Ripples in the Terraform: Judges Rakoff and Torres Disagree Over Whether Exchange-Based Sales of Tokens Are Investment Contracts (Part 2 of 3)

© Ari Gabinet – Senior Fellow Watson Institute and Legal Expert In Residence, Brown University

The Contract to Buy An Investment Contract Is not the Investment Contract — Part 2 of 3

In ruling that the exchange-based “Programmatic” sales of XRP did not violate section 5 Judge Torres focused on the characteristics of the transactions themselves; for example that Programmatic purchasers might not have received promises or assurances of Ripple’s efforts to enhance XRP’s value, and that the purchases did not have the same types of terms and conditions that accompany IPO sales.  Thus, the judge Torres concluded, the Programmatic purchases lacked indicia of the third Howey criterion, expectation of profit from the efforts of third parties. 

This approach treats the purchase of XRP as the putative investment contract.  But that is the wrong focus.  An asset may be an “investment contract” before anyone has purchased it.  The question is not whether the purchase of the asset is a contract that qualifies as a security, the question is whether the thing being purchased is itself an investment contract.   It is not necessary for any person to actually buy an instrument representing an interest in the investment “scheme” for an “investment contract” to exist for purposes of the ’33 Act. Consider that a person may violate section 5 of the ’33 Act by merely offering investment contracts for sale without a registration statement in effect.  In Howey itself, the SEC sought to restrain Howey “from using the mails and instrumentalities of interstate commerce in the offer and sale of unregistered and non-exempt securities in violation of § 5 (a) of the Act.”  This would not be possible if the purchase transaction itself were the “investment contract” in question. 

A thought experiment may demonstrate the point.  Imagine that before a single XRP token has been sold the SEC staff comes across Ripple’s advertisements offering XRP to institutional investors, offering the prospect of returns resulting from Ripple’s further efforts to develop the blockchain and create a market for XRP.  Imagine, of course, that there is no registration statement in effect for XRP nor any availing exemption.  Would the SEC be unable to bring an action to enjoin Ripple from violating section 5 of the ’33 Act because there was, as yet, no “contract” for an investment in XRP?  Would the SEC be required to wait until a purchase of XRP took place for there to be an “investment contract” whose offer and sale could be enjoined?  The prospect is nonsensical.

Tokens Aren’t Horses or Cars; They’re Interests in Thoroughbreds or Collectible Cars; They’re Not Oranges or Groves, They’re Orange Groves Plus Management

Just as a share of stock represents an interest in a corporation, a digital token may represent an interest in the blockchain enterprise from which it arises.  If the enterprise is a pooled one in which the expectation of return arises from the efforts of third parties, the interest itself should be understood as a security.  A share of stock is a share of stock regardless of whether anyone has purchased it.  A token that represents a participation in a scheme that satisfies Howey is an investment contract, regardless of whether anyone has purchased it, because although it is not one of the other instruments enumerated in section 2(a)(1), it’s fulfillment of the Howey criteria – a participation in a “scheme devised by those who seek the use the money of others on the promise of profits” makes it one of “the many types of instruments that in our commercial world fall within the ordinary concept of a security.”  Howey, 328 U.S. at 299.

Accordingly, there is little merit in the argument that XRP (or most other digital assets) are securities in some in some transactional settings but not others, as suggested in both Ripple and Terraform.  Both courts suggest that a token such as XRP might be viewed in some contexts as a simple commodity, not a security.  Of course, as Judge Torres notes in Ripple, Howey has been applied many times to prohibit the offer and sale of unregistered tangible assets (or intangible interests in or derived from them) when accompanied by or sold with undertakings to promote their value.  This includes digital tokens associated with blockchains. See Ripple, 2023 U.S. Dist. Lexis 120486 at * 22-23 (citing cases). 

As judge Torres noted, a simple commodity such as a car or a horse may be a speculative investment without being a security.  The speculative intent of the buyer is not what makes an investment an “investment contract.”  But, given the required commonality, when the buyer is buying a commodity bundled with prospect of returns from the efforts of others, that same commodity becomes a security.  A pooled interest in a horse or a car that is selected, groomed, garaged, fed, trained, tuned, maintained, exhibited and, ultimately perhaps marketed, by a third party IS a security. 

This analogy applies directly to many cryptocurrencies.  Most blockchain tokens cannot be likened to a horse or a car because they are offered with undertakings to develop the ecosystem and market that will enhance their value.  The token represents an interest in a scheme – a pooled enterprise in which the expectation of return from the efforts of third parties is an essential part.  XRP – unlike a pure currency – necessarily represents an interest in a scheme in which, in the words of Justice Jackson in Howey, “third parties seek to use the money of others on the promise of profits.”  The token evidences the participation in the scheme, much as  warehouse receipts for curated whisky represented the participation in the investment scheme in SEC v. Haffenden-Rimar International, Inc., 362 F. Supp. 323 (E.D. Va. 1973).  Such a scheme is itself an investment contract under Howey, and the physical or digital asset is the evidence of participation. 

Viewed this way, Ripple was not selling – to institutional investors or via exchanges – horses or cars or casks of whisky.  It was selling interests in horses or cars that Ripple would house, maintain, store, exhibit, and generally attempt to increase the value of.  The transaction in which a buyer purchased XRP was not the “investment contract” in question.  XRP itself IS the investment contract because it represents not a simple currency, but rather a currency accompanied by Ripple’s undertaking to increase its value.  XRP is like participation in oil and gas leases, not the lease itself (SEC v. Joiner, 320 U.S. 344 (1943); it is like warehouse receipts for casks of whisky in Haffenden-Rimar, supra.

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.