Last week, the U.S. District Court for the Southern District of New York, known for its handling of major financial crimes including those of Bernie Madoff and Sam Bankman-Fried, ruled favorably for the crypto industry in the SEC v. Ripple Labs, et. al. case. The case was opened in December 2020 when the SEC accused Ripple of selling its native token XRP in an unregistered securities offering, with the court ultimately finding that it had in fact violated the law in the case of institutional sales but had not violated the law in other sales and distributions. The ruling offers an optimistic reading of the 77-year old Howey test for crypto exchanges and individuals while also encouraging caution towards institutional partnerships. Those who have been watching the case and other actions brought by the SEC are right to breathe a sigh of relief, but wrong if they think this will be seen by the SEC as anything short of a clear mandate to file additional suits in line with the court’s ruling.
Ripple’s win in the justice system last week has many observers feeling a shared sense of relief, yet the company’s mission and mechanisms have historically clashed with the community’s shared values. At its founding in 2012, Ripple established itself a provider of blockchain-based cross-border payments targeted at major financial institutions, challenging the worldwide SWIFT monopoly. Ripple initially released 100 billion XRP, which its payments system didn’t require for use, tightly controlled the token via massive holdings, a “Unique Node List” of selected nodes validating its servers, and implemented other features that at the time set it widely apart from BTC’s truly decentralized and permissionless network.
While vying for institutions is not inherently problematic, Ripple’s focus on institutional investors in XRP and mishandling of such endeavors ended up being the only unfavorable ruling for the company in the Southern District of New York. When the SEC brought the case in 2020, it alleged that Ripple sold XRP worth $1.38 billion as securities offerings without registration from 2013 onwards. The lawsuit filed by the SEC on December 22, 2020 makes the following three accusations against Ripple the company (setting aside for now the accusations against former CEO Chris Larsen and current CEO Brad Garlinghouse), along with the court’s ruling in each instance:
1. Sales of XRP to hedge funds and financial institutions counted as a security offering without being registered as such: The court ruled that these were in fact a violation as institutional investors did in fact have an investment contract with Ripple. More on this below.
2. Sales of XRP to the market were a securities offering without being registered as such: The court labels these as “Programmatic Sales” and claims they are not securities offerings and thus did not break the law, in a huge win for the industry.
3. Other distributions of XRP including compensation to employees counted as unregistered securities: On this frivolous charge, the court ruled this doesn’t even satisfy the first prong of the Howey test that there be an investment of money by the recipient, let alone other Howey requirements.
To understand how we got here, it’s important to look at what happened in the two and a half years since the case was opened. Those advocating for a fair interpretation of the Howey test could have speculated a similar outcome to what Judge Torres decided, but the steadfast force of the SEC under Chairman Gary Gensler to pursue regulation by enforcement as well as the intense lack of clarity from the agency regarding what digital asset sales should be classified as a securities offerings has left an huge information vacuum within the community. Ironically, in the original court filing, the SEC accuses Ripple of creating an “information vacuum” by not registering as a security.
In the midst of the case, Ripple was able to secure some wins including release by the SEC of the Hinman documents, which detailed intra-agency discussions surrounding a speech by former Chairman Bill Hinman where he claimed, “based on my understanding of the present state of ether, the Ethereum network and its decentralized structure, current offers and sales of ether are not securities transactions.” Optimism dwindled in November last year when a New Hampshire court ruled that LBRY sales of LBC were in fact unregistered securities offerings in SEC v. LBRY, Inc., with many allegations mirroring those Ripple was facing.
Ultimately, the years of battle was worth the outcome, as it can now be understood that crypto sales on exchanges, blind bids where buyer and seller don’t know each other, and other day-to-day transactions will not be classified as securities offerings in the eye of the justice system. The court also acknowledged the obvious reality that tokens themselves do not count as securities, it is only the sale or distribution of tokens which can be classified as securities offerings. Frustratingly, the agency in charge of regulating securities activity has failed to recognize this basic fact.
Importantly, this judgement has other implications such as rendering the SEC’s ongoing motions against Coinbase and Binance as essentially moot. The SEC cherry-picked a handful of tokens it claimed were sold by the exchanges as securities, despite the fact that tokens in and of themselves are not securities. Judge Torres ruled that similar sales as were occurring on the exchanges, which it labelled “Programmatic Sales” by Ripple were not required to register as securities under current law. Finally, since the act of selling is what is considered for purposes of the Howey test and Coinbase and Binance exchange all tokens in a similar fashion, unless there is an additional investment contract on the exchange for handful of tokens singled out by the SEC, their distribution should be treated like all others. Therefore, not securities offerings.
Another important note is that the court’s summary judgement relied heavily on the SEC v. Telegram Group, Inc. case that was settled in 2020, showing that the justice system has little other relevant case law to base digital asset decisions on. The SEC has brought more than 130 crypto lawsuits to date according to Cornerstone Research, with the Ripple case being the first true loss for the agency. While the agency must re-evaluate moving forward, in any instance where there is even a hint of an investment contract as was formed between Ripple and institutional investors, the SEC will aggressively pursue and likely win its case.
Furthermore, many are speculating as to whether the SEC will appeal this decision, a move that would align with its typically aggressive approach to crypto. While the appeals process would take years, as noted by Brad Garlinghouse since the decision, appealing would be the SEC’s only chance to have any semblance of an argument in other currently outstanding cases. This means it must either appeal or dramatically alter its crypto stance if it wants to rack up court wins. Given that Gary Gensler still has three more years left of his term as Chairman and Congress is unlikely to pass dramatic changes to law while control is split between the parties, especially with a presidential race coming into full swing, the SEC will probably hold strong on its position and even bring more cases.
As a final point to consider moving forward, the judge’s decision in large part centered around her view that “Institutional Buyers were sophisticated entities, including institutional investors and hedge funds… [who] would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts.” Whereas people buying from exchanges are “generally less sophisticated as an investor,” and wouldn’t have understood the legal ramifications of their XRP holdings or have been able to “parse through the multiple documents and statements that the SEC highlights.”
Based on this supposed limited understanding of regular crypto holders, there was no investment contract. While the judge overall made the right call by ruling that market sales were not securities offerings, she got it wrong on how knowledgeable the industry is. This win may soon create a paradox whereby individuals and projects will become more sophisticated due to this ruling, potentially jeopardizing the lack of understanding of an investment contract in future cases.
In sum, there is still a long road ahead to real clarity until new laws are passed to definitely govern crypto.
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