What does the summary judgement mean for the future of digital asset regulation?
Last Thursday, Judge Analisa Torres of the Southern District of New York unveiled a landmark summary judgment decision in the case of SEC v. Ripple Labs et al., which may fundamentally alter our understanding of how U.S. securities laws apply to the sale of digital assets. Judge Torres concluded that Ripple’s XRP tokens aren’t inherently “securities,” but that the manner in which these tokens were sold constituted an illegal unregistered securities offering in certain instances and not others. To fully grasp the implications of this ruling and its impact on the broader digital asset sector, we first need to unpack the concept of what exactly constitutes a “security” within the context of American law.
Securities are traditionally financial instruments that confirm the holder’s ownership rights in a company, such as a stock, or the holder’s creditor relationship with a company or government, such as a bond. They can also include other contractual financial rights like options. But there’s an additional umbrella category of securities called “investment contracts.” This latter category generally does not apply directly to a given asset, but rather to the offer and sale of that asset, irrespective of whether it has the traditional hallmarks of a security like equity ownership, voting rights, or rights to profit shares. Thus, applying the famous “Howey Test,” from a 1946 Supreme Court case, which serves as the legal benchmark for this category of securities transactions, courts have imputed the existence of investment contracts from the offer and sale of assets as diverse as citrus groves, whisky casks, and phone booths, none of which look much like paradigmatic case of a debt or equity security. Under the Howey Test, a transaction qualifies as an investment contract if it involves each of four elements: (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits, (4) primarily driven by the efforts of others.
The first important takeaway from Judge Torres’s opinion in the Ripple case is her ruling that XRP tokens are not, in and of themselves, “securities” or investment contracts, but that the Howey Test governs whether or not each individual instance of sales of XRP by Ripple Labs constituted an investment contract and therefore an (unregistered) securities offering. Judge Torres’s ruling to this effect serves as an implicit rejection of the “embodiment theory,” previously espoused by the SEC, according to which digital tokens like XRP could themselves be treated as securities like stocks or bonds because they “embody” the Howey Test requirements for an investment contract irrespective of the circumstances of each individual sale. It also leads to the counterintuitive result that the sale of XRP is subject to the jurisdiction of the SEC in only some cases, but not others.
Applying the Howey Test, Judge Torres analyzed three different categories of sales of XRP by Ripple Labs: (1) direct institutional sales to venture capitalists and hedge funds, (2) programmatic sales to retail investors via cryptocurrency exchanges, and (3) grants of XRP tokens to employees and contractors as a form of compensation.
Unsurprisingly, in the context of institutional sales, Judge Torres found that the offer and sale of XRP did, in fact, constitute an investment contract. According to Judge Torres’s reasoning, each of the four Howey prongs were met by these institutional sales because (1) the institutional buyers directly provided capital to Ripple Labs in exchange for XRP tokens, (2) the institutional purchasers stood to benefit from the price appreciation of XRP on a pro rata basis to their ownership of the tokens, and (3–4) Ripple’s communications and marketing strategies reasonably shaped an impression among the institutional buyers that the company would use the capital raised from the institutional sales to foster the XRP market, leading to a potential increase in XRP's value.
While this part of the decision might appear as the most significant setback for Ripple and will serve as the basis for the largest financial penalties that Ripple Labs will owe as a result of this lawsuit, it ironically carries the least legal weight with regard to the broader digital asset sector. Currently, most private sales of cryptographic tokens to institutional investors are openly conducted as securities offerings in compliance with SEC registration exemptions like Regulation D (limiting sales to “accredited investors”) and Regulation S (restricting sales to foreign investors). They often take the form of ancillary instruments like “token warrants,” purchased as part of a broader venture capital investment in the issuer's equity or paper contracts such as Simple Agreements for Future Tokens (“SAFTs”) or Token Purchase Agreements (“TPAs”) that are explicitly designed to comply with U.S. securities laws. Therefore, despite the particular ruling in this case that Ripple Labs violated the law through its institutional sales, the methods for token sales to institutional investors have significantly evolved to accommodate existing regulatory frameworks, and this evolution shields a large portion of the industry from the fallout of this judgment.
The most significant precedent set by Judge Torres’s opinion regards her analysis of Ripple’s "programmatic” sales of XRP to retail buyers on digital asset exchanges. Here, in contrast with her analysis of the institutional sales, Judge Torres ruled that these transactions did not meet the fourth prong of the Howey Test because while many programmatic buyers may have purchased XRP hoping to profit from their investment, those expectations were not necessarily predicated on Ripple’s efforts, and instead may have been due to a desire to speculate on broader market trends within the cryptocurrency sector. Judge Torres found significant that the majority of programmatic buyers were unaware they were buying directly from Ripple, and therefore Ripple could not have made any promises or offers to the programmatic buyers that could have led them to expect to profit based on Ripple’s efforts, emphasizing the importance or Ripple’s marketing materials concerning XRP, which were circulated amongst institutional, but not programmatic investors. Judge Torres also noted that the programmatic sales of XRP lacked the legal terms such as lockup provisions, resale restrictions, and indemnification clauses, which were present in the institutional sales and are characteristic of traditional securities offerings.
This ruling marks a significant shift from prior jurisprudence regarding the application of Howey to digital assets. Previously, legal analysts and courts alike had looked at the economic realty surrounding the offer and sale of digital assets to determine whether purchasers of those assets were reasonably reliant on the managerial efforts of the issuer or promoter of those assets in order to profit from their investment, regardless of whether or not such issuers or promoters made specific representations to, or directed towards, those purchasers. For example, in the SEC v. Telegram Group Inc. et al. case in 2020, Judge Castel of the Southern District of New York had found that purchasers of Telegram’s TON tokens were reliant on Telegram’s efforts to develop, launch, and support the blockchain protocol that contained the TON tokens, and to provide a use case for the tokens through integration with the Telegram messaging application in order to profit from their investment in TON. Judge Castel noted that if Telegram ceased such operations, even though the TON tokens would continue to exist on the blockchain, the ability for TON holders to profit would be severely diminished. In parallel, one might have thought that in the context of the Ripple case, purchases of XRP (whether institutional or retail) would be essentially reliant on the efforts of Ripple Labs in order to develop technology and business partnerships to support XRP and make manifest the “internet of value” that Ripple directly promoted in the context of its sales of XRP to institutional buyers. However, Judge Torres’s opinion makes clear that the lack of communication by Ripple to the programmatic purchasers of XRP was, for her, a decisive factor in whether or not such programmatic sales amounted to investment contracts under Howey.
If this holding survives scrutiny by the appellate courts following the SEC’s inevitable appeal to the Second Circuit, it may effectively legalize a large amount of secondary market activity that the SEC has thus far argued runs afoul of securities laws. While Judge Torres was careful to note that her opinion did not specifically address the question of whether secondary peer-to-peer sales of XRP constituted investment contracts, her reasoning as to why the programmatic sales did not meet the fourth Howey prong should seemingly apply equally well to such transactions. After all, if Ripple’s lack of marketing to retail purchasers was insufficient to create a reasonable expectation of profit for retail investors who bought XRP directly from Ripple Labs, why would secondary market transactions whereby retail investors bought XRP from market participants other than Ripple fair any differently? This holding is of the upmost significance to the forthcoming lawsuits by the SEC against cryptocurrency exchanges Coinbase and Binance, in which the Commission will try to argue that the secondary market sales of tokens on those platforms constituted investment contracts under the Howey Test. It is also of great consequence to aspiring token issuers, who may now have the ability to sell digital assets to retail investors in the United States outside of the jurisdiction of the SEC so long as they frame those tokens as a speculative bet on the cryptocurrency sector as a whole and are careful in their marketing materials to avoid making representations about their plains to promote the adoption of the tokens in question.
In the second key holding of the Ripple case, Judge Torres again significantly deviated from the SEC’s and the broader legal community’s consensus on the understanding of the Howey Test, this time with regard to the “investment of money” prong. Judge Torres determined that Ripple’s “other distributions” of XRP, namely to employees as compensation and to third parties as incentive to develop new applications for XRP, did not constitute an “investment of money” because the recipients of these tokens did not provide “tangible consideration” in exchange for XRP. Judge Torres ruled that the Howey Test requires evidence that investors “provide the capital,” “put up their money,” or “provide cash” in exchange for the asset in question. Yet recipients of Ripple’s “other distributions” did not pay money or provide tangible consideration to Ripple in exchange for the tokens—and in fact in most cases they were actually additionally paid cash compensation by Ripple for the work for which they were granted XRP. This part of the decision throws a substantial curveball at the previous prevailing legal interpretation that any action taken by the recipient of a digital asset—even taking the effort to claim an 'airdrop' token by providing a blockchain “wallet address”—could potentially satisfy the first Howey prong.
If courts are to adopt this new, more stringent, definition of “investment of money” going forward, this could give a tremendous amount of legal cover to token issuers who issue tokens via an airdrop, a “hard fork,” or any other kind of “fair launch” mechanism that does not require the recipients to literally pay for the tokens to be received. However, there is some disagreement among legal commentators as to whether this narrowing of the “investment of money” prong is the correct way to read Judge Torres’s opinion, or if her ruling is instead based on a technical deficiency on the part of the SEC to submit evidence that the “work” done by the recipients of Ripple’s “other distributions” of XRP served as the “tangible consideration” for the tokens required by Howey.
In conclusion, last week’s summary judgment ruling in SEC v. Ripple Labs et al. marks a potentially transformative moment for U.S. securities laws and their applicability to digital assets. Particularly, Judge Torres’s distinction between Ripple’s institutional and programmatic sales of XRP, and her interpretation of what constitutes an "investment of money," challenges the established legal consensus regarding how the Howey Test applies to the offer and sale of the thousands of tokens that have proliferated over the years. This ruling, if sustained on appeal, may reshape the SEC’s jurisdiction over digital assets and significantly impact forthcoming lawsuits involving major cryptocurrency exchanges like Coinbase and Binance. As we anticipate an appeal to the Second Circuit and await the outcomes of impending lawsuits, Judge Torres’s decision may serve as a potential bellwether, and perhaps even prompt new legislation to clarify the contours of how securities laws apply to cryptocurrencies.