Tuesday, August 29, 2023

Coming Up In Crypto: "The Ripple and Terraform Cases Tee Up a Dramatic Showdown over Cryptocurrency Regulation"

From Columbia Law School's CLS Blue Sky blog, August 14:

On July 31, U.S. District Judge Jed Rakoff in New York decided a case with significant implications for how and even whether the Securities and Exchange Commission can regulate cryptocurrencies as a security. His decision contrasts sharply with a ruling just two weeks before by one of his colleagues on the court and brings at least a little clarity – and common sense – to the issue for regulators, investors, companies, and the public at large.

In ruling on a motion to dismiss, Rakoff held that the cryptocurrencies at issue may be securities and refused to draw a distinction based on whether they were sold directly to institutional investors or on the secondary market. His decision in SEC v. Terraform Labs. Pte. Ltd. rejected the approach in a separate case, Securities and Exchange Commission v. Ripple, et.al., where Judge Analisa Torres did make such a distinction, mangling the so-called Howey Test, which for almost 70 years has determined what is a security or, more specifically, an investment contract. The judges’ conflicting rulings means the Second Circuit will almost certainly decide on appeal one of the most important and confusing securities-law issues to arise in decades.

Back to Basics
When the Securities Act of 1933 was enacted, it allowed the SEC to regulate a variety of securities, including the ill-defined “investment contracts.” In 1946, the Supreme Court handed down a landmark case, Securities and Exchange Commission v. W.J. Howey Co., which laid out a four-part test to determine whether the transaction would be classified as the sale of a security. In short, it required 1) an investment of money 2) in a common enterprise 3) with the expectations of a profit 4) to be derived from the efforts of others.

A Ripple in the Water
In December 2020, the SEC brought an action against the Ripple Labs and several affiliated individuals for the sale of unregistered securities in violation of Section 5 of the Securities Act. The action centered on a token issued by Ripple known as “XRP.” After extensive discovery and a series of initial motions, the Ripple court agreed to hear cross-motions for summary judgment on September 13, 2022.

The Ripple court considered three questions, one with several subparts. The first asked whether XRP is an investment contract defined as a security. The second focused on whether certain transactions involving XRP constituted breaches of the Section 5 registration requirements. The final question asked whether executives at Ripple aided and abetted the company in violating securities laws.

As to the first question, the Ripple court ruled 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.” Many commentators stopped reading at this point and argued that this was a win for Ripple. However, the court went on to say that a totality of the circumstances surrounding the differing transactions by the different defendants must be examined.

Sometimes a Security, Other Times Not?
To answer the second question, the Ripple court examined four broad categories of transactions involving XRP. The first was sales to institutional investors. The second involved so-called “programmatic sales” on digital asset exchanges. The third involved “other distributions” under written contracts. The fourth was sales by individual executives, specifically Chris Larsen, one of the founders and a former CEO of the company, and Brad Garlinghouse, the current CEO of Ripple.

Judge Torres found that the sales to institutional investors constituted a sale of unregistered securities because those investors were “situated in the position of Institutional Buyers.” Such buyers could reasonably understand that Ripple would use the money to improve the XRP Ledger and thus increase the value of the token. The repeated public statements by the company and its executives all seemed to indicate a plan to increase the value of the token. Finally, the buyers were required to comply with lockup provisions and resale restrictions based on the trading volume of XRP – thus they were not purchasing with the intent to resell or otherwise distribute....


This is what Courts of Appeal are made for.