Distinguishing XRP From Ripple
July Mid-Month Commentary
“It is always darkest before the dawn” seems to be particularly apropos when looking back over the first half of this year. At the turn of 2023, the digital asset industry was reeling from frauds uncovered during 2022, fresh US bank failures, and regulatory enforcement actions. Since then, we’ve witnessed a couple of rays of positivity. Last month, a spate of established TradFi asset managers applied to offer spot bitcoin ETFs, sparking renewed interest. Then on July 13, after a prolonged two and half years of legal uncertainty, the industry received a ruling that XRP, the token itself, is not a security in response to the December 2020 SEC lawsuit against Ripple Labs. While this is a welcomed win in the US against regulatory enforcement and a step away from classifying digital assets as securities, the details and conclusions are quite nuanced.
The Original Lawsuit and Summary Judgement
The SEC’s 2020 lawsuit came punching out of its corner by framing XRP as a security. It stated that the “Defendants [Ripple Labs, Inc., Bradley Garlinghouse, and Christian Larsen] sold over 14.6 billion units of a digital asset security called ‘XRP’ …” The offerings were conducted over five venues consisting of Market Sales, Institutional Sales, Other XRP Distributions, and two counts of individual sales by Bradley Garlinghouse and Christian Larsen. The SEC proceeded to use the Howey Test to establish that XRP was “an investment contract and therefore a security”. Since Ripple never filed a securities registration statement, the SEC alleged that Ripple conducted illegal securities offerings, and that Garlinghouse and Larsen personally profited from these illegal activities.
As a side note, the Howey Test stems from the 1946 US Supreme Court ruling on the SEC vs W.J. Howey Co. lawsuit. The suit involved Howey Co. selling tracts of orange groves to buyers and the buyers, in turn, agreed to lease back the land and groves to Howey Co. to maintain and cultivate for the mutual sharing of profits. The transaction at hand was the agreement to purchase and subsequently leaseback and maintain the orange groves. The Supreme Court ruled in favor of the SEC and asserted that the agreement was indeed an investment contract. As a result, the Howey test was devised to determine if certain instruments constitute an investment contract within the context of US 1933 Securities Act. The test states that “an investment contract is ‘a contract, transaction[,] or scheme whereby 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.’" The ramifications, obviously, would be that such investment contracts would fall under the regulatory jurisdiction of the US SEC.
Quite pivotal in the Analysis section of the recent ruling, Judge A. N. Torres lays out the case that XRP is an asset and not an investment contract. She writes, “Howey and its progeny have held that a variety of tangible and intangible assets can serve as the subject of an investment contract. … In each of these cases, the subject of the investment contract was a standalone commodity, which was not itself inherently an investment contract.” But Judge Torres does not let the Defendants off the hook either, when she added, “Even if XRP exhibits certain characteristics of a commodity or a currency, it may nonetheless be offered or sold as an investment contract.” To clarify her point, she summarily states, “XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract. … (‘Each transaction must be analyzed and evaluated on the basis of the content of the instruments in question, the purposes intended to be served, and the factual setting as a whole.’) “
There you have it. XRP is an asset, not an investment contract, and it is the transaction, with which XRP is offered, that needs to be individually evaluated to determine if the transaction is in and of itself an investment contract. In other words, XRP is the proverbial orange grove in the SEC v. W.J. Howey Co. lawsuit. Cue the mic drop.
By this point, we’re sure the reader has read in some form or other about the summary judgements in the remainder of this ruling. Briefly,
Having satisfied all three conditions of the Howey Test, “the Court concludes that Ripple’s Institutional Sales of XRP constituted the unregistered offer and sale of investment contracts in violation of Section 5 of the Securities Act”, handing a partial win to the SEC. Note that it is the institutional sales conducted by Ripple that constituted an investment contract.
In contrast, “the Court concludes that Ripple’s Programmatic Sales of XRP did not constitute the offer and sale of investment contracts.” Specifically, these programmatic sales were made to retail for which the Court stated, the “Programmatic Sales also lacked other factors present in the economic reality of the Institutional Sales which cut in favor of finding ‘a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.’ … For instance, the Programmatic Sales were not made pursuant to contracts that contained lockup provisions, resale restrictions, indemnification clauses, or statements of purpose.” In other words, programmatic sales failed to meet the third condition of the Howey Test.
The “Other Distributions”, which consisted of using XRP to compensate employees and third-party service providers were deemed not to be investment contracts. It failed on the Howey Test’s first condition as there were no investments of monies.
Finally, regarding Larsen’s and Garlinghouse’s individual sales of XRP, the Court noted that these were similar to the Programmatic Sales and ruled that each of their offerings of XRP were not offerings of investment contracts.
However, Judge Torres left unresolved the allegations of Larsen’s and Garlinghouse’s roles in aiding and abetting Ripple’s illegal Institutional Sales. This will go to trial at a later date.
OK, if it’s not a security, then what type of asset is it?
Financial columnists, podcasters, and other journalists were quick to cover this ruling in the ensuing days. The opinions ran the spectrum from celebratory relief that XRP is not a security (Bankless, “How Ripple's Win Reshapes Crypto …”) to confusion as to why an asset would sometimes be deemed a security and sometimes not based on its offering methods (Matt Levine’s Money Stuff: Ripple Is a Security and It Isn’t (bloomberglaw.com)), and even to a sense of dissatisfaction (Ripple Labs Ruling Throws U.S. Crypto-Token Regulation into Disarray – Preston Byrne).
We are in the camp that this ruling actually clarifies that XRP is an asset and not a security, although it remains unclear as to what type of asset it is. In doing so, it opens the door for other digital assets to be similarly classified.
As to what type of asset class XRP and other tokens are, it’s understandable that digital assets are hard to pin down. An interesting attempt at this classification came from analysts Chris Burniske and Adam White at Ark Invest back in January 2017 in their article, Bitcoin-Ringing-The-Bell-For-A-New-Asset-Class.pdf (ark-invest.com). To make the case for bitcoin being a new asset class, Burniske and White leveraged the framework of asset “Superclass[es]” from Robert Greer’s 1997 paper in the Journal of Portfolio Management, “What is an Asset Class, Anyway?” Greer classified the traditional asset classes of equities, bonds, commodities, etc. into the three Superclass categories – 1) Capital Assets, 2) Consumable/Transformable Assets, and 3) Store of Value Assets. For example, equities and bonds would fall into the Capital Assets category; commodities like grain or energy fall into the Consumable/Transformable Assets; precious metals would have characteristics of both Consumable/Transformable Assets and Store of Value Assets while fine art would be considered a Store of Value Asset. Conceivably, an asset like ETH may fit into all three – invest to stake to earn a yield (Capital Asset), use for gas for transactions (Consumable/Transformable Asset), and hold for appreciation due to adoption and a declining supply due to the burning of portions of transaction fees (Store of Value Assets).
This ruling that positions XRP as an asset and not a security is a seminal step with which we can come to form consensus on what they are and what level of regulation we want around them. There is still much work that needs to be done. Gold, as a commodity, requires no regulatory disclosure. We all know what it is. Gold ETFs, on the other hand, require a lot of disclosure on issues regarding its custody, liquidity of the ETF instrument, trading venue, etc. Although many have claimed BTC is digital gold, we cannot treat BTC like the gold commodity, asking for little to no disclosures. Similarly, ETH and XRP may be the proverbial orange groves, but they are far more complicated. Dogecoin started in 2013 as a joke and even describes itself as an “accidental crypto movement”. At least Dogecoin is transparent. How many other digital asset projects are going to be as forthright about their intentions? More generally, what do we require of digital assets? What levels of details do we want to see in a whitepaper? How can we be sure that these projects are not rug pulls? What disclosure do we want to see from DApp tokens that provide utility to ensure that its code has been audited and to have a sense of security from hacks? Quite importantly, this ruling highlights the inadequacy of the current legislative and regulatory framework. We hope it gives impetus to the digital assets community, legislators, and regulators to work closely together to define the appropriate level of oversight needed for this new asset class.