A pair of recent rulings from the Southern District of New York (SDNY) have potentially increased confusion around the regulatory status of crypto asset regulation—but may also provide some interesting signs of what’s to come. In a long-awaited decision, Judge Analisa Torres ruled that certain sales by Ripple Labs, Inc. (Ripple) of its XRP token did not constitute unregistered sales of securities, as alleged by the U.S. Securities and Exchange Commission (SEC). Weeks later, Judge Jed S. Rakoff denied Terraform Labs Pte. Ltd.’s (Terraform) and Do Hyeong Kwon’s motion to dismiss an SEC complaint alleging that Terraform and Kwon violated securities laws based in part on the assertion that various tokens developed and distributed by Terraform are securities.

Judge Rakoff explicitly disagreed with key elements of Judge Torres’s decision, including whether the nature of the counterparties in a particular transaction in a digital asset and whether the transaction is executed on an exchange should be determinative of whether a transaction involves a securities transaction. As we discuss below, the resolution of this split within the SDNY may be critical to future regulatory action by the SEC, and it was therefore almost inevitable that the SEC has sought leave to file an interlocutory appeal of the Ripple ruling.

This difference aside, Judge Torres and Judge Rakoff both rejected arguments that the defendants did not have adequate notice that transactions in the relevant crypto assets may have involved securities transactions. Judge Rakoff, while ruling that Terra’s UST stablecoins were securities, also suggested that at least some stablecoins (namely, those truly pegged to the dollar and used as units of value) may not be properly deemed securities.

This alert discusses the rulings and these implications in more depth.

The Ripple Ruling

In the Ripple case, Judge Torres addressed whether Ripple’s sales of XRP involved illegally unregistered offerings and sales of securities in violation of Section 5 of the Securities Act of 1933 (Securities Act), which requires that all offerings and sales of securities be registered with the SEC or comply with an exemption from registration.

Judge Torres found that Ripple’s sales of XRP to various hedge funds and other institutional buyers did involve offerings and sales of securities under the U.S. Supreme Court’s decision in SEC v. W.J. Howey.¹ Judge Torres noted, among other reasons, that Ripple’s efforts in marketing XRP and touting its investment potential likely led these investors to expect that Ripple would promote XRP and protect its position in the market, which would be a primary driver of value. As a result, these investors would have expected their profit to derive primarily from Ripple’s efforts.

In contrast, Judge Torres found that three other types of transactions in XRP did not involve offerings and sales of securities:

• Ripple’s “programmatic sales” of XRP on various crypto exchanges through trading algorithms did not involve offerings and sales of investment contracts in part because buyers transacted blindly and thus did not know that they were buying from Ripple. Judge Torres concluded that these on-exchange buyers did not know that they were paying Ripple, and therefore did not “invest” in Ripple. In addition, because Ripple did not know who the buyers were, it did not make any promises or offers to them, and thus buyers had no expectation that Ripple would undertake efforts to ensure profits from XRP purchases. These on-exchange buyers were also less sophisticated than the institutional buyers, and therefore less equipped to evaluate the marketing statements Ripple made in public interviews, social media, and other forums. Judge Torres also noted that programmatic sales investors did not receive the documentation marketing XRP and laying out lockups and other terms of investment that institutional buyers did.
• XRP sales by Ripple’s CEO and Executive Chairman (Bradley Garlinghouse and Christian Larsen, respectively) in their individual capacities on crypto exchanges did not involve offerings and sales of investment contracts because they involved programmatic sales in blind transactions similar to those described above.
• Ripple’s distributions to employees and developers did not involve any “investment of money” under Howey, and thus no offer and sale of investment contracts, because recipients did not pay money or other “tangible and definable consideration” for XRP. Judge Torres does not explicitly address the labor or other services employees and developers provided Ripple and its platform.

The Terraform Ruling

A few weeks after the Ripple ruling, Judge Rakoff found that Terraform’s tokens potentially meet the definition of a security under Howey, and thus that Terraform and Kwon engaged in several violations of the securities laws, including Section 5 of the Securities Act. An important reason, among others cited by Judge Rakoff, was that Terraform and Kwon had engaged in extensive marketing efforts to build investor expectations of profit, including through investor meetings, marketing materials, and social media posts.

Importantly, Judge Rakoff disagreed with Judge Torres’s finding that the “manner of sale” of an asset, and in particular whether it is sold directly to institutional investors or on-exchange to retail purchasers, determines whether the asset is a security under Howey. Judge Rakoff took the position that Howey “makes no such distinction between purchasers,” irrespective of whether the purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction. Instead, Judge Rakoff noted, the question is whether a “reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts,” which he found occurred in the instant case.

A Few Takeaways

• Judge Torres’s emphasis on the nature of the purchasers, whether buyers know who sellers are, and whether transactions occur on exchange is arguably a new interpretation of Howey. In Judge Torres’s reasoning, the same asset, with the same issuer, sponsor, associated business, and public marketing, appears to be treated as a security for regulatory purposes in certain transactions but not in others, depending in part on whether the buyer knows the identity of the seller and thus can look to the seller for a potential increase in value. In contrast, Howey and subsequent case law have focused first and foremost on the characteristics of the asset involved, the services to be provided with respect to the asset, and whether buyers would expect its value to be primarily driven by the efforts of the issuer, regardless of who the seller is. Judge Torres’s analysis seems to suggest, however, that another element of Howey is whether the parties have privity of contract—and know they do.

  Further, Judge Torres’s ruling that certain blind, on-exchange transactions do not, by their nature, involve securities transactions potentially suggests that transactions in assets that are securities because they are “investment contracts” are not subject to regulation under part or all of the Securities Exchange Act of 1934 (Exchange Act), which (among other things) governs securities intermediaries such as exchanges and broker-dealers. Arguably, the Exchange Act does not make that distinction; like the Securities Act, the Exchange Act includes the term “investment contract” within its definition of what a “security” is.

  If adopted, Judge Torres’s analysis could be viewed as a significant new reading of Howey and a change in interpretation of the securities laws and the SEC’s jurisdiction.

• Appeal of the Ripple ruling by the SEC was virtually inevitable. The SEC has sought to file an interlocutory appeal challenging the Ripple ruling. This is not surprising for a variety of reasons, including because the Ripple ruling could torpedo SEC crypto enforcement efforts such as its actions against Coinbase and Binance. More broadly, the SEC likely felt compelled to challenge the potential outcome that the Exchange Act would not apply to transactions in many, if not all, digital assets—or in investment contracts more generally.
• The different decisions and SEC appeal in the Ripple case suggest that it is premature for industry participants to change business plans or models based on Judge Torres’s findings. It will likely be some time before the split is resolved, and crypto industry participants should be cautious in using the Ripple ruling as guidance.
• Despite the differences, both courts in essence agreed with the SEC that sales of tokens by the sponsor involved securities transactions. While this finding may also be an issue on appeal, the agreement between the courts—and a number of other district courts²—points to the continuing likelihood that most non-stablecoin issuers must comply with the federal securities laws when they offer, sell, and presumably repurchase their tokens.
• Nonetheless, the district court decision in Ripple is good news—if perhaps only temporary good news—for crypto trading platforms in the U.S. The Ripple court’s decision, if affirmed on appeal, would mean that much secondary trading of tokens does not involve the trading of securities, and therefore crypto trading platforms could generally not only continue their current activities, but also trade a wider range of tokens, including tokens that may be securities when sold by the issuer, but that may not involve investment contracts when traded in the secondary markets. Again, however, any conclusions here from the Ripple decision may need to await a decision on appeal by the Second Circuit and, perhaps, the U.S. Supreme Court.
• The Ripple ruling also challenges precedent on giveaways. Judge Torres’s finding that distributions of XRP to employees and developers did not involve distributions of securities subject to Section 5 of the Securities Act because there was no “investment” is a narrower reading of this element of the Howey test than in most existing precedent. Generally, courts and the SEC have taken the position that non-cash “contributions of value,” and not just cash consideration, can meet the investment prong of Howey.³
• The Terraform and Ripple decisions also pave new ground by finding that Terraform, Kwon, and Ripple had fair notice of the SEC’s stance. Ripple, Terraform, and Kwon each argued that the SEC violated their due process rights by bringing an enforcement action against them without first providing them “fair notice” that their crypto assets would be treated as securities. Both Judge Torres and Judge Rakoff disagreed (although Judge Torres only discussed the defense with respect to the institutional sales that she determined involved sales of investment contracts). Judge Torres stated that “the caselaw that defines an investment contract provides a person of ordinary intelligence a reasonable opportunity to understand what conduct it covers.”⁴ Judge Rakoff cited prior litigation and enforcement actions as well as the “Framework for “Investment Contract” Analysis of Digital Assets” published by the SEC in April 2019.⁵
• Judge Rakoff’s ruling also includes statements about stablecoins that could support arguments that at least some stablecoins are not properly treated as “investment contracts” and thus securities. In his ruling, Judge Rakoff stated that where a stablecoin is designed exclusively to maintain a one-to-one peg with another asset and used as a stable store of value, there is no reasonable basis for expecting that the tokens would generate profits through a common enterprise. As a result, these “true” stablecoins might not qualify as investment contracts. Importantly, however, Judge Rakoff distinguished that scenario from Terraform’s stablecoin, where (among other differences) one coin represented the right to purchase another in a multi-coin stablecoin system, and the second token was sold as a yield-bearing investment with a value dependent on the general Terraform business. This finding may be less helpful for stablecoin projects that involve two or more tokens to support a pegged stablecoin algorithmically.

Conclusion

Due to significant uncertainty surrounding these two rulings, crypto industry market participants should be cautious in relying on either Ripple or Terraform as guidance. Neither appears to be moving to final resolution soon, and both were made in the context of specific assets and transactions.

Please contact Amy Caiazza (202 973 8887), Neel Maitra (202 973 8827), Mara Alioto (415 947 2185), or another member of Wilson Sonsini’s fintech and financial services practice with any questions.

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[1] 328 U.S. 293 (1946). Section 2(a)(1) of the Securities Act defines a “security” using a long list of instruments, including an “investment contract.” Courts have assessed whether an asset is an “investment contract” under Howey, in which the Supreme Court found that for an investment contract to exist, there must be 1) an investment of money, 2) in a common enterprise, 3) with an expectation of profit, 4) based primarily on the entrepreneurial or managerial efforts of others. In Howey, purchasers bought plots of land in an orange grove, along with a suite of management services provided by the sponsor of the offering, who would cultivate the land and harvest, market, and sell the fruit. While the plots of land alone were not securities, the overall scheme—the plots of land along with the services—constituted an investment contract.

[2] See, e.g., Sec. & Exch. Comm’n v. Telegram Grp. Inc., 448 F. Supp. 3d 352 (S.D.N.Y. 2020) (granting a preliminary injunction on the basis that the SEC had a substantial likelihood of success in proving that contracts and understandings related to the sales of tokens were part of a larger scheme to distribute the tokens into a secondary public market in an unregistered offering of securities); U.S. Sec. & Exch. Comm’n v. Kik Interactive Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020) (finding that company’s sales of cryptocurrency constituted illegally unregistered offerings of securities). 

[3] See, e.g., Uselton v. Comm. Lovelace Motor Freight, Inc., 940 F.2d 564, 574 (10th Cir. 1991) (stating that for the purposes of an investment contract, the investor’s contribution may take the form of cash, goods and services, or any other exchange of value); Capital General Corporation, 54 SEC Docket 1714, 1728-29 (July 23, 1993) (stating that Capital General’s gifting of securities constituted a “sale” because it was a disposition for value “by virtue of the creation of a public market for the issuer’s securities”); see also Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, SEC Rel. No. 81207, available at https://www.sec.gov/litigation/investreport/34-81207.pdf, at 11.

[4] SEC v. Ripple Labs at 29.

[5] SEC v. Terraform Labs at 26.