A federal judge in the Southern District of New York issued a ruling in August 2023 that was hailed as a landmark victory for the crypto community. In the case of SEC v. Ripple, Judge Analisa Torres ruled that Ripple’s sales of the token XRP to retail purchasers on crypto exchanges were not unregistered sales of “securities,” as the Securities and Exchange Commission had alleged. While other aspects of the opinion went the SEC’s way, this principal holding was celebrated by the crypto industry, and crypto asset prices shot up overnight.
But the battle is far from over. Shortly after, a different Southern District judge dampened the mood. In the case of SEC v. Terraform, Judge Jed Rakoff rejected Judge Torres’s reasoning, and held that the SEC’s complaint adequately alleged that the stablecoin UST and the token LUNA were sold as “securities.”
All eyes turn now to the SEC’s suit against Coinbase, in which the SEC has charged the largest crypto exchange in the U.S. with operating an unregistered “securities” exchange. Although the issues in SEC v. Coinbase differ in certain respects, the Ripple and Terraform rulings provide important clues for how Coinbase may be resolved, and how the SEC’s ongoing enforcement campaign against the crypto industry will fare.
The Dispute – What Is A “Security”?
Casual crypto fans may have heard of the “Howey test,” a legal standard used to determine whether an asset constitutes an “investment contract” and thus a “security” subject to certain SEC regulations. The test comes from a 1946 Supreme Court decision that built on depression-era laws prohibiting the unregistered sale of securities, a term defined to include stocks, bonds, other familiar assets, and any “investment contract.”
In the Howey case, a company sold orange groves to individuals, who then leased the land back to the commonly owned and managed service company for maintenance of the groves; in return, the individuals were promised a share in the profits from the orange sales. The SEC alleged that this arrangement constituted an “investment contract” and thus a “security,” the sale of which was subject to SEC registration requirements. The Supreme Court agreed. It held that an economic arrangement qualifies as an “investment contract” when a person (1) “invests his money;” (2) “in a common enterprise;” and (3) “is led to expect profits solely from the efforts of the promoter or a third party.” While the orange groves themselves were not securities, the economic arrangement was an “investment contract” because of the cultivator’s promise to share in the profits from the orange sales.
Since that decision, courts have applied the Howey test to determine whether all manner of investment schemes – involving everything from whiskey casks to chinchillas – are securities. The latest in this line is crypto assets.
A Win For Crypto – SEC v. Ripple
In 2020, the SEC sued the tech company Ripple, and two of its executives, alleging that several different types of distributions of the Ripple ecosystem’s native XRP token constituted unregistered sales of securities. Of greatest significance for the broader crypto industry, the SEC alleged that Ripple’s sales of XRP to public buyers on crypto exchanges were unregistered sales of securities.
Judge Torres granted Ripple’s motion for summary judgment as to this category on July 13, 2023. She held that exchange-based sales to public buyers were not “investment contracts” because the SEC had failed to establish Howey’s third prong—that buyers of XRP had a reasonable expectation of profits from the efforts of others. Judge Torres reasoned that because these were blind bid/ask transactions, buyers of XRP did not know whether their payments went to Ripple or to a third-party seller, and therefore the buyers could not reasonably have expected to profit from Ripple’s efforts.
While Judge Torres stated that her decision was limited to these sales of XRP by Ripple, crypto observers quickly emphasized the enormous consequences this reasoning would have for the broader industry: by this logic, blind bid/ask transactions on centralized crypto exchanges would generally not be sales of securities, effectively removing these exchanges and their users from the SEC’s domain. The SEC recognized the ruling’s significance too, as it sought to appeal, stating that the issue is of “programmatic concern to the SEC’s enforcement of the securities laws and potentially to a large number of pending litigations.”
Judge Torres’s ruling was not a complete victory for Ripple and its industry counterparts, however. In contrast to sales of XRP to public buyers on exchanges, Judge Torres ruled that Ripple’s direct sales of XRP to institutional investors were investment contracts. This set up an unusual dichotomy wherein sales to sophisticated investors are regulated while sales to retail investors are not. This distinction would soon be rejected by one of Judge Torres’s colleagues.
The SEC Strikes Back – SEC v. Terraform
Terraform Labs is a software development firm that created the “Terraform ecosystem,” which includes a blockchain and a series of interconnected crypto assets. These assets included LUNA, a token which once had a market value among the ten highest for crypto assets, and UST, a “stablecoin,” the value of which was pegged to the U.S. dollar by virtue of an algorithm (until it de-pegged from the dollar in May 2022, leading its value and that of LUNA to plummet).
The SEC sued Terraform and its CEO in February 2023, alleging that they engaged in unregistered sales of securities with regard to LUNA, UST, and certain other crypto assets. The SEC further alleged that Terraform and its CEO engaged in a fraudulent scheme to mislead investors through certain false and misleading statements about the business. Terraform and its CEO moved to dismiss the complaint, arguing, as relevant here, that the assets in question were not sold as securities.
Judge Rakoff denied that motion on July 31, 2023, holding that the SEC had sufficiently alleged the assets in question were sold as securities. Judge Rakoff reasoned that the SEC had adequately alleged that Terraform “coaxed investors to continue purchasing LUNA” by advertising “the possibility of future investment returns,” whereby profits from the sale of LUNA “would be fed back into further development of the Terraform ecosystem, which would, in turn, increase the value of the LUNA coins.” Judge Rakoff similarly concluded that the SEC had adequately alleged that Terraform marketed UST as an asset that, when deposited into an investment pool called the Anchor Protocol, would generate returns based on Terraform’s managerial efforts.
In so doing, Judge Rakoff rejected Judge Torres’s distinction between crypto assets sold directly to institutional investors and those sold on exchanges through blind bid/ask transactions. In Judge Rakoff’s view, it does not matter if a token buyer knows whether her money goes directly to the token promoter. If the promoter – here, Terraform – has “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting [their] profitability [ ] and the managerial and technical skills that would allow the [promoter] to maximize returns on the investors’ coins,” then a buyer can reasonably expect to profit from the efforts of the promoter.
While Judge Rakoff’s decision was made at a preliminary stage of the case, at which he had to assume the facts alleged by the SEC to be true, his disagreement with Judge Torres is fundamentally a dispute about the proper legal analysis. Judges in future cases will have to resolve which of these approaches is correct.
Round 3 – SEC v. Coinbase
The next to weigh in may be Judge Katherine Failla, one of Judge Torres and Rakoff’s Southern District colleagues. She presides over the SEC’s recent suit against Coinbase, alleging, among other things, that Coinbase operated an unregistered securities exchange by providing a marketplace which “brings together orders of multiple buyers and sellers of crypto assets and matches and executes those orders.”
While the Ripple and Terraform suits focused on sales of crypto assets by the assets’ promoters, the Coinbase case is principally about secondary market transactions in such assets. In its motion for judgment on the pleadings, Coinbase argues that this is a critical difference: whether or not an offering by a promoter is a securities offering, Coinbase’s role in facilitating a secondary market transaction between a buyer and a seller is not. In Coinbase’s view, it is merely facilitating an asset sale. A crypto asset is not itself a security – just as the orange groves themselves were not in Howey. Rather, such an asset can be an “investment contract” only when accompanied by a contractual undertaking that grants the purchaser a “right to the profits, income, or assets of a business enterprise.”
Despite the different context, the Ripple and Terraform decisions loom large in Coinbase. Notably, both judges rejected a version of Coinbase’s argument that an “investment contract” requires post-sale obligations on the promoter and the investor’s right to share in the profits of the business. But Judge Torres reached a similar conclusion by a different route when she reasoned that buyers in blind bid/ask transactions cannot reasonably expect to benefit from the efforts of the promoter. That reasoning would seem to carry the day for Coinbase. By contrast, Judge Rakoff’s focus on the marketing efforts directed at crypto asset purchasers and the expectations derived therefrom would seem to favor the SEC’s position (though the outcome with respect to any given asset may depend on how it was marketed). Whichever side of this debate Judge Failla chooses may go a long way towards determining the outcome of the Coinbase suit, and will have significant consequences for the broader crypto industry.
It is too soon to tell who will prevail in the SEC’s campaign against the crypto industry. But one thing is clear: the differing opinions in Ripple and Terraform highlight the legal uncertainty created by the SEC’s attempt to regulate through enforcement actions. The SEC’s approach has been met with growing criticism, from the courts to the Congress. Will the SEC listen? Round 3 may be decisive.
To read more from Thomas A. McKay, please visit www.maglaw.com.
Emily Smit and Victor Obasaju, associates at the firm, assisted in the preparation of this blog.
Follow me on LinkedIn.
