BRADLEY GARLINGHOUSE & CHRISTIAN LARSEN
UNITED STATES DISTRICT COURT
SOUTHERN DISTRICT OF NEW YORK
Introduction
In the complex realm of digital finance, a significant legal battle unfolded in 2020, pitting the United States Securities and Exchange Commission (‘SEC’) against Ripple Labs, Inc. (‘Ripple’), a trailblazer in blockchain technology and the creator of the XRP cryptocurrency token. The SEC alleged that Ripple had raised over $1.3 billion through the sale of unregistered XRP tokens to investors in 2013. Ripple countered by citing statements from a former SEC director, arguing against the classification of XRP as a security.
Moving ahead to 13.07.2023 when the US District Court delivered its verdict. The court ruled that XRP, and similar cryptocurrencies should not be deemed securities when offered to the public through cryptocurrency exchanges. However, it determined that these cryptocurrencies do qualify as securities when sold to institutional investors. This ruling’s significance lies in its focus on the SEC's authority over digital assets based on their manner of offering or sale, irrespective of their inherent attributes. This marks a positive step forward for the industry.
Interestingly, Ripple's legal battle coincided with a booming cryptocurrency market, where Bitcoin reached remarkable heights, yet XRP laced due to investor concerns tied to the impending court decision. The implications of this case have reverberated throughout the cryptocurrency sector, which previously operated with relatively lenient regulatory oversight. While the industry anticipated increased regulation, this case stands as a notable instance of a securities regulator scrutinizing an initial coin offering (‘ICO’), sparking substantial attention and discussion.
Brief Facts
Ripple, initially founded as OpenCoin in 2012, emerged as a pioneer in blockchain technology and introduced the XRP token. In a less crowded cryptocurrency landscape, XRP gained recognition for its sizable coin supply and rapid transaction capabilities, positioning it as a solution for cross-border remittances.
The value of the XRP token grew significantly, transitioning from millions to billions in 2017. This trajectory halted when the SEC initiated legal action in December 2020, prompting major crypto exchanges like Coinbase to suspend XRP trading, aggravating negative sentiment.
The SEC’s allegations were against Ripple, along with its executives Bradley Garlinghouse and Christian Larsen. At the core of the SEC’s case was the determination of whether XRP distribution met the criteria of a security under the Securities Act, 1933. Its contentions revolved around the absence of a registration document, which is typically mandatory for companies seeking public capital.
The focal point in this case lay in assessing whether the alleged transactions aligned with the three-pronged test established by the US Supreme Court in SEC v. W. J. Howey Co.[i], which had introduced the concept of an “investment contract” security.
Ripple countered such assertions, citing a former SEC director’s statement to support its claim that XRP was not a security. The SEC contended that Ripple’s selective information sharing created an information vacuum.
Decision
The court’s ruling resulted in partial victories for both parties, establishing the SEC’s jurisdiction over transactions with institutional entities. It also affirmed the legitimacy of cryptocurrency trades on exchanges as not inherently constituting securities transactions.
The pivotal factor was the application of the Howey test, derived from SEC v. Howey (supra). This test determines if a transaction qualifies as an investment contract, thus classifying it as a security. An investment contract was defined to include the investment of funds in a shared venture, expecting profits arising from the efforts of others.
Under the Howey test, transactions involving (1) monetary allocation (or, investment of money) in (2) a common enterprise with (3) profit anticipation from external endeavours are securities. Ripple would have needed to meet public disclosure requirements and other compliance measures if XRP were deemed a security.
The ruling clarified that XRP, and similar cryptocurrencies are securities when introduced to institutional investors, but not when transacted on exchanges with retail investors, for the following reasons:
The negotiated sales of significant XRP blocks to institutional buyers, referred to as “institutional sales,” met the criteria of the Howey test. This is because the institutional investors invested money (fulfilling the 1st principle of the Howey test. Additionally, such investment was placed into a shared enterprise (satisfying the 2nd principle of the Howey test), all while anticipating profits generated through the efforts of the common enterprise’s management (meeting the 3rd principle of the Howey test). Thus, the issuance of XRP to institutional investors would be classified as the trading of ‘securities’.
However, Ripple’s anonymous exchange sales (“programmatic sales”) and XRP exchanges for services (“other distributions”) did not meet the Howey test criteria. For programmatic sales, the court found that the 3rd Howey test principle was not met, as profit expectations did not relate to Ripple’s efforts. Unlike institutional buyers, programmatic buyers participated in a blind bid without the knowledge of whether their investments benefitted Ripple. Regarding other distributions, including compensation to employees and third parties, they did not fulfil the 1st Howey test principle of investment of money as such recipients did not provide capital to Ripple but rather received XRP from Ripple.
The SEC prevailed in claims regarding institutional sales, while Ripple’s founder Christian Larsen and CEO Bradley Garlinghouse faced further adjudication. Both deny any alleged improprieties.
Analysis
Upon appeal, the current ruling will undergo review by the United States Court of Appeals for the Second Circuit to confirm its validity. A subsequent appeal thereafter, the case will be elevated to the United States Supreme Court. The decision delivered by this highest court of appeal in the United States will hold final and binding authority.
The SEC-Ripple clash holds significant consequences for the cryptocurrency industry. The SEC's partial victory could lead to broader cryptocurrency regulation. Ripple’s partial success may backfire if subsequent appeals favour the SEC. Notably, the court’s treatment of the “expectation of profit from the efforts of others" for different buyer groups is distinctive. It considered accessible information for each group, presuming institutional buyers recognized Ripple’s influence on XRP value.
The Ripple decision’s repercussions extend to potential future legal precedents for the SEC, particularly in its disputes with exchanges like Coinbase and Binance over token classification.
Irrespective of the appeal’s outcome, the cryptocurrency sector benefits from the court's focus on transaction mechanics over underlying assets. The court's deviation from linking “security” to traditional financial instruments reflects a shift towards Howey's focus on investment contracts, highlighting actions and expectations surrounding transactions.
Though this decision does not have direct applicability in Indian laws, the unresolved question of whether cryptocurrencies qualify as ‘securities’ is pertinent in India as well. An example is the imposition of Goods and Services Tax (‘GST’) on cryptocurrency transactions, which hinges on categorizing them as ‘goods’ or ‘services’. Presently, the definitions of both ‘goods’ as well as ‘services’ expressly excludes securities from their purview. Thus, if a cryptocurrency is legally held to be a ‘security’, its supply would be exempt from GST. Conversely, if classified as a security, it would be subject to regulation under the Securities Contract (Regulation) Act, 1956.
End Notes:
[i] SEC v. W.J. Howey Co., 328 U.S. 293 (1946)
Authored by Srishty Jaura, Advocate at Metalegal Advocates. The views expressed are entirely personal and do not constitute legal opinion.
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