So, Ripple

This week, I was going to blog about the decision in Sobel v. Thompson, 2023 WL 4356066 (W.D. Tex. July 5, 2023), where a Texas district court relied on a forum selection bylaw to dismiss a derivative Section 10(b) claim in favor of Delaware Chancery, which – you guessed it – has no jurisdiction to hear Section 10(b) claims.  The court could have dismissed on the merits, especially given the dismissals of related cases in other jurisdictions, but instead, it purported to follow Lee v. Fisher, which I blogged about most recently here, but of course, Lee v. Fisher involved Section 14, and the court relied heavily on the purportedly-suspect pedigree of derivative Section 14 claims.  The SolarWinds court did not bother with that kind of analysis before extending Lee v. Fisher to derivative 10(b) claims and yeah, pretty much that’s it, you can read Alison Frankel’s Reuters piece here, and in the meantime just call me Cassandra.

Anyway, I was going to blog about all of that, but now I’m not, obviously, because the summary judgment opinion in the SEC’s enforcement action against Ripple finally came down, and I think I’ve made it clear by the absence of discussion that crypto is very much not my thing but sadly I do, in fact, have to teach “What is a security” to my students so I forced myself to read the decision and, well, yikes.

*deep breath*

Section 2 of the Securities Act defines a “security” to mean multiple kinds of instruments (stock, notes, voting trust certificates), and then has a catch-all provision that an “investment contract” is a security.  But “investment contract” is not a recognized type of instrument and so needed a definition.  In 1946, the Supreme Court decided SEC v. Howey Co., 328 U.S. 293 (1946), which laid out the so-called Howey test for whether a new instrument is an investment contract.  There must be an investment of money, in a common enterprise (which usually means pooling of investor resources), with the expectation of profit by the investor, derived from the efforts of others (usually, a centralized management team).

This test is, intentionally, broad, in order to prevent promoters from designing instruments that evade the Act but nonetheless are of the type that Congress felt needed regulation.  (These instruments tend to be ones where the purchaser is vulnerable to disloyalty or shirking by centralized management, and ones where a collective action problem among investors would inhibit bargaining to cure informational asymmetries.  Thus, the need for registration – forced disclosure – before their sale). 

As a result, a number of rather esoteric arrangements have been found to be investment contracts.  In Howey itself, purchasers bought small strips of land in an orange grove, coupled with a service contract to have the oranges cultivated and harvested.  The oranges from all the plots were pooled, sold, with profits returned pro rata to each investor.  The Supreme Court held that these collective arrangements were akin to buying a fractional interest in an orange business with centralized management.  In another case, investors were sold chinchillas, and promised that if they bred them, the seller would repurchase the babies at a higher price and resell them to new investors.  Investors were promised that raising chinchillas was nearly effortless.  It wasn’t, they died, and the Eighth Circuit held that the entire set of arrangements might be the equivalent of investing in a chinchilla business, and hence potentially a security.

In Ripple, the defendants created the XRP Ledger and the XRP token, which had various uses, but critically, would end up being used for cross-border payments.  Like a lot of crypto, XRP was also traded speculatively – people bought it in hopes the price would rise and they could sell it.  Additionally, as I understand it, this dynamic was necessary for the cross-border payments to work.  Someone wanting to transmit US dollars to someone else who would receive payment in Japanese yen would instead use the dollars to buy XRP, and then the XRP would be transmitted on the XRP Ledger, and the recipient would sell the XRP for yen.  That only works if there’s consistent liquidity and transparent pricing.

The defendants generated a lot of XRP token, which they sold to initial investors – mainly institutions – touting XRP as an investment tied to the company’s success.  The funds raised were used to continue to grow Ripple’s business.  Defendants also made a number of public statements about XRP’s potential, including in XRP market reports and on Reddit.

Later, once a secondary market for XRP had developed, defendants sold additional XRP tokens into the market and raised funds that way.  Defendants also paid employees in XRP token, which they could then sell in the secondary market.

The SEC brought an enforcement action claiming that XRP was a security, and therefore all of the defendants sold securities without registering them, in violation of Section 5 of the Securities Act.  The court held that the sales to institutional investors were sales of securities, but not the remaining sales. 

I’ll start with: The holding makes no sense, but to understand where it’s coming from, you need to understand the arguments, which are similar to those made in other crypto cases.

The SEC’s position was this was straight up Howey.  People paid money or other currency; the common enterprise was Ripple itself and the other crypto buyers; they expected to profit by flipping the tokens – and that expectation was cultivated by Ripple itself through its statements about the tokens’ potential – and they relied on Ripple’s management team to develop use cases for the token and otherwise market it to cause the price to rise.

Among the defendants’ arguments was the claim that when the Securities Act uses the phrase “investment contract,” it means there must be something like an actual contract – a promise, or legal obligation, of some kind, between the promoter and the investor.  Howey did not formally include such a requirement, but most of the cases do in fact have such a feature.  In Howey, the promoter promised to cultivate the land, sell the oranges, and distribute the proceeds; in the chinchilla case, the promoter promised to buy back the chinchillas, and so forth.  But with the XRP tokens, there was no obligation between Ripple/the defendants and token holders.  That might not be true for all crypto tokens – there are some where the token holder has some kind of continuing rights against the issuer – but with XRP, there were no such rights.  Therefore, argued the defendants, there was no contract, and no investment contract.

That argument, the court rejected, and decided to apply Howey as written:

The Court declines to adopt Defendants’ “essential ingredients” test, which would call for the Court to read beyond the plain words of Howey and impose additional requirements not mandated by the Supreme Court. The Court sees no reason to do so. Neither Howey, nor its progeny, hold that an investment contract requires the existence of Defendants’ “essential ingredients.” To the contrary, these cases make clear that the relevant test reflects a focus on an investor’s expectation of “profits . . . from the efforts of others,” rather than the formal imposition of post-sale obligations on the promoter or the grant to an investor of a right to share in profits.

The court further found that the initial institutional investors who bought XRP from the defendants clearly did so with an expectation of profit.  They knew Ripple planned on using their funds to develop its business and promote the token, and they agreed to lockups and resale restrictions that only made sense if one was buying as an investment.

When it came to the sales into an existing market, however, it was a different story.  Those buyers were buying in an impersonal market, and had no idea that it was the defendants, rather than anyone else, who was selling to them.  That meant they had no expectation that the money they paid for their tokens would be received by Ripple and plowed back into the business.  And that – said the court – meant they could not have invested with an expectation of profit from Ripple’s efforts.  As the court put it:

Having considered the economic reality of the Programmatic Sales, the Court concludes that the undisputed record does not establish the third Howey prong. Whereas 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, Programmatic Buyers could not reasonably expect the same. Indeed, Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP….

Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract…

It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple

Now, I’m comfortable with the idea that a particular asset may be sold as a security in some instances and not others, because whether something is promoted as “for profit” may depend on the facts and circumstances.  But the distinction the court draws here does not make sense.  The purchasers may not have known they were supplying capital to Ripple, but they knew what the institutional investors knew about Ripple’s intentions.  They knew Ripple was making efforts to expand the business, promote the token, and develop it as an asset.  They almost certainly were motivated to buy it for that reason; Ripple made statements encouraging them to do so.  That they didn’t know their particular moneys would assist that effort isn’t really …. relevant.  Moreover, as I said, the cross border system depended on a liquid market for XRP – of course Ripple would promote one.

What it looks to me is going on is that the court kind of stealthily accepted defendants’ “contract” argument after all, in a way.  The judge held that it was a security for the buyers who had a direct relationship with Ripple and knew where their money was going.  For buyers who had no such relationship, there was no security.

Presumably, the outcome would have been different if, say, the instrument were more like debt sold in an impersonal at-the-market offering.  In those cases, the buyer might not know they were buying from the issuer rather than another trader, but the buyer would know they had a debt claim – a contract, with ongoing obligations – against the issuer.  Thus, an expectation of profit.

In Ripple, buyers in an impersonal market did not have any expectation of profit directly from a contractual relationship (defendants’ argument), and so the court, rather than saying a contractual relationship was necessary, instead said that absent one – by directly supplying capital – there’s no expectation of profit from Ripple’s efforts.  The court split the difference between the defendants’ argument and the SEC’s, and came up with something that is incoherent on its face.

She casually rejected other arguments that the buyers in the impersonal market might have expected profits from Ripple’s efforts even if they did not know they were supplying capital.  She said that Ripple’s public statements – some of which were inconsistent and shared across many different media – were just too complicated to assume an ordinary retail investor, rather than an institutional investor, would have understood:

There is no evidence that a reasonable Programmatic Buyer, who was generally less sophisticated as an investor, shared similar “understandings and expectations” and could parse through the multiple documents and statements that the SEC highlights, which include statements (sometimes inconsistent) across many social media platforms and news sites from a variety of Ripple speakers (with different levels of authority) over an extended eight-year period

And, she noted, the buyers in the open market did not agree to lockups and resale restrictions, the way the institutional investors did.

That also meant the XRP issued to Ripple employees was not a security.  They had not made an investment of money/currency, and they could not have functioned as underwriters with their resales because – again – sales into the impersonal market were not sales of securities.

And, with that, she said remaining issues would go to trial (these include some aiding and abetting claims, I’m not sure what else).

Okay.

Let’s just get out of the way that it’s perverse that sales to institutions are treated as securities because institutions are sophisticated.  That’s backwards; it subverts the purpose of the securities laws (to protect less sophisticated investors) and contradicts other tests for whether assets are securities (the Reves test often weights investor sophistication against finding the presence of a security).

Beyond that, I would not be surprised to see both sides seek an interlocutory appeal, in which case, the Second Circuit would get a crack at it.

What about future crypto cases?  Well, the thing about crypto is, the facts are different in every case.  Assuming the Ripple decision is followed in other cases, some would involve ongoing obligations of some kind between the issuer and the token holder, and in those cases, courts may be more likely to find there was an expectation of profit from the promoter’s efforts.  And some courts may be more sympathetic to claims that public statements promoting the token are sufficient to demonstrate an expectation of profit by open market purchasers.  Those courts don’t even necessarily have to reject the Ripple analysis; they can just distinguish it, and say well, the promoters were more blatant here.