Ripples in the Terraform: Judges Rakoff and Torres Disagree Over Whether Exchange-Based Sales of Tokens Are Investment Contracts (Part 1 of 3)
© Ari Gabinet – Senior Fellow Watson Institute and Legal Expert In Residence, Brown University
Part 1 of 3
When is a cryptocurrency or digital token an “investment contract” that fits the Federal securities law definition of a security, and when is it just a speculative asset – one that the Federal securities laws don’t reach? According to a recent District Court decision, that may depend not just on the returns the promoter touted, but on whether the buyer bought directly from the promoter, or on an exchange where it didn’t know from whom it was buying. SEC v. Ripple Labs, Inc., 2023 U.S. Dist. Lexis 120486 (S.D.N.Y. July 13, 2023). But, according to another District Court decision from a different judge on the same district court bench, no such distinction based on what the buyer knew from whom they were buying. SEC v. Terraform Labs Pte. LTD, 2023 U.S Dist. Lexis 132046, (S.D.N.Y. July 31, 2023).
Which of these decisions makes more sense? The answer lies in the courts’ rubric for determining whether something is an “investment contract,” and how that rubric is applied. The Ripple court seemed to view the sale of the token, rather than the token and accompanying representations, as the putative investment contract. Judge Torres took the view that only purchases which buyer knows will deliver proceeds directly to the promoter and in which the promoter has made representations directly to the buyer can be investment. In this view, whether an unregistered token offering violates section 5 of the ’33 act depends on to whom, and by what medium, the token is actually sold. The Terraform court, on the other hand, “decline[d] to erect an artificial barrier between the tokens and the investment protocols with which they are closely related” and noted that the issuers’ representations about the creation of value were directed to exchange-based and direct purchasers alike. 2023 U.S. Dist. LEXIS 132046 at *45.
Although judge Rakoff appeared to confuse Ripple’s direct sales of XRP via exchanges with true secondary market transactions between XRP holders, Id. at *46, he was correct to refuse to erect a barrier between the token and the bundle of rights and expectations that are sold with it. And he was correct to reject the Ripple court’s conclusion that the medium through which the token is sold determines whether the token is a security. An asset IS an investment contract if it evidences participation in a pooled scheme in which there is an expectation of return from the efforts of third parties. The manner in which, or to whom or from whom, it is bought or sold, is irrelevant. It satisfies the Howey test.[1] A token that derives value from the efforts of third parties to make it more valuable – by building the ecosystem or by promoting a speculative marketplace that offers liquidity – without which the token would be worth less – is a security because it represents an interest in the underlying “scheme.” It is the underlying structure of the investment opportunity, not the manner of its sale, that makes it a security under the Howey test. A “contract, scheme or transaction” that fulfills the Howey test need not be a “contract” in order to be an “investment contract” for purposes of section 2(a)(1) of the ’33 Act. [2]
Howey revisited and reiterated.
In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the Supreme Court provided a definition of “investment contract” for purposes of the definition of “security” under the Securities Act of 1933. As repeated numerous times, Howey involved the sale of orange groves – real estate – with a management contract, pursuant to which the Howey Company would tend, harvest, sell, and distribute the profits from the sale of the fruits grown on the groves. The buyers entered into a “bundle” of contracts along with other buyers and participated in the profits derived from Howey’s management of the real property and its fruits. The SEC contended that Howey had engaged in an unregistered offering of securities – the combination of hard asset and management contract combined to create an interest in a pooled orange farming business constituted an “investment contract.” Agreeing with the SEC, the Court articulated the following definition:
[A]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise.
Howey, 328 U.S. at 298-299 (emphasis supplied). The Court embraced an expansive reading of “investment contract” because allows the application of the disclosure requirements of the Federal securities laws “to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” id. at 299.
[1] This might be the best reason for the court’s decision in SEC v. Kik Interactive, Inc., 492 F. Supp. 3d 169 (S.D.N.Y. 2020), that Kik Interactive’s sale of Kin to retail investors was the sale of a security, despite Kik making no futher entrepreneurial or managerial efforts
[2] On August 9, 2023, the SEC requested that Judge Torres grant leave for the SEC to take an interlocutory appeal of her ruling as to Programmatic sales, as well as her ruling that transactions in which Ripple issued tokens in exchange for trading activity, rather than an investment of money, were not “investment contracts” under Howey. The SEC’s letter requesting interlocutory appeal noted the direct conflict between the Ripple and Terraform decisions among other grounds for granting leave under 42 U.S.C. §1292(b). See letter from Jorge Tenreiro, Esq., to Hon. Analisa Torres, 8/9/2023, available at SEC-letter-for-appeal-v.-Ripple.pdf (crypto-law.us).
Ari Gabinet is a Senior Fellow at the Watson Institute for International and Public Affairs and the Legal Expert in Residence at Brown University. The Brown Undergraduate Law Review is grateful for his support as our Faculty Advisor.