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

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

A Horse is a Horse and a Security is a Security, but the Map is Not the Territory — Part 3 of 3

Accordingly, for purposes of Howey and section 5 of the ’33 Act, it is irrelevant whether Ripple offered XRP directly to investors or through an exchange.  Indeed, as judges Torres and Rakoff noted, the subjective state of mind of the purchaser is irrelevant; what’s relevant is the nature of the underlying opportunity in which their funds are invested.  Judge Torres’ ruling that exchange-based sales of XRP could not be “investment contracts” because the buyers couldn’t know if they were buying directly from XRP cannot be correct if, as she and judge Rakoff agree, the subjective state of mind of the offeree/purchaser is not what makes something an “investment contract.”  The terms and conditions of the “scheme” itself – the fact that the returns are to be generated by efforts of third parties and are marketed as such – is what makes the token an investment contract, not the subjective expectation of specific buyers. 

This exposes another potential flaw in the courts’ analyses.  Courts have often looked at evidence of how an opportunity was marketed in determining whether it involved an “expectation of profits from the managerial or entrepreneurial effort of others.”  This may be in part because the Court in Howey used the words “led to expect” profits.  But just as a map is not the territory, marketing evidence of the entrepreneurial efforts of others is not the same as the fact that any expected profits will come from those efforts.  If a promoter does not tell investors that the efforts of third parties will be involved, but in fact the returns are dependent on those efforts, is the opportunity not a security?  And if the promoter tells some, but not all investors, about those efforts, is the opportunity not a security, or only a security in the former but not the latter cases?  If an investor who HAS been told about the efforts of third parties convinces a friend to invest without describing the third party’s role, is that friend not buying a security?  More importantly, from a policy standpoint, what SHOULD the securities law outcome be?

The Ripple opinion makes the error of confusing the map for the territory; judge Torres concludes that the Programmatic sales of XRP were not investment contracts in part because Ripple did not make statements about the anticipated profitability and returns directly to Programmatic buyers.  Not only does this put subjective state of mind of the Programmatic buyers at the center of the analysis, as judge Torres said should NOT be done; it confuses the marketing of the opportunity with the essential nature of the XRP of which Ripple’s marketing is simply evidence.  As the Supreme Court stated in Joiner, the “test . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution and the economic inducements held out to the prospect.”  320 U.S. at 352-53.  Given the broad remedial purposes of the ’33 Act, it would make little sense to exonerate an issuer or promoter who sells an investment opportunity without offering disclosure to purchasers; indeed, it would conflict directly with the prospective nature of section 5’s prohibition on offers of unregistered securities.  What should matter is not what the Programmatic buyers knew or didn’t know; what should matter is what XRP was, as described in Ripple’s own statements, regardless of whether those were delivered to, read by, ignored or unknown to Programmatic buyers.   

Making the status of an investment opportunity as security dependent on the subjective knowledge or state of mind of purchasers – and by extension on the medium through which the opportunity is marketed – would defeat the purpose of the Federal securities laws.  The inclusion of the catch-all “investment contract” in the definition of security “permits the fulfillment of the statutory purpose of compelling full and fair disclosure relative to the issuance 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 (citation omitted).  If an investment opportunity involves an investment of value in a pooled enterprise with the expectation of profits derived from the efforts of others, should the requirement of full disclosure depend on whether the promoter offers the opportunity directly or via an exchange?  Under Judge Torres’ analysis, an issuer could avoid section 5 liability by simply offering its token exclusively on an exchange on which secondary market transactions also occur.  Again, this seems to be an undesirable outcome and an incentive for unsavory regulatory arbitrage.

As Judge Rakoff put it in Terraform, "’The Exchange Act,’ which established the SEC, ‘delegates to [the agency] broad authority to regulate ... securities,’ but securities only.  The statute, in other words, sets forth the bounds of the SEC's regulatory authority by defining what sorts of products can be considered ‘securities’ and, therefore, are subject to SEC regulation and enforcement.”  2023 U.S Dist. Lexis 132046, at * 21 (citation omitted).  The Howey test provides a time-tested approach to articulating the parameters of the SEC’s jurisdiction; it synthesizes common characteristics “securities” listed in Section 2(a)(1) of the ’33 Act and differentiates those things from speculative investments that are not subject to SEC regulation.  It cannot be contended that whether in institutional sales or Programmatic sales, Ripple [sought] the use of the money others on the promise of profits.”

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.