Security Today, Non-Security Tomorrow: Have Recent Crypto Decisions Under the Howey Test Created Unworkable Standards?

Judge Torres’s summary judgment opinion in the SEC v. Ripple (S.D.N.Y. July 13, 2023) litigation was a detailed, carefully reasoned analysis under SCOTUS’s 77-year-old Howey test. But subsequent decisions—including Judge Torres’s subsequent October 3, 2023 order denying leave for interlocutory appeal—reveal that the Ripple decision may prove untenable or otherwise lead to absurd results.

Applying the Howey test to XRP (Ripple), the court identified and distinguished three categories of XRP transactions: (1) “Institutional Sales,” meaning sales of XRP to “sophisticated individuals and entities . . . pursuant to written contracts”; (2) “Programmatic Sales,” meaning sales “to public buyers . . . on digital asset exchanges”; and (3) “Other Distributions,” meaning “distributions pursuant to written contracts to employees as compensation and to third parties.”

The court concluded that XRP was a security when made in the Institutional Sales but not when made in the Programmatic Sales or Other Distributions. The court’s analysis adhered to Howey’s standards, as applied to the specific facts in the record at summary judgment. And the result was elegant, acknowledging that cohorts of XRP transactions had unique characteristics yielding differing results under the Howey elements. Because Howey focuses on “the expectation of profit to be derived solely from the efforts of others,” the court found that a single asset (e.g., XRP) can be a security when obtained by one person but not a security when obtained by another person.

Nonetheless, the court may have missed the forest for the trees. If one focuses on the structure and purpose of the U.S. securities laws as a whole—rather than applying the antiquated Howey test to XRP in a vacuum—the Ripple decision could prove unworkable. From a practical perspective, the securities laws cannot function properly if, as held by Judge Torres, an asset’s status as a security is transient.

An asset’s classification as a “security” is neither nominal nor superficial. That classification is substantive, if not existential. If an asset, arrangement, or financial product is deemed an “investment contract” and, in turn, a “security,” then all transactions in that security are subject to hundreds of statutory, regulatory, and common law obligations, liabilities, and rights. The Securities Act of 1933 and Securities Exchange Act of 1934 require registration of the security (or proof of an exemption) and timely disclosures of a host of financial and operational information about the issuer and asset. Public trading must take place on a registered exchange. The SEC has jurisdiction over issuers, promoters, buyers, and sellers. The PSLRA and SLUSA alter the laws and procedures for civil litigation. Purchasers have a right to rescind the purchase as to the immediate seller. Sellers have a right to obtain damages for losses.

Simply put, a “security” is subject to a comprehensive legal framework that has evolved for 90 years, whereas a non-security is entirely exempt from that framework. Consequently, a host of problematic, unanswered questions arise if an asset’s status as a security (or non-security) is provisional—for example:  

• Must XRP be registered, and must the issuer timely file 10-Ks and 10-Qs containing the information normally provided for publicly-traded securities?

• If XRP is registered, can an owner of XRP from a Programmatic Sale or Other Distribution rely on that information, or is the information exclusively for owners of XRP from an Institutional Sale?

• If an XRP owner from an Institutional Sale then re-sold the XRP in a Programmatic Sale, when did that XRP convert from a security to a non-security? Would the XRP convert back to a security if the XRP was sold back to the same person?

• How should an issuer report the number of outstanding XRP securities, if some XRP are converting between being securities and non-securities outside of the issuer’s knowledge or control?  

• Is it insider trading if an owner from an Institutional Sale has material nonpublic information and then sells XRP through a Programmatic Sale? Is it insider trading if a buyer from a Programmatic Sale has material nonpublic information and then re-sells XRP?

 In sum, if a widely-traded asset is sometimes a security and sometimes not a security, how will issuers, promoters, buyers, sellers, regulators, and courts comply with, enforce, or seek relief through the securities laws?

Unfortunately, Judge Torres has not answered those questions or even acknowledged the material implications of her Ripple decision. In denying leave for interlocutory appeal, the court downplayed the case’s precedential value in other matters involving other assets, stating that the holdings were “based on the totality of the circumstances in this case.” The court also stated that the decision did not conflict with Judge Rakoff’s subsequent holding in SEC v. Terraform (S.D.N.Y. July 31, 2023) that “Howey makes no such distinction between” original purchasers and re-sale purchasers.

But the decisions do conflict. The Ripple decision indicates that a cryptoasset can change from a security to a non-security, depending on, for example, whether it is being sold in an original transaction or as a resale in the secondary market. In contrast, the Terraform decision specifies that an asset’s status as a security does not change under those circumstances.

Thus, even if the court downplays the implications of its analysis, the Ripple decision poses critical questions as to practicability. Unless subsequent applications of Howey (for cryptoassets or otherwise) confront those issues, good faith issuers, promotors, buyers, and sellers of cryptoassets will not have a reasonable option for complying with the securities laws.

-Constantine P. Economides is a founding partner at Dynamis LLP, where he practices complex litigation and specializes in crypto, fintech, and securities disputes, including class actions.