transaction met all three prongs of the test established by Howey for whether the sales were of investment contracts.  For the institutional sales, Judge Torres ruled that the institutional investors: (a) provided money to Ripple in exchange for XRP; (b) invested in a common enterprise because Ripple pooled the money it received and used funds “to promote and increase the value of XRP by developing uses for XRP and protecting the XRP trading market”; and (c) reasonably expected that they would derive profits from Ripple’s efforts.  The court cited a variety of evidence reflecting that Ripple promoted XRP to institutional investors as an opportunity to profit based upon the company’s success. Among other evidence, the court cited a report Ripple issued in 2017 that its efforts to “sign up banks to commercially deploy its enterprise blockchain solution and join its global payments network” could favorably impact XRP’s price and trading volume.  As noted, however, Judge Torres’ ruling that Ripple’s institutional sales were securities turned out to be the SEC’s sole victory.

In a significant win for Ripple, however, Judge Torres found that sales of XRP through the use of trading algorithms on digital asset exchanges were not securities under the Howey test.  Specifically, these so-called “programmatic sales,” which accounted for approximately $757.6 million of sales of XRP on digital asset exchanges, were blind bid/ask transactions such that Ripple did not know who was buying XRP and purchasers did not know who was selling it.  Judge Torres rejected the SEC’s argument that these were securities transactions. Although the institutional investors reasonably expected Ripple to use sales proceeds to further the value of XRP, the programmatic buyers could have had no such expectation because they could not even have known whether their funds would even go to Ripple.  Programmatic buyers may have reasonably hoped to profit, but any expectation of profit was based on market forces and trends and not on Ripple’s efforts.  Programmatic buyers also lacked written contracts with lockup provisions, resale restrictions, and indemnification clauses typically seen in securities transactions. 

Finally, Judge Torres ruled that Ripple’s use of XRP to pay employees and third parties were not securities transactions because these counterparties did not invest money in exchange for XRP.  And the court also ruled that the Ripple executives’ sales of their own XRP were not securities transactions because they were akin to the programmatic sales, i.e. they were executed on digital asset exchanges.

Although the SEC may appeal, for the time being Judge Torres’ decision is likely going to be frequently cited to guide courts in the cryptocurrency battles that are pending and that are to come.  For now, her ruling is likely to be persuasive in the many cases around the country where the SEC is pursuing enforcement actions in the crypto asset space. In particular, her ruling, if more widely adopted, could lead to a narrowing of the SEC’s enforcement efforts to circumstances where a cryptocurrency issuer clearly promotes the sale of their native tokens as an investment opportunity to earn profits based on the success of the business, as opposed to companies that run cryptocurrency exchange operations or operate other “DeFi” or decentralized business models. This prospect was apparently received as bad news by the SEC Chair, Gary Gensler, who commented that he was “disappointed” with Judge Torres’ ruling. His reaction is not entirely surprising, given that the SEC and Mr. Gensler have been criticized in some circles for adopting a “one size fits all” approach to cryptocurrency regulation.

While it remains to be seen whether Judge Torres’ decision will be upheld if, in fact, the SEC pursues an appeal, her decision, at the very least, thoughtfully highlights important distinctions between common methods of buying and selling cryptocurrencies that could prove influential for issuers, regulators, and courts alike.