Ripple XRP Decision Addresses When a Digital Asset is a Security: SEC is ‘Disappointed’

The digital assets industry received welcome news from the long-awaited Ripple Labs decision, holding that the XRP token is not a security under the securities laws when it is sold publicly on digital asset exchanges or when it is used as a form of payment for services. Ripple Labs is a major victory for the digital assets industry, because the Court effectively rejected the SEC.’s recent position that virtually all digital assets qualify as securities.  But it is a limited victory, because the Court held that sales of XRP did qualify as sales of securities when Ripple sold XRP directly to institutional investors – and the decision is subject to appeal by the SEC.

In SEC v. Ripple Labs, Inc. et al, (S.D.N.Y., July 13, 2013), the Court ruled on motions for summary judgment on whether sales of the Ripple Labs (“Ripple”) native token, XRP, were sales of securities under the federal securities laws.  The Court reached a split decision:  (1) Sales of XRP publicly on digital asset exchanges or through the use of trading algorithms are not sales of securities; (2) Sales to employees or third parties as compensation for services are not sales of securities; but (3) Sales of XRP directly to sophisticated Institutional Buyers through contracts are sales of securities under the securities laws. 
 
First, in the most significant ruling, the Court held that sales of XRP on digital asset exchanges were not sales of securities, because XRP buyers on exchanges do not have a reasonable expectation that their money is being paid to Ripple to fund managerial efforts to increase the value of XRP.   Sales of XRP on digital exchanges are “blind bid/ask transactions” where buyers do not know the identity of the seller.  And Ripple itself made up less than 1% of the sales volume on digital asset exchanges.  Thus, purchasers of XRP on digital exchanges did not have the expectation that they would profit from Ripple’s efforts, as required for a security under the Howey test’s third prong – as opposed to, for example, profit from general market trends. 

Second, the Court held that sales of XRP as compensation for services to employees and third parties who developed new applications for XRP were not sales of securities.   The Court reasoned that employees and third-party developers did not provide any capital or money to fund Ripple’s efforts to increase XRP’s value – only their services.  Further, the SEC. had not alleged that the employees or third-party developers acted as underwriters by promptly re-selling XRP to other holders. 

Third, the Court held that Ripple’s direct sales of XRP to institutional investors did qualify as sales of securities under the Howey test.  These direct institutional sales involved the investment of capital in a common enterprise to help Ripple promote and increase the value of XRP by developing uses for XRP and protecting the XRP trading market.  In particular, the Court relied on Ripple’s marketing to institutional investors, which promoted Ripple’s “vocal … commitment to XRP” as driving the increase in XRP’s price and trading volume.   These marketing materials emphasized that Ripple’s “entrepreneurial and manager efforts” would increase “the investment potential of XRP.”   The Court also noted that the institutional-investor sales contracts included lockup provisions and resale restrictions to retain capital in the company, which was inconsistent with being a currency.

In reaching its ruling, the Court rejected the Ripple defendants’ arguments that treating digital assets as securities violated due process, or required adopting a different test than the traditional Howey test for deciding whether a transaction is a sale of securities.  The Court noted that the Supreme Court adopted the Howey test, and it was not free to ignore Howey’s plain words or to add new requirements.  Further, the Court held that the long line of case law applying Howey and history of SEC enforcement actions gave the Ripple defendants sufficient notice to meet due process requirements.  The Court also denied the SEC’s motion for summary judgement on aiding and abetting claims against Ripple executives, because there were fact issues about their liability that should be decided at trial. 

The Ripple Labs decision has many important implications.  It is a rejection of the SEC’s position that virtually all sales of digital assets are sales of securities, which is a setback for the SEC in its efforts to widely regulate the entire digital assets industry.[1]  It is a very positive result for Coinbase in its ongoing case against the SEC, because the ruling that sales of a digital asset on a digital exchange are not securities should apply directly in Coinbase’s favor.  Indeed, Coinbase’s stock price jumped by 25% within twenty-four hours of the Ripple Labs decision.   And the Ripple Labs decision will be used as a blueprint in many other cases to defend against claims that digital asset sales are unregistered sales of securities that trigger liability for damages.
Sadis & Goldberg has a dedicated practice focused on Digital Assets and Blockchain Technology.  We are available to discuss all matters related to digital asset and blockchain litigation, investments or fund formation.  If you have any questions about the Ripple Labs decision, this article, or any other digital assets issue, please contact Douglas Hirsch (dhirsch@sadis.com), Sam Lieberman (slieberman@sadis.com), or Frank Restagno (frestagno@sadis.com).