Former SEC Official's Interpretation: Is the Ripple Ruling Worth Celebrating for the Crypto World?

Author: John Reed Stark, former Director of the SEC's Cyber Enforcement Division

Compiled by: Wu Says Blockchain

The recent Ripple ruling has been extensively reported as a painful defeat for the SEC, and endlessly praised on social media as an exciting and well-deserved failure for the SEC/Gary Gensler. Indeed, it is a loss for the SEC.

However, in my view, this ruling is built on an unstable foundation, is likely (and already poised) to be appealed, and may very well be overturned, thus not necessarily worthy of celebration.

Ripple Decision: Category One, "Institutional Sales"

Regarding the issuance of securities, the court categorized Ripple's issuance into three categories and ruled on each category separately: 1) Institutional Sales; 2) Programmatic Sales; and 3) Other Sales.

For the first category, the court ruled that Ripple's institutional sales of XRP to knowledgeable individuals and institutions with written contracts constitute securities when XRP is sold to institutional investors, thus constituting an illegal sale of securities. Therefore, these investors have the right to rescind, and Ripple must pay the price for the violations. Reportedly, the amounts involved in these sales reached $720 million.

The court stated: "Based on all the circumstances, the court finds that a reasonable investor in the position of institutional buyers would purchase XRP with the expectation of profiting from Ripple's efforts. Given Ripple's communications, marketing activities, and the nature of the institutional sales, a reasonable investor would understand that Ripple would use the capital obtained from the institutional sales to improve the market for XRP and develop uses for the XRP ledger, thereby increasing the value of XRP."

The court also ruled that a jury is needed to determine whether Ripple's senior executives aided and abetted Ripple in conducting unregistered offerings.

Ripple Decision: Fair Notice

The court ruled that at least in terms of institutional sales, Ripple had fairly been aware that unregistered offerings were illegal, rejecting Ripple's due process defense. The court stated:

"The court rejects the defendants' fair notice and vagueness defense regarding institutional sales. First, the case law defining investment contracts provides a reasonable opportunity for an ordinary person to understand the conduct it encompasses… Howey provides a clear test to determine what constitutes an investment contract, and subsequent cases provide guidance on how to apply this test to various factual scenarios… This is constitutionally sufficient to satisfy due process requirements. See United States v. Zaslavskiy, No. 17 Cr. 647, 2018 WL 4346339, at *9 (E.D.N.Y. Sept. 11, 2018) ('At all levels of the judicial system, the rich case law interpreting and applying Howey, along with the SEC's relevant guidance regarding its regulatory authority and enforcement scope, provides all the notice required by the Constitution.').

Second, the case law presents sufficiently clear standards to eliminate the risk of arbitrary enforcement. Howey is an objective test that provides the necessary flexibility to assess a wide range of contracts, transactions, and schemes. The defendants focus on the SEC's failure to provide guidance on digital assets and its inconsistent statements and practices regarding the regulation of digital assets as investment contracts… but at least in terms of institutional sales, the SEC's enforcement approach is consistent with the agency's enforcement actions regarding the sale of other digital assets to buyers under written contracts to raise funds. See, e.g., Telegram, 448 F. Supp. 3d 352; Kik, 492 F. Supp. 3d 169. Moreover, the law does not require the SEC to issue warnings to all potential violators, whether individuals or industries…"

However, the court also noted in a footnote: "Because the court finds that only institutional sales constitute the offering and sale of investment contracts, the court has not addressed the defendants' fair notice defense regarding other transactions and schemes. The court's ruling is limited to institutional sales, as the SEC's theory regarding other sales in this case may be inconsistent with its enforcement in prior digital asset cases."

Thus, the court seems to take seriously the position of the crypto world that the SEC's information on how to apply the Howey test to secondary market transactions of tokens is confusing and inconsistent.

Ripple Decision: "Essential Elements Test" and "Investment of Money"

The court rejected Ripple's attempt to reshape the Howey test with a new test called the "Essential Elements Test," stating:

"In fact, in the seventy-five years of securities law cases following Howey, courts have found the existence of investment contracts even in the absence of the defendants' 'core components,' including in recent digital asset cases in this district. This makes sense because the purpose of the Howey test is to 'embody a flexible rather than static principle that can adapt to the countless and variable schemes designed by those seeking to use the money of others for profit.' 328 U.S. at 299. In other words, the purpose of the Howey test is to achieve 'a statutory policy of broad protection for investors,' which 'should not be thwarted by unrealistic and irrelevant formulas.'

The court also dismissed Ripple's argument that, for the purposes of the Howey test, 'investment money' is distinct from 'merely paying money,' pointing out:

"The defendants argue that 'investment money' is different from 'merely paying money'—that is, Howey requires not only the payment of money but also the intent to invest that money… Not so. The distinction claimed by the defendants is not supported by case law. The proper inquiry should be whether these institutional buyers 'provided capital,'… or 'paid' cash."

Ripple Decision: Category Two, "Programmatic Sales"

For the second category of investors, namely the public (referred to by the judge as 'programmatic buyers' of digital asset exchanges), the court ruled that because there is no actual relationship between exchange customers and Ripple, when institutional investors or Ripple anonymously sell XRP to exchanges, XRP is no longer a security.

The court seems to have made an assumption that programmatic buyers do not expect to profit from the issuer's efforts but may expect profits from other factors, such as general trends in the cryptocurrency market, especially since the court speculated that programmatic buyers are unaware of whom they are purchasing tokens from.

The court stated: "Considering the economic realities of programmatic sales, the court concludes that the undisputed record does not establish the third prong of Howey. While institutional buyers reasonably expect Ripple to use the capital it obtains from sales to improve the XRP ecosystem, thereby increasing the price of XRP… programmatic buyers cannot reasonably expect the same. In fact, Ripple's programmatic sales are blind bidding/asking transactions, where programmatic buyers cannot know whether their money is going to Ripple or to any other seller of XRP… An institutional buyer purchases XRP directly from Ripple under contract, but the economic reality is that a programmatic buyer is in the same position as a secondary market buyer who does not know who they are paying or what they are paying for… Of course, some programmatic buyers may purchase XRP with the expectation of profiting from Ripple's efforts. However, 'this inquiry is an objective investigation into the commitment and provision to investors; it is not a search for the precise motivations of each participant.'

… Here, the record confirms that with respect to programmatic sales, Ripple made no commitments or provisions because Ripple does not know who is purchasing XRP, and the purchasers do not know who is selling… Programmatic sales also lack the other factors present in the economic realities of institutional sales that favor the discovery of 'reasonable expectations of profits from the entrepreneurial or managerial efforts of others'… For example, programmatic sales were not conducted under contracts containing lock-up provisions, resale restrictions, indemnification clauses, or purpose statements.

Similarly, Ripple's promotional materials, such as the 'Ripple Primer' and 'Gateways' brochures, circulated widely among potential investors like institutional buyers. However, there is no evidence that these documents were widely distributed to the general public, such as XRP purchasers on digital asset exchanges. There is also no evidence that programmatic buyers understood the statements of Larsen, Schwartz, Garlinghouse, and others as representative of Ripple and its efforts.

Finally, institutional buyers are experienced entities, including institutional investors and hedge funds… 'A comprehensive examination of the understanding and expectations of both parties,' including 'the full set of contracts, expectations, and understandings regarding the sale and distribution of' XRP, supports the conclusion that a reasonable investor, if in the position of institutional buyers, would understand that Ripple's marketing activities and public statements link the price of XRP to its own efforts… There is no evidence that a reasonable programmatic buyer, who as an investor is typically not sophisticated enough, could have similar 'understandings and expectations' and could penetrate the multiple documents and statements emphasized by the SEC, including statements made by various Ripple speakers (with different levels of authority) over an eight-year period on many social media platforms and news sites (sometimes inconsistently)."

Ripple Decision: Category Three, "Other Sales"

The final category of XRP issuance and sales is based on written contracts for "Other Distributions," with Ripple recording $609 million in "non-cash consideration" in its audited financial statements. These other distributions include distributions as compensation to employees and distributions to third parties as part of Ripple's Xpring program to develop new XRP and XRP ledger applications.

The court stated: "Other distributions do not satisfy the first prong of Howey, which requires the investment of money in a transaction or scheme… Howey requires proof that the investor 'provided capital,' 'invested their money,' or 'provided' cash… 'In every [finding of investment contract] case, the purchaser relinquished some tangible, definable consideration to obtain a benefit of a security nature'… Here, the record shows that the recipients of other distributions did not pay Ripple money or 'any tangible, definable consideration.' Instead, Ripple paid these employees and companies in XRP.

Moreover, in fact, there is no evidence that 'Ripple raised funds for its projects by transferring XRP to third parties and then allowing them to sell XRP,' as Ripple never received payment from these XRP distributions… The SEC did not develop such an argument that these secondary market sales constitute the offering or sale of investment contracts, especially since the payments for these XRP sales were never traced back to Ripple, and the court could not make such a ruling. Therefore, after considering the economic realities and all circumstances, the court concludes that Ripple's other distributions do not constitute the offering and sale of investment contracts."

Does the Ripple ruling make sense to me? It does not.

In my personal view, the Ripple ruling is troubling in multiple respects.

The SEC's position is that this is a traditional application of Howey. "People paid money or other consideration; the common enterprise is Ripple itself and other cryptocurrency buyers; they expect to profit by selling tokens—this expectation is cultivated by Ripple itself through statements about the token's potential." The SEC's position seems quite straightforward and aligns with its mission—to protect investors. The Ripple ruling seems at odds with the SEC's mission and authority.

First, the Ripple ruling grants institutional investors full SEC protection, along with all the remedies associated with SEC violations, including rescission, fines, penalties, etc. However, retail investors receive no SEC protection at all. This seems at least inverted.

Second, the Ripple ruling seems to declare that if any cryptocurrency issuer sells their tokens through an exchange, then securities laws do not apply because the exchange's customers are deemed to be completely unaware of the cryptocurrency issuer.

But mere ignorance or unwillingness to research on the part of investors has never been a valid defense against securities violations.

Moreover, I do not believe retail investors are that ignorant. Buyers may not know they are providing capital to Ripple, but they likely know the same information about Ripple's intentions as institutional investors. Retail investors choose XRP for a reason—because they believe the price of XRP will rise due to Ripple's efforts. Ripple encourages retail investors to buy XRP. This seems axiomatic.

The Ripple court seems to believe that if the issuer does not know who is purchasing their tokens, and the purchasers do not know who is selling the tokens, then even if the issuer uses the proceeds from the original, initial sale of the tokens to fund the issuer's operations, the tokens are not securities.

Following this reasoning, the Ripple court acknowledges that it is likely that many programmatic buyers purchase XRP tokens with the expectation of profiting through Ripple, yet still assumes the opposite.

How could any buyer not know who the issuer is? How is this not considered preordained? Furthermore, there is no contract between buyers and sellers on the exchange, but the lack of a contract does not somehow strip stocks of their identity as securities. Additionally, under Howey, why would knowing who the counterparty is matter? The question is whether investors can expect to profit from the efforts of known or unknown third parties.

Even if a token purchaser refuses to read or understand any information about the issuer, that should not render the token "not a security." Consider why many token purchasers buy tokens in the first place. Unlike traditional investments, token purchasers cannot view financial statements (none); cannot view balance sheets (none); cannot view cash flows (none); etc.

Thus, the typical basis for purchasing tokens is speculation, namely that someone else is willing to pay a higher price (a.k.a., the "greater fool theory"). Even if retail investors purchase tokens solely based on the greater fool theory, even if token purchasers do not know from whom they are buying tokens, the investment should still be a security.

How can a token be a security when sold to institutional investors, and then miraculously transform into "not a security" when those institutional investors or the issuer themselves sell the tokens on Coinbase or Binance?

The Ripple court states: "Institutional investors have reason to expect that Ripple will use the funds obtained from its sales to improve the XRP ecosystem, thereby increasing the price of XRP." But investors using exchanges "cannot reasonably expect the same."

This seems to directly contradict the fundamental concept of investment. For example, when purchasing Apple stock (or any other stock) on any registered exchange, Apple stock never loses its identity as a security after its IPO.

Moreover, no one buys Apple stock directly from Apple. Typical investors buy Apple stock from people they do not know, and this anonymity does not affect whether Apple stock is a security. The Ripple ruling somehow distinguishes between Apple's IPO and trading and the ICO and trading of tokens.

When anyone purchases a share of Apple stock, they do not know from whom they are buying the stock, and Apple does not know who the purchaser is. Yet, Apple stock retains its characteristics as a security. The analysis of tokens should be no different.

Employees and Third Parties

The court's distinction regarding the gifting of tokens to employees and third parties also lacks much significance. Employees providing services to the protocol and third parties developing applications for the protocol are clearly receiving compensation in the form of tokens, just as employees or third parties receiving compensation in the form of restricted stock units or stock options.

How can it be said that XRP tokens granted ("airdropped") have no contractual consideration whatsoever? In fact, the consideration required by Howey may be minimal, even symbolic, and this is not typically a contested issue in Section 5 cases related to crypto.

However, despite the obvious "two-way contractual consideration flow" in Ripple's relationships with employees and third parties, the court concluded that the necessary contractual consideration still does not exist, and employees and third parties did not pay Ripple "tangible or definable consideration."

SEC "Free Stock" Cases

In fact, there are SEC precedents (albeit untested) that contradict the Ripple court's decision regarding the amount of consideration required to trigger Howey's registration requirements.

Token airdrops seem similar to the so-called "free stock" enforcement actions, which the SEC initiated in 1999, when the SEC sued four promoters and two internet companies that offered and distributed free stock through online websites without properly registering their offerings. In these cases, despite the stocks being given to subscribers completely free of charge, the nominal consideration involved was sufficient to trigger Section 5's registration requirements.

At the time, SEC enforcement director Richard H. Walker stated: "In these cases, 'free stock' is actually a misnomer. While there is no cash transaction, the issuing companies received valuable benefits. In these cases, securities laws grant investors the right to full and fair disclosure, but they did not receive that in these cases."

I distinctly remember these free stock enforcement actions and was involved in handling all four cases during my tenure at the SEC. It seemed that everyone with an email account received someone's free stock offer, so the free stock enforcement actions garnered media attention at the time.

In these four cases, investors were required to register on the issuer's website and disclose valuable personal information to receive shares. Recipients of free stock would sometimes also receive additional shares for referring extra investors or, in other cases, linking their own website to the issuer's website, or purchasing services offered by the issuer. In the free stock cases, just like in Ripple, the issuers gained value through these marketing tactics by incubating their shares' primary public market, increasing their business, creating public interest, boosting their website traffic, and in two cases, stimulating interest in a potential public offering.

Based on a series of precedents related to Howey, the "investment of money" for Howey purposes does not actually need to include a transfer of funds. See, e.g., Capital General Corp., Securities Act Rel. No. 7008, 54 SEC Docket 1714, 1728-29 (July 23, 1993) (Capital General's "gift" of securities constituted a sale because it was a valuable disposition, 'value' 'arising from the creation of a public market for the issuer's securities'). See also SEC v. Harwyn Industries Corp., 326 F. Supp. 943 (S.D.N.Y. 1971).

Therefore, when the purpose of the "gift" is to advance the economic goals of the donor rather than for altruistic reasons, the gifting of stock constitutes a "sale" as defined by the Securities Act. This case law may counter the Ripple court's decision to refuse to consider employee and third-party Ripple distributions as securities due to a lack of consideration.

A Quick Note on Precedents and Appeals

The trial order in the Ripple case is a partial summary judgment from a single district court judge. While it is important and worthy of study, this decision is not binding on other courts.

Moreover, just like insider trading cases, cryptocurrency cases are always different, sometimes subtly, sometimes significantly, but always different. Some cryptocurrency issuance cases may involve stronger relationships between buyers and sellers, with ongoing obligations that may create more apparent investor expectations of profiting from the promoter's efforts. Additionally, some courts may distinguish Ripple, for example, based on the impact of marketing activities on retail investors. Such analysis is clearly conducted on a case-by-case basis according to the totality of the circumstances.

The Ripple ruling may also be appealed. In fact, given the unprecedented nature of the ruling, the court is likely to certify an immediate interlocutory appeal, and the Second Circuit Court of Appeals may take action to hear the appeal.

The Ripple case can also be said to conflict with the SEC's case against Telegram, which was ruled by the same district court as Ripple. As Preston Byrne correctly pointed out, in Telegram, Judge Kevin P. Castel "linked the buyers' profit expectations to 'Telegram's fundamental entrepreneurial and managerial efforts,' rather than to the entrepreneurial and managerial efforts of intermediaries selling Telegram SAFT contracts to everyone and their grocer at the time.

It was 'Telegram's commitment to develop the project,' rather than the resale efforts of intermediaries, that the court found constituted the 'essential efforts of others' for this Howey factor. This seems to contradict the Ripple court's analysis and creates conflicting decisions within the same district.

Looking Ahead

The Ripple ruling is troubling in multiple respects, particularly the distinction between private sales and public sales (which I will label as "public sales"), where the former involves accredited investors purchasing XRP directly from the company in bulk, while the latter involves the notion of selling tokens to anyone on cryptocurrency trading platforms.

First, the Ripple ruling seems to establish a class of quasi-securities that vary and differentiate based on the sophistication of the investors purchasing the securities. This seems counterintuitive, inconsistent with SEC case law, and is unprecedented in this context. The Ripple court essentially claims that Ripple's marketing efforts and business operations are too complex for ordinary retail investors, but not for institutional investors, who would understand what it truly means to invest in a token.

In other words, retail investors are generally presumed to be foolish, so the court refuses to assume that retail investors expect to profit from Ripple's efforts. This not only seems condescending but is downright insulting.

Second, the Ripple ruling seems to suggest that if a company sells tokens to a savvy VC firm, then that sale will render the tokens securities. However, if a company sells those same tokens to an exchange, which then sells the tokens to a random retail trader, then the tokens are no longer securities and become "non-securities." The transformation of tokens into "non-securities" is predicated on the assumption that retail traders do not understand what they are purchasing and, like any stock exchange, do not know who the seller is.

This argument seems to contradict the sacred and fundamental principles of investor protection. Whether or not investors read or are unable to read materials related to their purchases should not determine the level of protection investors receive. In any case, it seems reasonable to presume that investors purchasing XRP (whether institutional or retail) are betting on Ripple for some reason.

Third, the Ripple ruling seems to suggest that wealthy hedge funds and venture capitalists are protected from malicious token issuers and can seek relief from the SEC, while less affluent retail investors are left entirely to fend for themselves, with no SEC protection whatsoever. This seems completely inverted and is precisely the opposite of why the '33 Act, '34 Act, and '40 Act were enacted.

In stark contrast, securities laws are designed to protect investors, especially retail investors, not to abandon them (even if they wish to be abandoned and left alone). In other words, the wealthy have avenues for support and remedies, while the poor are left to their own devices. This seems unfair and contradicts the fundamental principles of U.S. securities law.

As the renowned Bloomberg columnist Matt Levine stated: "In the 1920s, many people formed very shady companies and raised a lot of money by selling stocks with bad and misleading disclosures, which is why we created securities laws to stop them. This did not eliminate stock offerings in America. Quite the opposite! The U.S. stock market benefits from having disclosure rules and protections for retail investors. The basic rule of the U.S. stock market is 'you can do what you want with sophisticated investors, but there are strict rules about how much you must disclose to retail investors,' and this works well. The opposite rule in this case—'you can do what you want with retail investors, but stay away from sophisticated investors'—seems likely to lead to bad outcomes. If the law encourages crypto companies to take advantage of the least sophisticated investors, then who would want to invest in crypto?"

Securities laws are specifically designed to protect individual investors, based on the notion that they cannot protect themselves, and that fraudulent investors can lead to catastrophic market events (such as the crash of 1929). The Ripple ruling undermines this concept.

As Professor Ann Lipton sarcastically pointed out: "Let's just say it directly: treating sales to institutions as securities because institutions are sophisticated is perverse. This is a regression; it undermines the purpose of securities law (to protect less sophisticated investors) and contradicts the tests for whether other assets are securities (the Reves test often weighs the sophistication of investors against the existence of securities)."

Finally, the Ripple ruling seems to suggest that when tokens are purchased by institutional buyers for cash consideration, then those tokens are securities. However, the Ripple court also seems to believe that when tokens are given to employees as consideration for work, those tokens are not securities. This notion seems to contradict established principles of contract law.

Whether consideration is in cash or in the form of work should not affect the analysis of contractual relationships and other contract law issues. Even if a token is gifted to an employee, the company still benefits from it, which should be the only important thing—and should trigger SEC registration.

The bottom line is: stocks are always stocks—they cannot transform into "non-stocks." Therefore, my view is that the SEC will appeal the Ripple decision to the Second Circuit Court, and the Second Circuit will overturn the district court's rulings on "programmatic" and "other sales."

Otherwise, be prepared for a new iteration of the crypto industry—PBTs—programmatic buyer tokens, which can be found on your local (unregistered and unregulated) crypto trading platforms.

According to the Ripple court's ruling, PBTs will be exempt from securities regulations because programmatic buyers know nothing about PBTs, do not know from whom they are purchasing PBTs, and do not know who is issuing PBTs.

The Ripple ruling suggests that the same token may sometimes be a security and other times not be a security. The more ignorance and willful blindness retail investors exhibit, the less protection they receive. The less disclosure there is about tokens, the less liability token issuers have. This cannot possibly be correct.