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Todd Baker is a senior fellow at the Richman Center for Business, Law & Public Policy at Columbia.
A balloon filled with pure joy was flying over crypto land for a few weeks after a US district judge’s hearing the SEC’s Ripple case led the crypto faithful to declare victory over hated foe Gary Gensler and the SEC.
But you can now hear the balloon deflating rapidly. The reason? The most respected securities authority in the federal judiciary just stuck a polite but lethal pin into the -cough- curious reasoning behind the Ripple decision.
In mid-July, Manhattan, a federal-district court hearing the SEC vs. Ripple case ruled that sophisticated VCs and other institutional investors were protected by the securities laws when buying Ripple’s XRP token but retail investors who bought through crypto exchanges or otherwise were not, because somehow the institutional transactions involved “securities” but the retail transactions did not under the SEC’s Howey test for what qualifies as an “investment contract”.
To quote the Ripple judge’s rationale:
Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP . . . Programmatic Buyers [i.e., retail buyers and sellers] could not reasonably expect the same. Indeed, 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.
Yes, you read that right. The court held that the big institutional investors get SEC protection but the little retail traders not so much because they, unlike the big boys, don’t know how the crypto sausage is really made.
Unsurprisingly, this result was met with dancing in the streets among the crypto crowd — crank up the hype engine! . . . start the airdrops! . . . retail crypto trading is unregulated! Coinbase Global quickly restarted trading in XRP and crypto traders began to hope that the SEC’s assault on unregulated crypto trading would soon be over.
The Winklevii could hardly contain their glee:
The Ripple decision was met with an equal amount of incredulity in those parts of the securities bar not currently representing a crypto company (and there aren’t many — all the big firms have a piece of that pie). Cooler minds emphasised just how topsy-turvy the Ripple result was.
In the words of former SEC enforcement attorney John Reed Stark, the “decision resides on shaky ground, is likely (and ripe) for appeal, will likely result in reversal.”
Enter judge Jed Rakoff.
Rakoff is without doubt the most respected judge in the country when it comes to complex securities matters. His resume would fill a book, and he has written five of those.
He didn’t like the reasoning in the Ripple case and had the opportunity to express that opinion when denying a motion to dismiss the SEC’s fraud case against Terraform Labs and its founder Do Hyeong Kwon (you remember him — the Terra and Luna algorithmic stablecoin promoter — and the crater he left behind before they jailed him in Montenegro?).
Judge Rakoff’s decision disposed of many of the usual defences ginned up by counsel in crypto cases — lack of personal jurisdiction, the “Major Questions Doctrine,” the Due Process Clause, and the Administrative Procedure Act. But it’s Judge Rakoff’s gentle defenestration of the Ripple court’s rationale that’s worth quoting at length, as his writing is as clear as his reasoning.
It may also be mentioned that the Court declines to draw a distinction between these coins based on their manner of sale, such that coins sold directly to institutional investors are considered securities and those sold through secondary market transactions to retail investors are not. In doing so, the Court rejects the approach recently adopted by another judge of this
District in a similar case, SEC vs. Ripple Labs Inc., . . . According to that court, this was because the re-sale purchasers could not have known if their payments went to the defendant, as opposed to the third-party entity who sold them the coin. Whatever expectation of profit they had could not, according to that court, be ascribed to defendants’ efforts.
But Howey makes no such distinction between purchasers. And it makes good sense that it did not. That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts. Indeed, if the Amended Complaint’s allegations are taken as true — as, again, they must be at this stage — the defendants’ embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets by touting the profitability of the cryptoassets and the managerial and technical skills that would allow the defendants to maximize returns on the investors’ coins.
As part of this campaign, the defendants said that sales from purchases of all crypto-assets — no matter where the coins were purchased — would be fed back into the Terraform blockchain and would generate additional profits for all crypto-asset holders. These representations would presumably have reached individuals who purchased their crypto-assets on secondary markets —- and, indeed, motivated those purchases — as much as it did institutional investors. Simply put, secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf.
It’s hard to argue with Judge Rakoff about securities law, as many a litigant has learned over the years. The Ripple case crypto balloon may have been filled with laughing gas after all.