The questions revolving around crypto assets typically begin with examining if a security is involved. The answer to that question is determined by applying the Howey test and frequently concluding that the asset is in fact a security. In SEC v. Ripple Labs, Inc., Civil Action No. 1:20-cv-10832 (S.D.N.Y. Ruling July 13, 2023) the Court concluded that in some instances the crypto assets were securities, but not in others. The ruling is thoughtful and raises significant questions about the future of crypto assets as well as the pending similar actions which are working their way toward decision in similar cases now.

The case

XRP Ledger traces its roots to 2011 and early 2012 when the source code or blockchain was developed. Since that time Ripple has sought to realize an “Internet of Value by using technology to facilitate the transfer of value across the internet . . . Specifically, Ripple looked to modernize international payments by developing a global payments network . . . ” (citations and internal quotations omitted). Some, but not all of Ripple’s products and services depended on XRP Ledger and XRP.

Eventually Ripple began selling XRP in three ways. In some instances sales were made directly to certain counterparties who were largely institutional or professional investors. These were called institutional sales. In others, the firm sold XRP on digital asset exchanges “programmatically” or through the use of trading algorithms. There were “blind bid/ask transactions” since the company did not know who was buying or selling XRP. In yet other situations there were distributions of XRP for things like wages at Ripple to its employees. There was no registration statement covering any of these transactions.

The question presented for resolution by the Court on cross-motions for summary judgment by the SEC and Ripple hinged on if the transactions involved the offer or sale of an investment contract or security within the meaning of the Supreme Court’s seminal decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The answer from the Court was “sometimes.”

The ruling

The focus under Howey, the Court began, ties to an investor’s expectation of profits from the efforts of others. In addressing this question the “Supreme Court was guided by the ‘fundamental purpose undergirding the Securities Acts,” in which Congress ‘painted with a broad brush” in recognition of the “virtually limitless scope of human ingenuity.” The Supreme Court crafted the decision to ensure that “the protections Congress sought to afford investors” would not be thwarted “by unrealistic and irrelevant formulae” the Court concluded.

Viewed in this context the issue is not if a digital token is a contract, transaction or scheme that somehow embodies the Howey test. To the contrary, to apply Howey the court must examine the “totality of circumstances surrounding Defendants’ different transactions and schemes involving the sale and distribution of XRP,” the Court concluded. Here there are three variations of those transactions which must be considered: 1) Institutional sales; 2) Programmatic sales; and 3) Other distributions.

Institutional Sales. Here each prong of the Howey test is met the Court concluded. The transactions involve an “investment of money” by the purchasers at the outset, that is the buyers “put up their money.” The point was for an investment in a common enterprise as that phrase is used by Howey. Stated differently there was “Horizontal commonality . . . where the investors’ assets are pooled and the fortunes of each investor are tied to the fortunes of other investors, as well as to the success of the overall enterprise.” All are at risk, and all will share in the profits or losses from the common enterprise.

The economic reality of the sales made to institutional investors, the Court concluded, was that all were part of a common enterprise. Viewed through this lens, the reasonable expectation of profits need not be the sole reason a purchaser buys an investment. Rather, it is sufficient the Court found, that “reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s communications, marketing campaign . . .” and other efforts.

Programmatic Sales. For this category, the Court reached the opposite conclusion. While it was clear that those involved with the Institutional sales could reasonably expect that future profits could come from the efforts of Ripple, there are no facts supporting that point as to this group. This is because “Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. ” This point was bolstered by that fact that since 2017 less than 1% of the global XRP trading volume involved such transactions. While Ripple may have targeted speculators as the SEC argued, that is not a sufficient basis on which to concluded that an investment contract is involved here. To the contrary, in this case Ripple did not know who was buying the XRP and the purchaser did not know who was selling it. There is no investment contract the Court concluded.

Other Distributions. This category failed the first prong of the Howey test, the Court found. That prong of the test requires that there be an investment of money as part of the transaction or scheme. Stated differently, the investor must “put up their money” in the words of the Court (citation omitted). Here, they did not. Therefore, the transaction does not involve a security.

Comment

The Court’s opinion clearly constitutes a careful, thoughtful and rigorous application of the Howey test. The application of that test to the Institutional Investors is fully consistent with not just the basic principles of the decision but its underlying tenants which are keyed to assessing the economic reality of the situation.

Those same comments clearly apply to the Court’s ruling as to the third group. If those in the third group are typified by Ripple employees, for example, who apparently receiving a distribution of the assets not as a substitute for compensation but perhaps as some type of “employee appreciation,” then there is little reason to view the transactions through the lens of making an investment of money to join with others in a hoped for future profit, the Howey test.

The same cannot necessarily be said of those in the second group, the Programmatic sales. There the Court’s statement that this group represents a very small percentage of overall distributions or sales fails to actually address the Howey test. Likewise, statements such as those noting that Ripple has no real contact with those in this group or that the distributions were only 1% of the total also fail to address the questions being posed and thoughtfully debated as to other groups. This is particularly true given the impact of the decision. In the end, the question deserved better consideration.

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The talk of the town – or at least the world of the Commission – was the ruling in SEC v. Ripple, 20 Civ 0832 (S.D.N.Y. File Dec. 22, 2020) last week. The action centers the what the firm calls XRP crypto assets. The court held that the assets were not a security but in some instances may be. For those who understand the Howey test this is not a surprise. Indeed the assets involved in many of the crypto cases are commodities subject to the CFTC’s jurisdiction. In some instances the assets may be securities, such as when the Howey test is met. More on this later in the week.

Last week the Commission filed a number of new cases. Those included offering fraud actions and cases involving the misappropriation of investor assets as discussed below.

Have a great and safe day.

SEC

Proposals: The Agency proposed rule amendments to broker-dealer customer protection Rule 15c3-3. The proposal would require broker-dealers with large total credits to increase the frequency of their customer and related reserve computations from weekly to daily, according to a July 12, 2023 release (here),

Rules: The Commission adopted amendments to certain rules governing money market funds. They include: increasing minimum liquidity requirements; removing provisions that permit a fund to temporarily suspend redemptions and removing the regulatory ties between the imposition of liquidity fees and a fund’s liquidity level; requiring certain funds to implement a liquidity fee framework to better allocate costs of providing liquidity to redeeming investors; and improving certain reporting requirements to improve the Commission’s ability to assess money market fund data. The new provisions were announced on July 12, 2023 (here).

SEC Enforcement – Filed and Settled Actions

Statistics: This week the Commission filed 3 civil injunctive actions and 1 administrative proceedings, excluding 12j, tag-along proceedings and those presenting a conflict for the author.

Offering fraud: SEC v. Celsius Network Ltd., Civil Action No. 1:23-cv-60005 (S.D.N.Y. Filed July 13, 2023) is an action which names as defendants Celsius and its founder Alexander Mashinsky. Defendants are alleged to have raised billions of dollars through unregistered and fraudulent offerings. The company, founded in 2018, claimed to have an alternative to traditional financial institutions in the crypto asset area. There were two key investment opportunities. The first promised high earning rates for those who purchased the CEL, Defendants’ crypto asset. The second came from the Earn Interest Program. There investors tendered their crypto assets to Celsius in exchange for interest payments supposedly as high as 17%. The programs were marketed with a series of false statements such as claims that the trading was not risky or that much more than 80% of revenue was frequently paid out. The complaint alleges violations of Securities Act Sections 5(a), 5(c) and 17(a) and Exchange Act Sections 9(a)(2) and (10(b). The company is cooperating with the Commission and consented to the relieve sought in the complaint. The U.S. Attorney’s Office for the Southern District of New York announced a parallel criminal action against Defendants in this action. See Lit. Rel. No. 25779 July 14, 2023).

Misappropriation: SEC v. Todd, Civil Action No. 5:23-cv-00431 (M.D. Fla. Filed July 12, 2023) which names as defendants Joseph Todd, Todd Financial Services, Inc. and TFS Insurance Services LLC. Defendant Joseph Todd and the two entity defendants that are controlled by him misappropriated at least $3 million from 20 customers of the broker who employed him. This was done by having investors write checks to the entity defendants. Defendant Todd subsequently kept the funds for his personal use. The complaint alleges violations of Securities Act Section 17(a) and Exchange Act Section 10(b). Defendants have consented to the entry of injunctive relief and Mr. Todd, in addition, agreed to the entry of an officer/director bar. Defendants have also agreed to pay disgorgement, prejudgment interest and penalties in amounts to be determined later. See Lit. Rel. No. 25777 (July 13, 2023).

Offering fraud: SEC v. Choudhury, Civil Action No. 1:23-cv-00573 (M.D.N.C. Filed July 12, 2023) is an action which names as defendants: Nayeem Choudhury and Dream Venture Capital Group, LLC. Defendant Nayeem Choudhury is a clinical research project manager at UNC Chapel Hill; Dream Venture is owned by him. Beginning in mid-2022, Defendants have raised about $9.3 million for what was claimed to be a hedge fund. In reality, it is a Ponzie scheme that lost at least $4.8 million trading. Investor funds have been diverted in part to personal use and in part to repay other investors. The complaint alleges violations of Securities Act Sections 5(a), 5(c0 and 17(a), Exchange Act Section 10(b) and Advisers Act Sections 206(1), 206(2) and 206(4). The case is in litigation. See Lit. Rel. No. 25774 July 12, 2023).

Microcap stock promotion: SEC v. Costello, Civil Action No. 25773 (W.D. Wash.) is a previously filed action in which Defendants David Ferraro and Justin Costello engaged in a two year stock promotion scheme beginning in late 2019. During the period Defendants Ferraro and Costello engaged in the stock promotion of at least five microcap stocks owned by Defendant Costello. No disclosure was made regarding the ownership of the shares or the fact that the shares would be sold with each Defendant receiving a cut of the profits. Mr. Farraro previously consented to the entry of a bifurcated settlement. He consented to the entry of permanent inunctions based on Securities Act Section 17(a) and Exchange Act Section 10(b). The final judgment against Mr. Farraro included those provisions as well as a penny stock bar. He was also directed to pay disgorgement of $142,724.97 and prejudgment interest of $11,704.92. No penalty was imposed based on an affidavit regarding financial condition. See Lit. Rel. No. 25773 (July 11, 2023).

Unregistered exchange: In the Matter of RSE Markets, Inc., Adm. Proc. File No. 3-21526 (July 12, 2023) is a proceeding which names as respondent RSE. The Order alleges that beginning on July 1, 2018, and continuing for about three years, the firm maintained and provided the Rally Platform. It consisted of a website and trading functionality for U.S. based retail investors to purchase and sell equity interests issued by RSE affiliates in collectible assets. The firm also maintained a secondary market where it aggregated customer orders and matched them by price and order without charge. The Order alleges violations of Exchange Act Section 5. To resolve the proceedings, Respondent cooperated with the investigation and consented to the entry of a cease-and-desist based on the Section cited in the order. Respondent also agreed to pay a penalty od $350,000.

FinCEN

Task force: The FinCEN Financial Action Task Force held a meeting in San Antonio and brought together public and private stakeholders to combat fentanyl trafficking and human smuggling on July 12, 2023.

Australia

Comments: Deputy Chair Karen Chester, published an article titled ASIC Greenwashing Antidote, on July 22, 2023 in the Company Director Magazine (here).

ESMA

Assessment: The European Securities and Markets Authority and the National Competent Authorities announced an assessment of disclosure and sustainability risks in the investment fund sector on July 6, 2023 (here).

Hong Kong

Remarks: Tim Lui, delivered remarks at the Law Society of Hong Kong’s Forum titled “Developing Financial Markets in Changing Times” July 12, 2023 (here).

Singapore

Report: The Monetary Authority of Singapore published its Annual Report on the Financial Sector Development Fund on July 5, 2023 (here),

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