Monday, July 17, 2023

Ripple and Forman

Thanks to Ann for her great "So, Ripple" post last week.  I have been waiting for a case like this—one that engages a court in the details of how the Howey test applies to the way different types of  cryptoassets work.  I was especially interested in how the court in the SEC v. Ripple Labs opinion would handle the different ways in which cryptoassets are sold and traded.  Well, now we have an opinion to work with.

I especially appreciate Ann setting the stage so well with the doctrinal legal background of the case.  Well done, friend!  Like Ann, I teach Securities Regulation every year.  Unlike Ann, I am gleeful about teaching definitional content in the federal securities laws, including the definition of the term "security."  It is amazing how, as financial investment instruments have evolved, significant numbers of practitioners and their clients have paid insufficient attention to the niceties of that definition and the definition of the embedded term "investment contract."

Like Ann, I am comfortable that a single financial instrument can be a security in some contexts and not in others.  And, like Ann, I have questions about the court's analysis in Ripple.  Specifically, I am disappointed in the way the Ripple court fails to take on the profit expectations element of the Howey test head-on—especially as to the "Programmatic Sales" made by Ripple—sales made into the XRP market after Ripple's initial "Institutional Sales" were made.  Instead, the court’s opinion joins the concept profit expectations to the efforts of others in its analysis in ways that I find perplexing.  Undertaking an analysis of the profit expectations piece of the Howey test independently may be hard work.  But it may have been worth the court's while to dig in more on whether the purchasers of XRP expect profits before assessing whether those profits are generated through the efforts of others. 

For this profit expectations part of the Howey analysis, I reflect on the U.S. Supreme Court's opinion in United Housing Foundation v. Forman.  Leaving aside the fact that Forman was really a case about whether stock—not an investment contract—is a security, the Forman Court defines financial instrument profits in three distinct ways:

  • "capital appreciation resulting from the development of the initial investment" (421 U.S. at 852)
  • "a participation in earnings resulting from the use of investors' funds" (421 U.S. at 852)
  • the ability to resell at a price that exceeds the cost of purchase (421 U.S. at 854)

The Ripple opinion somewhat addresses each of these potential types of profit, but not always directly, distinctly, or completely.  The court focuses significantly on the first of the three, noting that "the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP," but that "Programmatic Buyers could not reasonably expect the same." (And I am not sure about that latter piece, by the way.)

Considerations relating to the third profit type, however, may be the most interesting—and challenging in application.  After reading the court's analysis, I still had many questions about whether those who bought the XRP that Ripple was selling in the Programmatic sales were buying because of anticipated market appreciation—appreciation that may be generated in part by the activities of Ripple in establishing and promoting (not to mention selling) XRP—or for more instrumental reasons.  The court finds that "each Institutional Buyer’s ability to profit was tied to Ripple’s fortunes and the fortunes of other Institutional Buyers because all Institutional Buyers received the same fungible XRP."  Yet, those who purchased XRP in Programmatic Sales also receive that same fungible XRP.  In general, I wonder how the Programmatic Sales made by Ripple are different from sales of stock made by, e.g., a founder into a preexisting trading market—an analogy worth considering.

The Ripple court's analysis of profit expectations under Howey in its opinion is, however, combined with its inquiry as to the "efforts of others."  In my teaching, I separate Howey into five prongs: (1) contract, transaction, or scheme; (2) investment of money; (3) common enterprise; (4) expectation of profits; (5) efforts of others.  Overall in my work (as exemplified in this article, in which I apply the Howey test to early crowdfunding interests), I have found it helpful to engage each of these five prongs of Howey independently, then follow with a synthesis that looks at the overall context in which the security determination is being made (including the related "economic realities" of the instrument in the circumstances).  That analysis of context is, of course, invited by the lead-in to Section 2(a) of the Securities Act of 1933, as amended (the “1933 Act”), which qualifies the definitions offered in Section 2(a) by an assessment of whether "the context otherwise requires."

The Ripple court’s failure to keep the two prongs—expectation of profits and efforts of others—analytically separate handicaps the court from addressing the Forman Court's core argument relating to the connection between the investment of money prong and the expectation of profits prong: that an instrument may represent a consumption or other interest, rather than an investment or profit-making interest.  Those who invest do so with the goal of achieving financial gain or another element of value.  The Forman Court's reasoning as applied in Ripple logically would result in a judicial determination of the nature of the XRP interest purchased by those acquiring XRP in the Programmatic Sales, which may well be different from the nature of the XRP interest acquired in the Institutional Sales.  Why were purchasers of XRP acquiring it at the time Ripple was selling in the Programmatic Sales?  What was at the heart of their acquisitions of XRP? The Ripple court fails to grapple with these questions.

The Ripple court does acknowledge in its opinion that some of those purchasers may have acquired XRP because they expected profits—even profits generated through Ripple’s efforts.  The court offers: “Of course, some Programmatic Buyers may have purchased XRP with the expectation of profits to be derived from Ripple’s efforts.”  But it discounts this rationale without offering an alternative.  Instead, the court points out that Ripple never made any promises to the purchasers of XRP who bought in Programmatic Sales.  Yet, explicit promises between a seller and a buyer are not the only conduct that can lead purchasers of financial instruments to expect profits . . . .

In that regard, the Ripple opinion somewhat conflates its Howey analysis of the "efforts of others" with an assessment of whether (and if so, how) Ripple offered to sell XRP to those who bought it (which may be irrelevant since Ripple did sell XRP into the market).  Section 5 of the 1933 Act—the legal provision that the Securities and Exchange Commission asserts Ripple violated—only applies to offers and sales of securities.  Consequently, it would seem logical to determine first whether what was offered or sold is a security and only then to address whether that security was offered or sold by the defendant. 

Instead, in analyzing whether there was an expectation of profits (and whether Ripple's efforts were sufficiently connected with profit generation) under the Howey test, the Ripple court focuses on whether the XRP purchasers knew from whom they were buying and where their money was going, alluding to a privity or tracing requirement of sorts.  Specifically, the Ripple opinion avers that “with respect to Programmatic Sales, Ripple did not make any promises or offers because Ripple did not know who was buying the XRP, and the purchasers did not know who was selling it,” noting that "a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money."  These considerations are more applicable to a determination of whether Ripple was offering or selling securities to a particular purchaser—a consideration relevant in a private action under Section 12(a)(1) of the 1933 Act—than to the determination of whether XRP is a security when it is sold by Ripple into a pre-existing market.

There’s more I could say on all of this, but this post already has gotten quite long.  So, I will leave it here.  Suffice it to say, in addition to the profit expectations analysis in the Ripple opinion, I have questions about the Ripple court’s analysis of the investment of money and expectation of others prongs of the Howey test.  Perhaps some of that will be a good topic for another post . . . .

Ann Lipton, Joan Heminway, Securities Regulation | Permalink


Hi Joan - thanks for this! FWIW, I think the analysis is different than it would be for stock. With stock, the instrument itself represents a claim on the earnings. XRP didn't have that, so the only profit potential was reselling, and if that wasn't viewed as tied to Ripple's efforts, then - per the court - there could be no security.
So I don't think this analysis holds for more traditional assets; it's why I say she kind of sub rosa accepted defendants' argument that you need an actual contract with the issuer to be a security.

Posted by: Ann Lipton | Jul 17, 2023 7:17:17 AM

But I'll add (and if you like you can edit this to include it in my original comment!) I think you're right she combined the prongs in a way that flattens the analysis and makes the logic harder to parse.

Posted by: Ann Lipton | Jul 17, 2023 7:19:45 AM

Thanks for the comment, Ann. I have no disagreement with you on the difference you note w/r/t stock, Ann. (Of course, many stocks don't pay dividends either—and realistically may never pay dividends. But it is still stock!)

I also see your point about demanding a contract for the efforts of others prong. But why? My post doesn’t cover that part of the Howey test, but I am reminded of the controversy over and analyses in the viatical settlement securitization cases. The efforts there were market-oriented efforts. It’s this type of analysis that I was hoping the Ripple court would engage. Maybe more on that later . . . .

Anyway, my main point in this post (admittedly a limited one) is to add to what you wrote and note that the opinion misses an opportunity to adequately explore the profits piece of Howey in the context of XRP. When linked to the investment piece, the profits piece has the potential of offering valuable information. Iow, that piece alone could add meaningfully to our knowledge of where the Howey test may go when it comes to cryptoassets. But I am sure we both will have more to say about this . . . .

Posted by: joanheminway | Jul 17, 2023 7:44:08 AM

Thanks for writing this! IANAL, but I'm very intrigued by the Howey analyses of these crypto cases. This one was a doozy it seems.

I saw on Twitter that Paul Grewal (Coinbase CLO) claimed that the ruling implied that "XRP itself is NEVER a security" because of the text on Page 15: "XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract."

Any thoughts on this? I tried to think about it from an "economic reality" perspective since I'm not very familiar with the case law, and it seems aking to saying that a stock certificate is not a security (which I believe is the case?). If I tried to create a marketplace for people to buy and sell stock certificates, however, it's pretty clear that the economic reality is that I'm operating a securities exchange. The certificate has a sort of "rider" of the contract of share ownership (which could theoretically disappear if, for example, the company ceased to exist), and the share ownership contract is the thing that is the security, correct? It seems like the legal thorn of crypto tokens is that they often carry a similar kind of rider (albeit of a different form than share ownership) but also function as the main product of the company. Should that matter? I could claim that my sale of stock certificates was exempt because the buyers may have been buying them due to a (hypothetical) burgeoning stock certificate art scene, but would this make any difference in the Howey analysis?

Perhaps I'm way out in left field.

Posted by: Alexander Trevelyan | Jul 18, 2023 11:03:10 PM

Welcome to the Howey test nerd club, Alexander. There are more than a few of us out there in this club, as you may know. I appreciate your questions.

I respectfully disagree that the text from the Ripple opinion to which you cite in your comment is definitive on the issue of XRP’s status as a security. For one thing, the Ripple opinion does support the initial XRP sales to institutional investors as securities, and the court grants the SEC’s summary judgment on that issue. But I do think that the court’s somewhat shallow analysis of key elements of the Howey test—investment of money, expectation of profits, efforts of others—offers us less guidance than it could.

I am not sure that I fully understand your “rider” analogy. But I will comment on a few aspects of what you wrote with the thought that it might help.

First off, stock is a separate kind of security than an investment contract. So, let’s leave stock aside for the moment. The Howey test only helps us to determine whether a particular financial instrument or arrangement is an investment contract. Investment contracts are presumed to be securities under Congress’s statutory definition of a security “unless the context otherwise requires.”

The core of the investment contract test under Howey (which involves the five factors I summarize in the post), as it relates to offers and sales of financial products is to get at whether what is being offered or sold looks like other products that we consider investment instruments commonly known/thought of as securities (as opposed to commodities, for example, addressed under a separate congressional enactment). The core of the federal securities law regime is to protect investors, ensure fair markets, and encourage capital formation. We look at the elements of the Howey test with all that in mind.

So, what is it that prospective and actual purchasers of XRP are buying? E.g., are they buying a token to facilitate currency transactions (its asserted instrumental function) or are they buying a token because of its profit potential? The court seems to acknowledge the latter possibility (at least for some purchasers), but never really digs in on the analysis. That’s my beef in the post. Instead, the Ripple court merely asks whether those profits are generated by Ripple’s efforts. I have complaints about that part as well. Among other things, the Howey test asks about the efforts of “others” in assessing investment contract status. Those efforts do not have to be those of the seller.

In any event, if we assume that XRP acquirers are purchasing with the expectation of making a profit, then we must ask what is generating that profit potential—what leads them to expect profits. There are several possibilities. The expected profits could be generated through some action or conduct of the purchaser. Or the expected profits could be generated by the action or conduct of the offeror or seller or someone else. Or the expected profits could result from more generalized market structures or behaviors (e.g., supply and demand factors) that may involve little effort from specific individuals. Importantly, while the Howey opinion requires that we look at whether the profits are expected “solely” from the efforts of others, over the years, courts have softened that part of the test to look at whether the efforts of other are the principal source of profit expectations.

This is where I think the Ripple court further ducks important questions. Given that some people so heavily associate XRP with Ripple that they refer to XRP as Ripple, can we easily say—without analysis—that people are not buying XRP principally because Ripple has designed and promoted XRP as a profitable investment opportunity? And can we easily say, when Ripple has withheld a percentage of the total available XRP for its own use/offer/sale—which enables it to control supply in the market—that the profit expectation of XRP purchasers is not principally attributable to Ripple’s efforts? These are questions I had hoped the court would acknowledge and address.

I hope some of this is helpful. I may write more on it in the future. Ann or others may have more or different analyses to share.

Posted by: joanheminway | Jul 19, 2023 4:46:03 AM

Thanks for the very thoughtful reply! I actually disagree with Mr. Grewal's interpretation of the text from the Ripple opinion as well, but my thoughts on it mostly stem from an "economic reality" analysis, being as I am pretty unfamiliar with relevant case law. My wanting to use stock analogies arises because I'm more familiar with stocks than with other kinds of securities, and stocks are plainly securities so that element is satisfied a priori, but perhaps they're not such an easy sandbox for creating situations to compare with more nuanced instruments.

I think your comments here get to the heart of one of the elements that I am curious about: "So, what is it that prospective and actual purchasers of XRP are buying? E.g., are they buying a token to facilitate currency transactions (its asserted instrumental function) or are they buying a token because of its profit potential?" This, to me, seems like a big thorn. Are there any good examples of other cases where the primary product of an organization also contained the crucial elements of a security?

On the one hand, it seems perfectly reasonable that some people may have purchased Ripple purely because they wanted to use it for its marketplace function (to exchange currencies, I gather), but the economic reality that it could be expected to increase in value based on the efforts of Ripple Labs (or, as you note, simply "others") is inherent in the token nonetheless (though the Ripple judge appears to disagree). The court cannot reasonably discern the individual reason that every unique person purchased XRP on the open market, but I suppose my question is should that even matter? The analogy of the stock certificate was one way that I thought about this—if we assume that people like to collect stock certificates for their artwork, let's say, then could I open an unregistered stock certificate exchange (which lists actively traded public companies) simply because it is likely that some, most, or even all participants are trading them based solely on their appreciation of the artwork? The stock certificate, seeing as it confers ownership of shares in a public company, seems to carry the weight of a security separate from any other utility it may have. This despite the fact that, as far as I am aware, the certificate is not a security in and of itself—hence my concoction of the "rider" on the physical certificate of stock ownership that travels with the certificate for so long as it confers that stock ownership.

Circling back to Mr. Grewal's statement about the court finding that "XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract" meaning that XRP is never a security, a position that as you noted seems undermined by the ruling that XRP sales to institutional buyers constituted a securities offering. My "economic reality" analysis of this statement would be to say "sure, the XRP token in and of itself is not a security, but that's immaterial because it carries the full weight of an investment contract, regardless of whatever other utility it may have, and thus sales and exchanges of this token implicitly derive their value in part from this contract." Again, this is granting that there is such a contract, which is a separate element.

What the court seemed to conclude was that, in the "programmatic sales" aspect, the tokens were not securities in part because they contained some other utility, and the court could not discern whether or not purchasers of the token acted pursuant to this utility. Is this an analysis of Howey that has existed up until this point?

Posted by: Alexander Trevelyan | Jul 19, 2023 2:46:15 PM

Thanks for the additional comment Alexander. If I understand your further probing, I do have some more thoughts for you. But tell me if I misunderstand . . . .

Specifically, you ask: “Are there any good examples of other cases where the primary product of an organization also contained the crucial elements of a security?” I suppose it depends on what you mean by primary product (blockchains, tokens, and related business models being sui generis—in a class of their own), but my general answer is “yes.” There are a few famous cases I would put in this category.

The Howey case itself (SEC v. Howey Co., 328 U.S. 293 (1946)) involves the marketing and sale of fractioned orange groves and related service contracts by a business that owned and harvested from those groves. SEC v. Edwards, 540 U.S. 389 (2004), involved the sale and leaseback of payphones that was found to be a security. There are others . . . .

You conclude by saying, in your comment: “What the court seemed to conclude was that, in the ‘programmatic sales’ aspect, the tokens were not securities in part because they contained some other utility, and the court could not discern whether or not purchasers of the token acted pursuant to this utility.” Maybe. But if so, that means (as I earlier suggested) that the court is ducking an analysis it should be engaging.

Hoping that responds and adds a bit more . . . .

Posted by: joanheminway | Jul 20, 2023 1:10:25 PM

Very interesting! I had to go back and read your original response a couple times to absorb everything and I realized that you'd addressed some of my last comment already, so thanks for bearing with me. Curious to see where this goes, as it seems that everyone expects an appeal in short order.

Posted by: Alexander Trevelyan | Jul 24, 2023 12:34:09 AM

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