Breaking Down the SDNY Ruling in SEC v. Ripple Labs, Inc.
On July 13, 2023, Judge Analisa Torres of the United States District Court for the Southern District of New York (SDNY) issued an important ruling in Securities and Exchange Commission (SEC) v. Ripple Labs, Inc., et al. that may signal a future loss for the SEC in the SEC v. Coinbase, Inc. case also currently pending in SDNY. The reason for this has to do with the court’s analysis of what it calls “programmatic sales” by Ripple Labs and the other Defendants.
In order for me to describe this fully, I need to provide you with some background about the case. In 2011 and early 2012, Arthur Britto, Jed McCaleb, and David Schwartz developed source code for a cryptographically secured blockchain, which is now known as the XRP Ledger. The XRP ledger is run on the Ripple Network, known as RippleNet which is a decentralized global network of over 150 validators (computers) that ensure all transactions on the network conform to the requirements specified in the software. RippleNet has a fixed total supply of 100 billion XRP coins, of which 80% were originally given to Ripple Labs and the remaining 20% was distributed among the three founders.
From this initial distribution of coins, XRP was further disseminated in three primary ways: (1) by institutional sales, (2) programmatic sales, and (3) as a form of payment for services. The institutional sales used written contracts between Ripple Labs and sophisticated counterparties that included provisions commonly associated with investments made by venture capital such as indemnification, resale restrictions, and lockup restrictions. The programmatic sales were blind bid/ask sales through cryptocurrency exchanges. The third way was using XRP as currency (medium of exchange) to compensate employees and third parties for their work on RippleNet.
The court’s analysis of whether Ripple Labs and the other defendants broke the securities laws focused not on the nature of XRP itself as a security, but on the method of its sale. This led the court to focus on whether those sales were “investment contracts.” I think that the simplest and most intuitive analysis is the institutional sales because there were actual written contracts between Ripple Labs and the institutional buyers. Those had very specific terms that appeared to demonstrate an expectation of profit from the efforts of Ripple Labs creating demand for the XRP coin. The other two situations are a little more abstruse.
The programmatic sales occurred on crypto exchanges where the buyers and sellers do not know the identity of their counterparty. The court rejected the argument that just because Ripple made public statements that may increase the interest of speculators or “specifically targeted” them did not provide those buyers with an objectively reasonable expectation of profit from the efforts of the seller (whose identity was unknown to them). In fact, these buyers were receiving no direct promises other than the receipt of XRP at an agreed upon price. These agreements lacked any of the restrictions contained in the contracts between Ripple Labs and the institutional buyers.
The final method of disseminating XRP is the most difficult to analyze. This part of the order focused on whether the people who received XRP as compensation (I’m going to refer to them as employees for ease of use) paid money in exchange for the coins they received. Because the employees provided services and not dollars to Ripple Labs in exchange for the currency, the court said it wasn’t an “investment of money” for a security. The first time I read this section, I thought that Judge Torres missed the mark in this part of her analysis because while the employees were not providing currency, they were clearly exchanging something of value for the XRP. The more I read it and thought about it, the more I realized that she was right. It wasn’t that the employees were exchanging something worthless for XRP, its that XRP was not in itself a security.
The reason I think this decision is so damaging for the SEC in it’s case against Coinbase is because the court didn’t consider the cryptocurrency coin itself to be a security and focused instead on the way it was sold. Coinbase isn’t alleged to have sold securities like Ripple Labs, it is alleged to be a securities exchange, broker and clearing agency. This means they are alleged to facilitate the exact kind of sales described by the court as “programmatic sales” and determined not to be investment contracts. While the Ripple case appears to be a partial win for the SEC, it is hard to see how they can hope to prevail against Coinbase without a serious split of opinion between the courts. They should negotiate a settlement and try to save face. I was of the opinion that the SEC had been overreaching its authority, but I think that there is now further support for that position.
About the Author
This article was written by Benjamin Inman, an estate and business planning attorney at Insight Law.