Ripple and Terraform: A Securities Law Framework for Crypto Begins to Take Shape
There has been a flurry of crypto enforcement news recently, including the Securities and Exchange Commission (“SEC”) suing two major crypto exchanges, Coinbase, Inc. and Binance Holdings Ltd. (“Binance”). The Coinbase and Binance lawsuits represent an existential threat to centralized crypto exchanges that, in part, hinges on whether tokens sold in secondary markets are securities. At the same time, two conflicting rulings last month in the SEC’s ongoing lawsuits against Ripple Labs, Inc. (“Ripple”) and Terraform Labs Pte Ltd. (“Terraform”) provide a possible framework for determining when a digital asset is a security.
On July 13, 2023, Judge Analisa Torres of the U.S. District Court for the Southern District of New York (“SDNY”) issued a summary judgment ruling regarding sales of Ripple’s token, XRP. Judge Torres issued a split ruling, finding that direct sales of XRP to institutional investors were a securities offering whereas “programmatic sales” to retail investors on digital asset exchanges were not. Judge Torres’ decision came down to whether XRP qualified as an “investment contract”—a type of security—under federal securities laws. The court, applying a three-pronged test first established by the Supreme Court in SEC v. W.J. Howey Co., defined an investment contract as:
a contract, transaction or scheme whereby a person (i) invests money; (ii) in a common enterprise; and (iii) is led to expect profits solely from the efforts of the promoter or a third party.
Although the court analyzed four types of XRP distributions under the Howey test, the first two are most relevant here: (i) sales of XRP made directly to institutional investors; and (ii) programmatic sales of XRP on digital asset exchanges. Judge Torres found that the initial sale of XRP to institutional investors met all three prongs of the Howey test. Notably, she found that Ripple’s marketing efforts caused the institutional investors to believe that their capital would be used to improve the XRP ecosystem and thereby increase the token’s value. In contrast, Judge Torres found that the programmatic sales of XRP on digital asset exchanges to retail investors failed the third prong of the Howey test because the investors could not have known whether they were purchasing XRP from Ripple.
Huge win for crypto. Hoorah! But wait….
Several days later, on July 31, 2023, Judge Jed Rakoff—also from the SDNY—denied Terraform’s motion to dismiss, finding that the SEC adequately pled that sales of Terraform’s UST, LUNA and MIR tokens (collectively, the “Terraform Tokens”) are securities. In determining whether the Terraform Tokens are investment contracts and, in turn, securities, Judge Rakoff applied the Howey test and found that Terraform had “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting the profitability of the crypto-assets and the managerial and technical skills that would allow the defendants to maximize returns on the investors’ coins.”
Judge Rakoff went on to expressly rebuke the Ripple decision:
[t]he Court declines to draw a distinction between these coins based on their manner of sale, such that coins sold directly to institutional investors are considered securities and those sold through secondary market transactions to retail investors are not. In doing so, the Court rejects the approach recently adopted by [Judge Torres].
Howey makes no such distinction between purchasers. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary re-sale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.
A few days later, on August 9, 2023, the SEC announced it will seek an interlocutory appeal of Judge Torres’ decision regarding the programmatic sales of XRP.
Although the SDNY’s decision in Ripple has limited precedential value and the SEC’s appeal was expected, it marked the first significant judicial pushback to the SEC’s perceived “crypto regulation through enforcement” campaign. If Judge Torres’ analysis were adopted as a judicial framework for applying the Howey test to digital assets, the SEC would be hamstrung in enforcement actions against certain token issuers and exchanges. Many commentators were quick to cite the decision as bullish for the prospects of Coinbase and Binance.
However, the Ripple framework never quite made sense, and the Terraform decision throws several gallons of cold water on it. The divergence between the Ripple and Terraform rulings ultimately comes down to Judge Rakoff’s refusal to draw a distinction between direct sales to institutional investors and secondary market sales to retail investors. This seems right—asserting that a reasonable retail investor would not have seen or understood Ripple’s public marketing campaign is dubious. Further, Judge Rakoff’s approach is better aligned with protecting retail investors, a core policy objective of existing securities laws.
Some additional notes:
- Judge Rakoff agreed with Judge Torres that digital assets are not de facto securities. This is correct. There are myriad examples of cryptocurrencies that are not part of an investment scheme (e.g., certain gaming tokens) or are sufficiently decentralized to not qualify as an investment contract under the Howey test (e.g., BTC).
- Neither court addressed the crypto elephant in the room: Can a token initially issued as an investment contract become sufficiently decentralized to “evolve” into a utility token? (Or, in the case of ETH, can a token evolve from an investment contract to a sufficiently decentralized utility token and then potentially back to an investment contract with the launch of Ethereum 2.0 and its proof of stake system. Simple stuff.)
- The inconsistency between these rulings—along with the dizzying logic of the previous note—underscores the need for legislative clarity to fill the regulatory gaps in applying US securities laws to digital assets. Although a recent House bill that would expand the CFTC’s oversight of digital assets has gained traction, it is not expected to clear the Senate.
- There are legitimate criticisms of the SEC’s public posturing with respect to crypto and its unwillingness to engage with industry participants. However, those are topics for another post. Our analysis here is limited to applying current US securities laws to the sale of tokens as a means for raising capital for development.
In light of the Ripple and Terraform rulings, we see the following framework emerging for sales of digital assets:
- The Howey test should be applied on a transaction-by-transaction basis, but also: If tokens are initially sold in a manner that constitutes an investment contract—and in a manner in which the tokens have equity-like characteristics—sales on an exchange or other secondary market will continue to qualify as investment contracts (on a transaction-by-transaction basis) unless the token evolves into a utility token. This approach begs the question of when a token originally sold as an investment contract can become sufficiently decentralized to no longer be considered a security, but it still supports the SEC’s position that tokens issued as a means for raising capital for development are generally securities.
- Put another way: If we think of certain tokens as equity+ (digital assets with equity-like characteristics plus the added use of blockchain functionality), it doesn’t make sense for those tokens to fall outside the scope of US securities laws simply because they contain an additional layer of use. However, it does make sense that “equity+ tokens” could become sufficiently decentralized to evolve into utility tokens. Maybe the next court will tackle the “sufficiently decentralized” question.
We are closely monitoring both cases along with the broader US regulatory environment for digital assets. Please feel free to reach out to us should you have any questions.
 While declining to address whether secondary market sales of XRP constitute investment contracts, the court seemed to imply as much by reasoning that the programmatic sales were not investment contracts because the retail investors “stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying money.”