As we previously reported in our summary of the Ripple case, a federal district court judged determined that under certain circumstances the offering of a digital asset does not create a security. The reasoning in the Ripple case has been criticized by leading to an outcome that places institutional investors ahead of retail investors and employees. In a separate, recently decided case involving digital assets, another federal district judge has declined to follow the ruling in Ripple.

The latest enforcement case was brought by the SEC against an issuer of digital coins and its promoters, and among other things alleged fraud in the offering of various digital coins. In finding that the coins at issue were securities under the Howey test, on motion to dismiss Judge Jed S. Rakoff opined that:

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 v. Ripple Labs Inc. . . . There, that court found that, “[w]hereas … [i]nstitutional [b]uyers reasonably expected that [the defendant crypto-asset company] would use the capital it received from its sales to improve the [crypto-asset] ecosystem and thereby increase the price of [the crypto-asset],” those who purchased their coins through secondary transactions had no reasonable basis to expect the same. . . . 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 . . . 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 . . . 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.

Judge Rakoff is a respected jurist, and his opinion captures many of the key critiques of the Ripple decision that academics and other commentators have raised. We have seen widespread misreporting in the crypto press and some other news sources on the holding in Ripple and its potential applicability to other digital assets. And as the latest case demonstrates, other federal district court judges—even those in the same district at the Ripple court—are not bound to follow the Ripple order. Accordingly, we continue to believe that until such time as an appellate court weighs in on the Ripple decision, issuers and intermediaries transacting in digital assets should tread carefully in applying the Ripple analysis broadly.

Judge Rakoff also brushed aside two other potential defenses to SEC enforcement that have been gaining interest in the crypto community under the major questions and fair notice legal doctrines. According to Judge Rakoff, “no doctrine — whether grounded in interpretive canons, statute, or the federal Constitution — bars the SEC from, as a preliminary matter, asserting that the defendants’ crypto assets are ‘investment contracts’ that are subject to federal securities laws.”