Monday, July 17, 2023
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 . . . .