Judge Analisa Torres’ greatly anticipated Order in the SEC’s lawsuit against Ripple is a split decision. The Order basically finds that Ripple’s digital token XRP is a security when sold privately to individuals and institutional investors pursuant to purchase agreements, but is not a security when sold on a digital asset exchange where sellers don’t know who’s buying and buyers don’t know who’s selling. Although the Order should be perceived as at least a partial victory for crypto, it perversely upends a fundamental tenet of the securities laws which is that the laws are designed to protect those who cannot fend for themselves. Moreover, the finding that digital tokens sold anonymously on digital asset exchanges is not a security also seems to contradict the “fraud on the market” theory of securities liability.
The SEC brought this lawsuit against Ripple and two of its executives in December 2020, arguing the defendants offered and sold over $1.5 billion of XRP without registration or exemption in violation of Section 5 of the Securities Act of 1933. You can read more in my blog post here from two years ago about Ripple and about the SEC’s complaint. In September of 2022, both sides filed motions for summary judgment. On July 13, Judge Torres granted the SEC’s motion for summary judgment as to private “institutional sales”, and granted Ripple’s motion for summary judgment as to “programmatic sales” on digital asset exchanges.
At the heart of this case was the issue that’s been central to just about every other enforcement action brought by the SEC in the digital asset space: whether XRP is an “investment contract” and thus a type of security as defined by the Securities Act of 1933. Under the standard set forth in the seminal 1946 Howey case, an investment contract requires (i) an investment of money, (ii) in a common enterprise, (iii) with a reasonable expectation of earning a profit through the efforts of others.
Ripple engaged in two distinct types of XRP sales: private “institutional sales” under written contracts for which it received $728 million, and “programmatic sales” on digital asset exchanges for which it received $757 million. Judge Torres analyzed the two transaction types through the lens of Howey, and both turned on Howey’s third prong: whether or not the investors had a reasonable expectation of earning a profit through the efforts of others.
Ripple sold $728 million of XRP to sophisticated individuals and entities (the “institutional buyers”) pursuant to written contracts.
The court cited precedent showing that “profit” includes increased value of the Investment. Further, “reasonable expectation of profit from the efforts of others” need not be the sole reason a purchaser buys an investment, as an asset can be sold for both consumptive and speculative uses. The inquiry is an objective one, focusing on the promises and offers made to investors; it is not a search for the precise motivation of each individual participant.
Based on the totality of the circumstances, the Court found that reasonable investors in the position of the institutional buyers would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts. Based on Ripple’s communications and marketing campaign and the nature of the institutional sales, the Court determined that reasonable investors would have understood that Ripple would use the capital to improve the market for XRP and develop uses for the XRP network, thereby increasing the value of XRP.
The Court reached the opposite conclusion as to the $757 million of “programmatic sales” to public buyers on digital asset exchanges. Whereas the institutional buyers reasonably expected that Ripple would use the capital it received from them to improve the XRP network and increase the price of XRP, programmatic buyers on digital asset exchanges could not reasonably expect the same.
Ripple’s programmatic sales were blind bid/ask transactions, and buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. Also, Ripple’s programmatic sales represented less than 1% of the global XRP trading volume, meaning that the vast majority of XRP buyers on digital asset exchanges did not invest their money in Ripple at all. Unlike institutional buyers who purchased XRP directly from Ripple pursuant to a contract, programmatic buyers stood in the same shoes as secondary market purchasers who don’t know to whom they were paying their money.
While some programmatic buyers may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts, a proper inquiry focuses objectively on the promises and offers made to investors, and is not a search for the precise motivation of each individual participant. Ripple didn’t make any promises or offers to these buyers because Ripple didn’t know who was buying the XRP, and the purchasers didn’t know who was selling. There was also no evidence that any of the promotional materials that Ripple provided to the institutional buyers were distributed to the general public.
The Court’s split decision provides helpful guidance to the crypto industry as to circumstances under which a digital token would be deemed a security and when it wouldn’t.
But the ruling that a digital token is a security when it’s sold to sophisticated investors but not when it’s sold to retail investors would lead to perverse results as a matter of policy in that those who have the wherewithal to defend themselves and have the leverage to negotiate for contractual safeguards will nevertheless receive the protections of the securities laws, yet retail investors will not. That seems to upend a fundamental tenet of the securities laws which is that they are intended to protect those who cannot fend for themselves.
Also, the ruling seems to contradict the “fraud on the market” theory of the securities laws. In a securities fraud case, a plaintiff does not need to prove that he relied on a company’s fraudulent misstatements or omissions. A plaintiff need only show that the company’s misrepresentations were material and publicly known, that the stock traded in an efficient market and that the plaintiff traded in the company’s stock during that time. The rationale here is that an investor who trades in a public market stock relies on the integrity of the price of that stock, and because most publicly available information is reflected in the market price, an investor’s reliance on any public material misrepresentations is presumed for purposes of a securities fraud action.
In his July 14 Money Stuff column, the ever creative Bloomberg columnist Matt Levine analogizes this to a company like Meta, which once upon a time sold an aggregate of approximately $11 billion in its IPO and one follow-on offering, but hasn’t sold any shares to the public in many years. People buy and sell approximately that much of Meta stock to each other — on any given day! – yet very few of those people ever look at Meta’s SEC filings. Nevertheless, if it turned out that Meta had made a material misstatement or omission in one of those filings, it would not be able to argue that the case should be dismissed because most of the retail traders in the stock didn’t even read the disclosures in the filings. Yet that is the implication of the Court’s ruling in Ripple.
 The Order also found that XRP is not an investment contract and thus not a security when offered and sold by Ripple to employees as compensation (because it failed the “investment of money” prong inasmuch as no consideration was paid for the Tokens) and when insiders sold XRP on digital asset exchanges (for the same reason that XRP sold by Ripple on exchanges were not deemed investment contracts, i.e., seller and buyer anonymity).