I’m taking a break from our regular Solidity programming to take a close look at the securities litigation filed against Ripple Labs on May 3. Let’s look very closely at Plaintiff’s claim that XRP is a security, which exposes it to a broad array of regulatory and private legal actions.

Current Procedural Posture

First, the case was filed recently (ok, back in May, but in judicial time that’s pretty recent) in California State Court as a securities class action against Ripple and its CEO. Plaintiff lives in San Diego.

Less than a week ago, the defendants removed the case from state court to federal court in San Francisco. This is a simple and common defense maneuver. Defendants do it because it’s often thought, whether true or not, that federal court is less “plaintiff friendly.” There will likely be some objections from the plaintiffs to try to send it back to state court.

As I write this, this only pending matter in open court is a routine status conference to be held in September. The parties are probably planning or have already started discovery requests. Discovery is the phase of litigation where the parties get to demand documents and conduct depositions. It’s the phase where Michael Avenatti is making so much progress against Trump in the Stormy Daniels litigation.

Almost surely, the defense is planning a motion to dismiss or some other tactic to stop the litigation before it really starts.

Substantive Claims

It’s a thirty page complaint, so there’s a lot of ground to cover – both on the facts and the law. Some of the issues border on the salacious (allegations of bribes to Coinbase or fraudulently conflating sources of revenue, for example), some issues are legal technicalities (e.g., seeking class action status), and some issues raised are actually fairly interesting discussions of the blockchain technology for the court’s benefit.

I’m going to focus on the three pages where plaintiff’s counsel alleges Ripple’s coin (“XRP”) is a security.

If it’s a security, then Ripple needed to file a registration statement (expensive), provide extensive financial disclosures, and is subject to a whole host of securities laws and private litigation, such as this case.

The Howey Test

Whether a local snow cone business, financial services company, or blockchain startup needs to comply with complex securities laws (both state Blue Sky laws and/or federal securities laws) often turns on whether those companies are selling “securities.”

Lawyers and courts look to the seminal Securities and Exchange Commission v. W. J. Howey Co. case to guide them in the analysis of whether someone is, or is not, dealing in securities. When you’re selling stocks, the analysis is pretty cut and dried. But there are many cases where it isn’t quite so clear, especially with the recent way of initial coin offerings (“ICOs”).

Given all the buzz over blockchains in the past year, it’s understandable that the Internet has recently minted a massive number of new experts on the Howey test.

We spent a lot of time on Howey in my securities regulation class. W.J. Howey Co. was selling real estate based contracts giving buyers a share of a large farm, which the buyers then leased back to Howey to run its farming operations. Buyers hoped for large profits from Howey’s agricultural management skill and experience. The court concluded that Howey was dealing in securities because buyers invested money into an endeavor where Howey promised to generate profits for the buyers through its agricultural management.

While today’s Howey analysts focus on a mechanical four pronged test crafted by Justice Murphy in 1946, they miss that courts often look to the simpler policy behind the mechanical rule to help guide a decision. It’s a pretty simple policy: if you’re hoping someone else will take your money, pool it, and generate profits for you, then it’s very likely you’re buying a security that needs to be regulated to protect investors and create confidence in markets.

Plaintiff’s Application of Howey

But who cares what I say? I’m yet another Howey analyst, right?

Notwithstanding everything I wrote above, here are the four prongs of Howey, summarized:

  1. an investment of money,
  2. in a common enterprise,
  3. with an expectation of profits, and
  4. profits depends on defendant’s management capabilities.

And here’s how the Plaintiff argued Howey applies in the Ripple case (keep in mind that, new facts will emerge from discovery to either strengthen or weaken the arguments):

First, XRP buyers invested money. This one is kind of simple. To buy XRP you either have to exchange it for some other cryptocurrency or put real cash into it. Either way, it’s money.

Second, investors are buying into a common enterprise in that XRP is fungible and, importantly, profits are intertwined with Ripple Lab because, as Ripple says, it “sells XRP to fund its operations and promote the network.”

Third, XRP buyers had a reasonable expectation of profits. This seems pretty obvious. Why else would you buy XRP? Plaintiff points out a number of facts to establish this element but the strongest might be that defendants “publicly touted XRP’s price performance on numerous occasions.”

Fourth, the profits were dependent solely on Ripple’s technical, entrepreneurial, and managerial efforts. Plaintiff points out that Ripple itself stated that it was selling XRP for the purpose of funding “its operation and [to] promote the network.”

What Happens Next

In litigation the plaintiff gets to make the opening argument, in the form of the complaint we just analyzed. Without a counter argument, it seems pretty convincing. Ripple and Garlinghouse will need to eventually answer the complaint, in which they may or may not give us a counter argument – we’ll see!

If they file a motion to dismiss, they’ll need to explain why Plaintiff’s analysis of Howey is wrong, which is be very interesting to read.

Stay tuned and I’ll provide updates as the case progresses.