Another federal judge recently weighed in on one of the more significant – and potentially existential – questions facing the crypto industry: are cryptocurrencies considered “securities” under the Howey test? Judge Hamilton of the Northern District of California seems to think so, at least with respect to certain retail sales of XRP.
In In re Ripple Labs, Inc. Litigation (Case No. 18-cv-06753-PJH), Plaintiff Bradley Sostack filed a class action complaint against Ripple Labs, XRP II (a Ripple subsidiary), and Ripple’s CEO, Bradley Garlinghouse that included four class claims based on Defendants’ failure to register XRP as a security in violation of both state and federal law. On June 20, 2024, the District Court granted Defendants’ summary judgment as to all four of those class claims on statute of limitations grounds for the federal claims and lack of privity for the state law claims.
Sostack’s fifth and final claim, however, was brought in his individual capacity against Garlinghouse for making misrepresentations in connection with the sale of a security in violation of California’s securities law. In addressing that claim, Judge Hamilton was forced to wrestle with the critical substantive question: is XRP a security in the first place? In SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court delineated a three-element test to identify a “security” under federal securities laws:
- There must be an investment of money;
- That investment must be in a common enterprise; and
- There must be an expectation of profits derived primarily from the efforts of others.
Judge Hamilton found that XRP checked all three boxes. She reasoned:
First, the plaintiffs had paid money in exchange for XRP tokens; the money was paid to exchanges and not directly to the Defendants, which was irrelevant.
Second, the parties were sufficiently engaged in a “common enterprise” because they “understood there to be a ‘direct relation’ between the success or failure of the investor and that of the promoter” based, in large part, on public statements made by Garlinghouse.
Third, the court found plaintiffs had a reasonable expectation of profits from the efforts of others by pointing to several of Ripple’s public statements touting its ongoing efforts to drive the XRP market forward.
Notably, Judge Hamilton’s decision is (at least partially) at odds with a recent Southern District of New York opinion issued just last year in SEC v. Ripple, 682 F.Supp.3d 308 (S.D.N.Y. 2023) granting in part, and denying in part, Ripple’s motion for summary judgment. There, the District Court also applied the Howey test and concluded that XRP was a security as to institutional buyers but not as to retail buyers. The third prong of the Howey test had been satisfied as to institutional buyers because – based on certain marketing and promotional materials – those investors understood “that Ripple was pitching a speculative value proposition for XRP with potential profits to be derived from Ripple’s entrepreneurial and managerial efforts.” Id. at 327-28. For purposes of summary judgment, however, the Court found that the relevant retail or “programmatic” sales were blind bid/ask transactions on secondary exchanges; as a result, those purchasers could not know if their specific payments went directly to Ripple or, alternatively, to another seller of XRP. Id. at 329. Those purchasers, therefore, had no reasonable expectation of profit from Ripple’s efforts.
Judge Hamilton acknowledged the Southern District of New York opinion but reached a different conclusion as to retail investors by citing evidence submitted by Sostack showing that Ripple had disseminated certain promotional materials – and made certain representations about Ripple’s efforts – to the public at large. Based on these representations, an investor in Sostack’s shoes could have reasonably expected profits derived from Ripple’s own efforts.
Ultimately, whether a specific cryptocurrency or digital token constitutes a “security” under federal securities laws remains a moving target and depends on the facts, circumstances, and “economic reality” of each case. SEC v. Ripple, 682 F.Supp.3d at 321 (citing Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). Two different federal courts came to two different conclusions about the same XRP token. As the goalposts move, it goes without saying that cryptocurrency issuers should be diligent in tracking (and trying to synthesize) these developments.
For more information on digital assets, please contact Benjamin Kussman, Esq. at ben@annagueymccann.com.
