The legal battle between the U.S. Securities and Exchange Commission (SEC) and Ripple, the pioneering force behind the XRP Ledger, has engrossed both the cryptocurrency community and legal scholars, evoking widespread interest and anticipation. SEC v. Ripple Labs, Inc. assumes paramount significance within the cryptocurrency domain, owing to its potential ramifications on the regulatory landscape governing cryptocurrencies and digital assets. It has ignited debates surrounding critical aspects such as the categorization of cryptocurrencies within the purview of securities law, the urgent need for regulatory clarity, the viability of various cryptocurrency business models, and the safeguarding of investor interests. Marking an unprecedented milestone, this case represents a landmark triumph for a cryptocurrency enterprise in its legal battle against the formidable SEC, thus reshaping the contours of the cryptocurrency regulatory landscape within the United States.
At the heart of the matter is the question of whether Ripple’s sales and distributions of XRP should be classified as unregistered securities offerings. If so, it would put Ripple in violation of securities laws.1 To assess the merits of this argument, it is essential to delve into the history of Ripple and the XRP Ledger, the nature of the sales and distributions, and the marketing campaigns employed by Ripple. We will explore the key aspects of the case and evaluate how these activities align with the four-pronged Howey test established by the Supreme Court. We will also cover subsequent case law that establishes that an “investment contract” exists when there is investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.2
History of the XRP
During the early stages of 2011 and 2012, three engineers, Arthur Britto, Jed McCaleb, and David Schwartz embarked on a transformative endeavor that birthed the XRP Ledger’s source code. The XRP Ledger is a decentralized public blockchain that allows for the fast, low-cost, real-time transfer of XRP tokens, fiat currencies, and other digital assets.3 Essentially the XRP Ledger allows anyone to transfer funds globally at a low cost almost instantaneously. This pioneering blockchain ledger emerged as an innovative solution to surmount the limitations of the bitcoin blockchain, striving for enhanced speed and efficiency. With its launch in 2012, the XRP Ledger entered the digital realm, accompanied by a fixed inventory of 100 billion XRP tokens, serving as the native digital assets of this ledger.
In parallel, Ripple, a company jointly established by Arthur Britto, Jed McCaleb, David Schwartz, and Chris Larsen (an Angel Investor) in 2012, embarked on a mission to revolutionize value transfer across the vast expanse of the internet. Anchored by its software product named RippleNet, Ripple set out to empower customers with the capacity to navigate cross-border financial transactions seamlessly, predicated upon mutually agreed-upon terms. One standout facet of RippleNet resides in its on-demand liquidity (ODL) mechanism, which grants patrons the ability to convert fiat currency into XRP and subsequently exchange XRP for alternative fiat currencies.
For instance, in the context of international commerce, an individual or a U.S.-based company may engage in online transactions with sellers located in other countries. Traditionally, such transactions involve a delay in shipping the purchased item until the payment has been successfully processed, leading to storage expenses and delayed receipt of the item by the seller. Additionally, the process of converting the U.S. Dollar (USD) used for the purchase into the seller’s local currency typically requires the involvement of intermediaries, causing further delays, often taking a day or more, and incurring transaction fees.
In contrast, utilizing the XRP Ledger offers a streamlined alternative for such transactions. Suppose the same purchase were conducted through the XRP Ledger, where the payment is made in USD. In this case, the USD is automatically converted into XRP tokens during the transaction. Settlement of the transaction occurs remarkably swiftly within a mere three seconds on the XRP Ledger, enabling seamless conversion of the XRP tokens into the seller’s preferred currency directly. The XRP Ledger boasts several advantages that render it a more favorable option for international transactions. Firstly, the default transaction fee for purchases conducted on the XRP Ledger is impressively low, amounting to $0.0000024, thus significantly reducing transaction costs. Secondly, the nearly instantaneous payment processing and settlement capabilities of the XRP Ledger contribute to its heightened feasibility, practicality, and cost-effectiveness for settling international transactions. Lastly, the XRP Ledger operates continuously, 24/7 and is open to anyone in the world through the peer-to-peer network that manages the ledger, further enhancing its appeal in facilitating swift and efficient cross-border payments.
While certain facets of Ripple’s offerings are reliant upon the XRP Ledger and its associated digital tokens, it is imperative to highlight that the ledger itself operates as an open-source framework, extending the invitation to all individuals to engage in its utilization, transaction submissions, node hosting, source code modifications, and application development endeavors. Evidencing its commitment to fostering innovation and diversity within the ecosystem, Ripple has actively allocated resources to support external enterprises via its Xpring initiative, propelling the realization of diverse use cases anchored within the XRP Ledger’s expansive potential.
Beginning in 2013, Ripple engaged in various sales and distributions of XRP through the end of 2020. These activities included institutional sales to certain counterparties, programmatic sales on digital asset exchanges, and other distributions of XRP as payment for services. Ripple owned between 50 and 80 billion XRP tokens during this period. Additionally, Larsen and Garlinghouse, executives at Ripple, individually sold XRP on digital asset exchanges, with Larsen making at least $450 million and Garlinghouse making approximately $150 million from these sales. The defendants did not file a registration statement for these offers or sales of XRP, and Ripple did not publicly file financial statements or other periodic reports related to XRP with the SEC. The SEC alleges that Ripple conducted a marketing campaign portraying XRP as an investment opportunity, citing various statements and documents circulated by Ripple since 2013. However, the defendants dispute the SEC’s factual narrative and argue that the SEC selectively presents excerpts from documents and statements made by multiple authors over an eight-year period.
The court made rulings, with different conclusions depending on the classification of each individual transaction. The three types of classifications of transactions are either: (1) institutional sales, (2) programmatic sales, or (3) other distributions. In each of the classifications, the court employed the Howey test in determining if the transaction is or is not a security.
Institutional Sales
The transactions considered to be “institutional” consist of sales of XRP made to sophisticated individuals and entities (institutional buyers) pursuant to written contracts. These sales are distributions of XRP into public markets through conduits, whether the institutional buyers were purchasing XRP as brokers or for potential reselling as part of a trading strategy.
The first prong of the Howey test examines whether an “investment of money” was involved in the transaction. The court found that institutional buyers invested money by exchanging fiat or other currency for XRP tokens. The defendants did not dispute this point but argue that an “investment of money” requires an intent to invest, not just the payment of money. However, the court rejected this argument, stating that case law does not support such a distinction. As long as there is a payment of money, the element of an investment of money is considered satisfied.4
The second prong of the Howey test focuses on the existence of a “common enterprise.” The court determined that horizontal commonality, where investors’ assets are pooled and their fortunes are tied to the success of the overall enterprise, was present. Ripple consolidated the proceeds of its institutional sales into various subsidiary bank accounts under its control, using the funds to finance its operations. The court noted that there was no segregation of investor funds, and the fortunes of institutional buyers were interconnected since they all received the same fungible XRP.5
The third prong of the Howey test examines whether the investors had a reasonable expectation of profits from the efforts of others. The court found that reasonable investors, in the position of institutional buyers, would have expected to derive profits from Ripple’s efforts.6 Ripple marketed XRP as an investment tied to the company’s success, emphasizing the potential increase in XRP’s value and the development of uses for the XRP Ledger. Statements made by Ripple’s senior leaders and promotional materials further supported the expectation of profits based on Ripple’s efforts.
The court highlighted certain provisions in the sales contracts, such as lockup provisions and resale restrictions, indicated that XRP was treated as an investment rather than a currency or consumptive asset. These provisions, along with other contractual terms, suggested that the parties involved understood the sale of XRP as an investment in Ripple’s efforts.
Based on the totality of circumstances and the economic reality surrounding Ripple’s institutional sales, the court concluded that institutional sales constituted the unregistered offer and sale of investment contracts, violating Section 5 of the Securities Act.7
Programmatic Sales
The court first highlighted that the programmatic sales occurred under different circumstances compared to the institutional sales. The SEC alleged that Ripple targeted speculators and sought to increase speculative volume in the programmatic sales to public buyers on digital asset exchanges.
In analyzing the economic reality of programmatic sales, the court concluded that the programmatic sales did not satisfy the third prong of the Howey test– a reasonable expectation of profits from the efforts of others. Unlike institutional buyers, who reasonably expected Ripple to use the sales proceeds to improve the XRP ecosystem and increase XRP’s price, programmatic buyers could not reasonably expect the same. The programmatic sales were blind bid/ask transactions on exchanges, and buyers did not know if their payments went to Ripple or any other seller of XRP. Furthermore, the programmatic sales represented less than 1% of the global XRP trading volume, indicating that the vast majority of individuals who purchased XRP on exchanges did not invest their money in Ripple.8
The court emphasized that the SEC’s argument that Ripple explicitly targeted speculators was not sufficient to establish an investment contract. Speculative motives alone do not evidence the existence of an investment contract under securities laws. The determining factor is whether the speculation came from the efforts of other people, such as entrepreneurs or managers. In the case of the programmatic buyers, the court found that they did not derive their expectation of profit from Ripple’s efforts, as Programmatic Buyers were unaware of whether they were buying XRP from Ripple or any other individual.9
While some programmatic buyers may have purchased XRP with the expectation of profits from Ripple’s efforts, the court stated that the inquiry is objective, focusing on the promises and offers made to investors. In the case of the programmatic sales, Ripple did not make any promises or offers because it did not know who the buyers were, and the buyers did not know who the sellers were. Ripple’s promotional materials and statements made by Ripple’s executives were not distributed widely to the general public purchasing XRP on exchanges, and there was no evidence that programmatic buyers understood these statements as representations of Ripple and its efforts.
Additionally, factors present in the economic reality of institutional sales, such as contractual provisions and promotional materials, were absent in the programmatic sales. The court also noted that the institutional buyers were sophisticated entities, while the programmatic buyers were generally less sophisticated investors who may not have shared the same understandings and expectations.
Considering the economic reality and totality of circumstances, the court concluded that Ripple’s programmatic sales of XRP did not constitute the offer and sale of investment contracts under securities laws.10
Other Distributions
The “other distributions” refer to XRP distributions made by Ripple to employees as compensation and to third parties as part of Ripple’s Xpring initiative. The SEC alleged that Ripple funded its projects by transferring XRP to third parties who then sold the XRP into public markets.
The court determined that these other distributions did not satisfy the first prong of the Howey test, which requires an “investment of money” in the transaction. The court emphasized that Howey requires a showing that the investors provided tangible and definable consideration in exchange for an interest that had substantially the same characteristics of a security. In the case of other distributions, the recipients did not pay money or provide any tangible consideration to Ripple. Instead, Ripple paid XRP to these employees and companies. Furthermore, there was no evidence that Ripple received payments from these XRP distributions.11
The SEC argued that the other distributions were an indirect public offering because the recipients could transfer their XRP to other holders in exchange for other currencies, goods, or services. However, the court found that the SEC does not allege that the recipients, such as Ripple employees and Xpring third-party companies, were Ripple’s underwriters. Additionally, the SEC does not develop the argument that these secondary market sales were offers or sales of investment contracts, especially since the payments for these XRP sales did not trace back to Ripple. The court concluded that Ripple’s other distributions did not constitute the offer and sale of investment contracts.12
Regarding Larsen’s and Garlinghouse’s offers and sales of XRP, the court cites Section 4(a)(1) of the Securities Act, which exempts transactions by persons other than issuers, underwriters, or dealers. The SEC argued that this exemption did not apply to Larsen and Garlinghouse because they were affiliates of Ripple. However, the court did not address this issue, as it determined that Larsen’s and Garlinghouse’s XRP sales were programmatic sales on digital asset exchanges through blind bid/ask transactions. The court noted that neither Larsen nor Garlinghouse knew the buyers, and the buyers did not know the identity of the sellers. Therefore, as a matter of law, the court found that the record could not establish the third prong of the Howey test for these transactions. Similar to the court’s analysis of Ripple’s programmatic sales, Larsen’s and Garlinghouse’s offers and sales of XRP on digital asset exchanges did not amount to offers and sales of investment contracts.13
The Rulings Impact on Future of Cryptocurrency
The recent ruling, while offering a degree of clarity within the confines of this specific case, leaves several pertinent matters relating to cryptocurrencies, their affiliated enterprises, and digital exchanges unaddressed. On one hand, this decision furnishes a defense foundation for digital exchanges that face allegations of selling unregistered securities through secondary market transactions. This ruling may play a critical part in the arguments and defenses as the imminent legal disputes involving the Securities and Exchange Commission (SEC) and digital exchanges like Coinbase are upcoming in the near future. However, it is crucial to note that this ruling lacks the force of binding precedent, as it does not establish a legal obligation for other District Court judges to adhere to or enforce the same ruling. The difficulties in this ruling are already on display. As recent as Monday, July 31, 2023, a federal judge in SEC v. Terraform Labs Pte. Ltd., rejected the use of the ruling in Ripple.14 This is particularly noteworthy considering on August 17, 2024, the court has approved a request from the SEC to file an interlocutory appeal in the SEC’s case against Ripple.
The outcome of this case marks a significant victory for the cryptocurrency industry in its entirety. However, the Securities and Exchange Commission (SEC) also secured a triumph in its stance regarding initial coin offerings (ICOs) being classified as securities. The recognition of institutional sales of XRP as investment contracts falling within the purview of securities law implies that the prevailing method of introducing new cryptocurrencies and raising capital via ICOs now falls subject to securities regulations. In light of this development, it is highly likely that a surge of potential lawsuits will emerge, focusing on cryptocurrency enterprises’ endeavors to navigate around securities regulations through alternative avenues apart from ICOs.
The cryptocurrency industry stands at a critical juncture where regulation through enforcement proves detrimental to the companies, individuals involved, and the nation as a whole. The exponential growth, as evidenced by the staggering number of over 23,000 distinct cryptocurrencies currently tradable within the United States, necessitates an urgent call for Congress to assume a proactive role in formulating and establishing unambiguous regulatory frameworks pertaining to the cryptocurrency landscape.15 Relying on the judicial branch to fashion regulations on a piecemeal basis, driven by case-specific circumstances, falls short of the cohesive and forward-thinking approach required in this domain. It is unequivocally evident that cryptocurrency has entrenched itself as a formidable force within the financial landscape, demanding the United States to emerge as a leader in shaping and implementing comprehensive regulatory measures that serve as a beacon of guidance for the international community at large.
Jeffry A. Collins, Esq. is an attorney, author, Nevada Bar Tutor, and criminal law adjunct professor at Mitchell Hamline School of Law. Jeffry has a passion for the law and writing, allowing opportunity to begin publishing in the legal and literary worlds. Jeffry’s legal interests cover a range of areas, including personal injury, business law, securities/cryptocurrency, trusts & estates, and criminal law.
Jeffry holds an associate degree from Ventura Community College, and a bachelor’s degree in criminal justice from the University of Nevada Las Vegas. Jeffry also holds a Juris Doctorate from Mitchell Hamline School of Law where he graduated Phi Alpha Delta Society of Scholars. He is currently pursuing a Master of Library and Information Sciences from Louisiana State University where he is a member of the Omega Nu Lambda National Collegiate Honor Society. Jeffry will be beginning a Doctor of Education program in 2024.
1 SEC v. Ripple Labs, Inc., 2023 U.S. Dist. LEXIS 120486 (S.D.N.Y. July 13, 2023)
2 SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”). See also United Housing Found., Inc. v. Forman, 421 U.S. 837 (1975) (“Forman”); Tcherepnin v. Knight, 389 U.S. 332 (1967) (“Tcherepnin”); SEC v. C. M. Joiner Leasing Corp., 320 U.S. 344 (1943) (“Joiner”).
3 Council, Blockchain. “What Is XRP Ledger (XRPL)? How Does It Work?” Blockchain Council, 7 Nov. 2022, www.blockchain-council.org/blockchain/xrp-ledger-xrpl/.
4 Id.
5 Id.
6 Id.
7 Id.
8 Id.
9 Id.
10 Id.
11 Id.
12 Id.
13 Id.
14 SEC v. Terraform Labs Pte. Ltd., No. 23-cv-1346 (JSR), 2023 U.S. Dist. LEXIS 132046 (S.D.N.Y. July 31, 2023)
15 Hicks, Coryanne. “Different Types of Cryptocurrencies.” Forbes, 25 July 2023, www.forbes.com/advisor/investing/cryptocurrency/different-types-of-cryptocurrencies/#:~:text=How%20Many%20Cryptocurrencies%20Are%20There,market%20capitalization%20of%20%241.1%20trillion.
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