SEC v. Ripple: Court Declines to Adopt Ripple’s “Essential Ingredients” Test

DISCUSSION

I. Legal Standard

C. Defendants’ “Essential Ingredients” Test

In their summary judgment briefing, Defendants advance a novel “essential ingredients” test, arguing that, in addition to the Howey test, all investment contracts must contain three “essential ingredients”: (1) “a contract between a promoter and an investor that establishe[s] the investor’s rights as to an investment,” which contract (2) “impose[s] post-sale obligations on the promoter to take specific actions for the investor’s benefit” and (3) “grant[s] the investor a right to share in profits from the promoter’s efforts to generate a return on the use of investor funds.” Defs. Mem. at 2; see id. at 13–28.

The Court declines to adopt Defendants’ “essential ingredients” test, which would call for the Court to read beyond the plain words of Howey and impose additional requirements not mandated by the Supreme Court. The Court sees no reason to do so. Neither Howey, nor its progeny, hold that an investment contract requires the existence of Defendants’ “essential ingredients.” To the contrary, these cases make clear that the relevant test reflects a focus on an investor’s expectation of “profits . . . from the efforts of others,” rather than the formal imposition of post-sale obligations on the promoter or the grant to an investor of a right to share in profits. Howey, 328 U.S. at 301. The Supreme Court’s use of the word “profits” in Howey was intended to refer to “income or return,” Edwards, 540 U.S. at 394, and financial returns on investments are not equivalent to post-sale obligations or profit sharing. Thus, the Court is not persuaded that precedent supports the consideration of these “ingredients” in determining whether a contract, transaction, or scheme constitutes an investment contract under Howey.

Defendants do not cite a single case that has applied their test. See generally Defs. Mem. at 13–28. Rather, Defendants contend that the Court should look to the pre-1933 state “blue sky” law cases on which the Howey Court relied. Id. at 16–17. According to Defendants, every pre-1933 blue sky investment contract case involved a contract, post-sale obligations on the promoter, and the investor’s right to receive a profit. Id. at 18–21. That may be so, but the Howey Court relied on the state courts’ definition of an investment contract as “a contract or scheme for the placing of capital or laying out of money in a way intended to secure income or profit from its employment” when fashioning the relevant test. 328 U.S. at 298 (quotation marks and citation omitted). Had the Supreme Court intended to incorporate these ingredients as essential requirements, it would have done so. In any event, even accepting Defendants’ survey and analysis of the caselaw as accurate, the fact that pre-1933 investment contract cases shared some common features does not convert those common features into requirements necessary for finding an investment contract under Howey. Rather, 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.” Reves v. Ernst & Young, 494 U.S. 56, 60–61 (1990). So, too, must this Court be guided.

Indeed, in the more than seventy-five years of securities law jurisprudence after Howey, courts have found the existence of an investment contract even in the absence of Defendants’ “essential ingredients,” including in recent digital asset cases in this District. See, e.g., SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169, 175–80 (S.D.N.Y. 2020); Balestra v. ATBCOIN LLC, 380 F. Supp. 3d 340, 354 (S.D.N.Y. 2019) (“ATB Coins did not entitle purchasers to a pro rata share of the profits derived from any ATB-managed transaction . . . . However, such a formalized profit-sharing mechanism is not required.”). And this makes sense, given that the Howey test was intended to “embod[y] a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” 328 U.S. at 299. Put differently, the Howey test was intended to effectuate “[t]he statutory policy of affording broad protection to investors,” protection that is “not to be thwarted by unrealistic and irrelevant formulae.” Id. at 301. Accordingly, the Court rejects Defendants’ argument that all investment contracts must include post-sale obligations on the promoter and grant the investor a right to share in profits from the promoter’s efforts.

The Court does not reach Defendants’ first “essential ingredient”: that a contract must exist for an investment contract to exist.[11] As discussed in greater detail below, in each instance where Defendants offered or sold XRP as an investment contract, a contract existed.

[11] The SEC’s opposition papers misconstrue Defendants’ “essential ingredients” test. The SEC dedicates several pages to refuting the argument that a written contract must exist, see SEC Opp. at 19–24, but Defendants’ proposed test does not turn on the need for a written contract as opposed to an oral or implied contract, see Defs. Mem. at 2, 18–19; Defs. Reply at 9, ECF No. 832. Therefore, the Court does not address the SEC’s arguments that Howey does not require the existence of a written contract. See SEC Opp. at 19–24.