Institutional sales of XRP were securities, court rules

The court in SEC v Ripple has finally ruled on the parties’ summary judgment motions: institutional sales of XRP amounted to illegal securities based on the Howey test, Judge Analisa Torres found Thursday.

“Based on the totality of the circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts,” she said.

The court looked at Ripple’s marketing campaigns and communications, including brochures that touted XRP as an investment in the company’s success. When Ripple released market reports on XRP, it continued to connect the price of XRP to its own efforts. It also pointed to the nature of the sales themselves, which saw buyers agree to lockup provisions and resale restrictions based on the trading volume of XRP, which the court said “are inconsistent with the notion that XRP was used as a currency or for some other consumptive use.”

On the other hand, programmatic sales failed to meet the third prong of the Howey test. ‘Programmatic sales’ refers to the $757 million worth of XRP sold by Ripple on digital asset exchanges via trading algorithms. As these sales were blind bid/ask transactions, buyers could not know whether their money was payments to Ripple or any other seller of XRP.

“An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is 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,” Judge Torres wrote.

The court said that mere speculative motive on the part of a purchaser doesn’t evidence the existence of an investment contract for the purposes of the securities legislation.

Miscellaneous distributions, such as XRP paid to employees and developers to develop for the XRP ledger, were also found to not amount to securities offerings as they failed to meet the ‘investment of money’ prong of the Howey test.

The rest of the XRP trading volume is on the secondary market, which does not qualify as a securities offering under the Howey test.

The court also knocked down Ripple’s ‘fair notice’ defense, which has become a staple in the armory of industry pests in the last year. Ripple tried to argue that no matter what the court’s application of Howey revealed about the legality of XRP, it should be let off the hook because it lacked fair notice that its conduct was illegal.

Quoting an earlier case of United States v Zaslavskiy:

“The abundance of caselaw interpreting and applying Howey at all levels of the judiciary, as well as related guidance issued by the SEC as to the scope of its regulatory authority and enforcement power, provide all the notice that is constitutionally required.”

The court went on to say:

“Defendants focus on the SEC’s failure to issue guidance on digital assets and its inconsistent statements and approaches to regulating the sale of digital assets as investment contracts…But the SEC’s approach to enforcement, at least as to the Institutional Sales, is consistent with the enforcement actions that the agency has brought relating to the sale of other digital assets.”

What it means for digital assets

Though welcomed by Ripple and similarly non-compliant companies within the industry, the result is a mixed bag for anyone hoping the SEC could not enforce the securities laws against digital asset offerings.

The point Ripple can’t avoid is that its sales of XRP to institutional investors amounted to an illegal securities offering. As of July 14, 2023, Ripple has been confirmed to have illegally sold unregistered digital asset securities. This is significant and should be kept in mind as Ripple executives take victory laps on Twitter in the hope it can drown out confirmation that Ripple broke the law.

On the other hand, Ripple has avoided the worst case that every sale of XRP would amount to a securities offering. Since the Howey question is concerned with the circumstances in which the asset is offered instead of the underlying asset itself, this was never on the cards.

It’s also avoided having its sales to customers via exchanges treated as a securities offering on the basis that they were done on exchanges where the buyers could not know they were purchasing from XRP.

This was the narrow reason that XRP offerings in this context escaped classification as a security. However, this leaves a lot of space for XRP sales on exchanges to be found to be securities offerings down the line. Of particular concern to Ripple will be Judge Torres’ comments on secondary market sales generally:

“The court does not address whether secondary market sales of XRP constitute offers and sales of investment contracts because that question is not properly before the court. Whether a secondary market sale constitutes an offer or sale of an investment contract would depend on the totality of circumstances and the economic reality of that specific contract, transaction or scheme.”

So, subject to any appeals, the question of whether XRP was an illegal securities offering is over. XRP was an illegal securities offering when sold to institutional investors. It narrowly escaped a similar finding over the XRP offered on exchanges, but narrow as the escape was, it shouldn’t fill Ripple or any other digital asset provider with much relief.

The case will still head to trial, however. Ripple co-founders Brad Garlinghouse and Chris Larsen must still argue that they did not knowingly broke securities laws, a key element of the SEC’s case.

Reactions to XRP’s designation as a security

Maybe we can now start a rational conversation about crypto regulation in this country.

— Stuart Alderoty (@s_alderoty) July 13, 2023

In his tweet, Ripple’s Chief Legal Officer Stuart Alderoty entirely ignores that it’s arguments like Ripple’s failed ‘fair notice’ that are holding back digital asset regulation as opposed to anything the SEC is doing.

Then there’s Binance, proudly announcing that they never delisted XRP despite the securities risk it posed. Keep in mind that had the XRP decision been tweaked ever so slightly, all of the people who purchased XRP on Binance while the case was going on would now be massively underwater on an illegal security. They still seem destined to end up underwater as the public digests the mixed-bag XRP judgment. Binance’s attitude is no surprise, given they’re currently facing an enormous investigation for illegally listing digital asset securities.

Some see through the spin, however. ZeMing Gao posted his own analysis of the XRP judgment on Twitter:

The judge in the Ripple (XRP) case ruled that:

(1) selling XRP tokens to institutional buyers constituted a sale of unregistered securities because the institutional buyers would have understood what Ripple was promising and doing,

(2) but selling XRP tokens to the public (the…

— Zem Gao (@zeminggao) July 13, 2023

He identifies why it’s so easy for companies like Ripple to rally support for their cause even as the court confirms it had acted illegally.

“A lawsuit initiated by the SEC is to enforce the securities law, not an advocate of grievances on behalf of certain particular group of investors,” he tweeted.

“It is the responsibility of the SEC as well as the court to enforce the securities laws in general in order to protect the entire investment ecosystem. That’s why very often the SEC might seem to be even hurting the existing investors in a case in question.”

“For example, in every Ponzi scheme, enforcing the securities law hurts existing investors because they would be cut off from new supply of greater fools. But it is always the right thing to do to stop a Ponzi scheme.”

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