The SEC v. Ripple Lawsuit Exposes the Limits of the Howey Test

Meryl R. Jimenez—Amidst the global pandemic of 2020, the SEC filed a complaint against Ripple Labs Inc. and two of its top executives, Chris Larsen and Bradley Garlinghouse, alleging that Ripple raised $1.38 billion through the sale of 14.3 billion units of unregistered securities. The SEC’s complaint resurfaces an old legal question, this time with a modern twist: how are securities defined in the context of digital assets? In this case, the issue turns on whether XRP, the digital asset that Ripple’s technology leverages, is classified as a security or a digital currency. The outcome of the legal battle between the SEC and Ripple will have far-reaching consequences on the classification of cryptocurrencies. If the SEC prevails and XRP is classified as a security, other participants in the blockchain ecosystem could see the “ripple” effect of the decision and could potentially be accused of violating securities laws for unregistered digital assets.

Ripple is a technology company that provides solutions to facilitate cross-border payments using crypto and blockchain technology. Its goal is to transform “how people and businesses access financial services more widely” by building crypto solutions and partnering with financial institutions across the globe. In 2012, a decentralized ledger-based payment network, the XRPL, was created to serve as a more scalable and sustainable alternative for sending value than Bitcoin. The XRPL included a digital asset, the XRP, which Ripple used in its mission to transform global payments.  

To prove that XRP is an investment contract, the SEC’s complaint heavily relies on the 1946 W.J Howey Co. decision, in which the U.S. Supreme Court provides a framework for investment contracts. The Howey court found that an investment contract “means a contract, transaction or scheme whereby [1] a person invests his money [2] in a common enterprise and is led to [3] expect profits [4] solely from the efforts of the promoter or a third party.” Howey, the owner and grower of citrus groves, owned tracts of land—half of which he decided to sell to the public. Purchasers (or investors) were offered land contracts and service contracts for the maintenance of the groves. The service contracts stipulated that Howey retained the total control and exclusive right to service the land and cultivate the crops. The contract also stipulated that purchasers shared profits from the sale of the crops. In defining “investment contracts,” the Court found that Howey’s service contracts were unregistered and nonexempt securities under the Securities Act of 1933.

While the Howey test has proven applicable to countless securities’ disputes since its inception in 1946, should it apply to XRP and other participants in the blockchain ecosystem in 2022 and beyond?

In its complaint, the SEC argues that XRP tokens are analogous to the citrus groves in Howey in that Ripple is heavily involved in helping create and grow the XRP payment system. Under this theory, the SEC “bears the burden of proving that purchasers of XRP relied on Ripple’s efforts to increase the value of XRP.” The SEC argues that by selling XRP, Ripple meets the second and fourth factors of the Howey-test (“common enterprise” and “solely from the efforts of the promoter of a third party”). But like other cryptocurrencies, such as Bitcoin and Ethereum, XRP derives its profit potential from the valuation of the commodity—not from a single group of people at Ripple. Thus, the “common enterprise” factor of the test as it applies to digital assets like cryptocurrency is a gray area that necessitates further clarification.

Many advocates of the cryptocurrency industry argue that the Howey test is an outdated law and that Congress ought to establish clarifying guidelines for proper legal classification of digital assets. Perhaps the ongoing litigation between SEC and Ripple will help regulators to reexamine the definition of an investment contract as it applies to digital assets and cryptocurrencies.

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