Recently, U.S. District Judge Analisa Torres rendered an opinion regarding whether the offer and sale of a cryptocurrency called XRP violated certain securities laws. In 2020, the Securities and Exchange Commission (SEC) filed an action against Ripple Labs Inc. (Ripple) and two of its executives, alleging that they raised over $1.3 billion through an unregistered, ongoing digital asset securities offering of XRP. The SEC alleged that Ripple and certain executives violated Section 5 of the Securities Act of 1933 (the Act).
Investment Contracts Under the Securities Act of 1933
By way of background, the Act prohibits the offer and sale of unregistered securities unless an exemption is met. The SEC itemized various separate types of transactions that it claimed constituted the offer and sale of “securities” including direct institutional sales (primarily institutional buyers, hedge funds, etc.) and programmatic sales (sales on digital asset exchanges). For the SEC to prevail in the action, it first had to establish that a pertinent transaction involved the offer or sale of a “security.”
Investments such as stocks or bonds are securities. However, investments that are not typically considered “securities” may still be if they fall under the definition of an “investment contract.” To be deemed an “investment contract” and thus a security, there must be: (1) an investment of money; (2) in a common enterprise; with (3) an expectation of profits derived from the efforts of others. See SEC v. W. J. Howey Co., 328 U.S. 293, 299 (1946).
Split Decision on XRP as a Security
As Judge Torres correctly found, “the subject of a contract, transaction, or scheme is not necessarily a security on its face,” but still may be a “security.” As such, many investors who adamantly believe that cryptocurrencies are commodities (and not securities), will be surprised to learn that various assets have been the subject of an “investment contract.” For instance, the seminal case of SEC v. Howey found the existence of an “investment contract” (and thus a “security”) despite the subject of the investment being orange groves.
Judge Torres further cited various other cases to bolster this point including those involving condominiums, whiskey, payphones, and beavers. Therefore, Judge Torres found that “[e]ven if XRP exhibits certain characteristics of a commodity or a currency, it may nonetheless be offered or sold as an investment contract.”
Ultimately, Judge Torres applied SEC v. Howey and found that Ripple’s “institutional sales” constituted sales of “investment contracts” and thus “securities,” while the “programmatic sales” were not.
Crypto Rules Still Remain Unclear
Many investors believe Judge Torres’ ruling was a win for the cryptocurrency industry. However, a closer look at the opinion shows a lack of clarity going forward. At Footnote 16 of the opinion, Judge Torres clarifies that the court “does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the Court,” and that such analysis will “depend on the totality of circumstances and the economic reality of the specific contract, transaction, or scheme.” Specifically, the SEC’s enforcement action against Ripple concerned Ripple’s and certain executives’ offers and sales of XRP, not whether digital asset exchanges are facilitating securities transactions.
Judge Torres found it significant that the institutional buyers knew they were buying XRP from Ripple and were further aware of Ripple’s promotional materials that she categorized as “pitching a speculative value proposition for XRP with potential profits to be derived from Ripple’s entrepreneurial and managerial efforts.” On the other hand, Judge Torres found that the programmatic sales were transactions whereby the buyer “did not know to whom or what it was paying its money.” Critically, Judge Torres found there was no evidence that the promotional efforts were “distributed more broadly to the general public, such as XRP purchasers on digital asset exchanges” or that statements made by the promoters were “representations of Ripple and its efforts.”
Nevertheless, there is a take-home message from this ruling. There is a significant risk that the initial issuance of cryptocurrencies to investors violates the Act and potentially state securities laws, and therefore, should be performed pursuant to an exemption from registration in light of this ruling. Otherwise, the issuer and its promoters risk an SEC enforcement action and/or claims by investors seeking to rescind their investment. Furthermore, whether transactions on digital asset exchanges are deemed securities transactions will greatly depend on the facts and circumstances of each case.