On December 22, 2020, the US Securities and Exchange Commission filed a lawsuit against Ripple Labs Inc. (“Ripple”), Christian Larsen, co-founder, chairman and former CEO of the company. and Bradley Garlinghouse, the Company’s current CEO (collectively the “Defendants”) for the execution of an unregistered security offering totaling $ 1.38 billion.
Defendants have sold over 14.6 billion units of Ripple’s “XRP” digital assets to investors in the US and around the world for cash or other purposes since early 2013.
The SEC has taken the position that XRPs are “investment contracts” and therefore securities within the meaning of the Securities Act of 1933. Since Defendants did not view XRP as collateral, they did not attempt to register XRP with the SEC and accordingly did not meet the SEC’s requirements for securities offering. Similar to previous enforcement actions against Kik Interactive Inc., the SEC seeks permanent injunctions, the cancellation of illicit profits, and civil sanctions against the defendants.
This case has implications for participants across the crypto asset industry. Digital asset issuers are facing another conservative take on the Howey Test, a 75-year-old test that many consider to be unsuitable for crypto assets. Crypto exchanges and brokers remain in limbo, unsure whether to continue supporting a popular and powerful asset for fear of gaining regulatory scrutiny themselves.
Ripple was founded in 2012. It develops and maintains the XRP Ledger, an underlying peer-to-peer database on which the XRP tokens are executed. As a digital asset, XRP differs from Bitcoin or Ethereum in that the latter two are shaped by an ongoing process called mining. The supply of XRP was set in advance at 100 billion XRP in 2012, of which 80 billion should be reserved for planned allocations, and the remaining 20 billion XRP are held by individuals including the two executives. Since then, Ripple has gradually released XRP according to the alleged unregistered one described above.
The SEC claims that Ripple began increasing speculative demand and trading volume for XRP in 2013 and continued those efforts in a number of ways: 1) Ripple conducted a “market sale” through intermediaries who sold XRP to public investors; 2) Ripple offered and sold XRP as part of its “institutional sale” to at least 26 institutional investors. 3) Ripple distributes and transfers XRP to third parties as compensation, service fee, commission, and incentives without restricting the resale of XRP. and 4) Ripple incentivized at least 10 digital asset trading platforms in XRP to list XRP and meet certain trading volume metrics. According to the SEC, prior to the distribution, Ripple was fully aware that XRP could be viewed as an “investment contract” (ie, security) and was warned by its attorneys of the risk should the SEC make such a determination.
In 2018, Ripple developed a use case for XRP – the product “On-Demand Liquidity” (ODL). The ODL network enables money transfer companies to make cross-border payments using XRP as an intermediary between two local fiat currencies. Ripple has issued 324 million XRP to ODL affiliates.
XRP sold as a “security”, “use” or “currency”?
The SEC claims that XRP is a security because money has been invested in a joint venture with a reasonable expectation that the profit will result from the business or administrative efforts of others (this analysis is commonly referred to as the “Howey Test” after the US of 1946) SEC v. WJ Howey Co.). In its analysis, the SEC highlighted the following aspects of the offering that led to the conclusion:
- Ripple distributed XRP for cash or other consideration worth over $ 1.38 billion.
- XRP buyers invested in a joint venture because XRP’s profits and losses are related to Ripple’s success and failure in increasing the demand and price of XRP. As a company, Ripple not only manages the public market of XRP, but also shares a common interest with investors as it holds a significant stake in XRP and uses the proceeds from the XRP sale to fund its operations.
- Defendants pledged to make significant efforts to develop, monitor and maintain a public market and a secondary market for XRP in order to increase trading volume and resale opportunities. Defendants have repeatedly made public statements highlighting their business development efforts that will fuel the demand, acceptance, and liquidity of XRP.
- Ripple has been the main source of information regarding XRP. These efforts resulted in investors reasonably expecting Ripple’s corporate and managerial efforts to fuel the success or failure of Ripple’s XRP project.
After concluding that XRP is an investment contract under the Howey Test, the SEC further argued that XRP is not being sold for its utility function within the ODL network. According to the SEC, ODL wasn’t commercially available until 2018, and even after its launch, the use of XRP was heavily promoted by Ripple’s money transmitters. XRP was sold and traded in quantities that “far exceeded any possible use of XRP as a medium for transferring value”. In addition, the SEC denied the possibility that XRP would qualify as “currency” because “the use of XRP as a“ bridge ”between two real fiat currencies does not give XRP legal tender status”.
The SEC also alleged that Ripple manually controlled XRP’s trading activity by “selectively disclosing information” to investors. The SEC also claims that Ripple manipulated the price and liquidity of XRP to maximize the amount of money Ripple could raise.
Implications and Effects
This lawsuit is another major case in the SEC’s continued enforcement activities against unregistered offers of crypto tokens. With a market capitalization of $ 12.1 billion, XRP is one of the top five most traded cryptocurrencies. Unlike other digital tokens, XRP is held by a large number of institutional investors and money transmitters such as banks. According to Brad Garlinghouse, CEO of Ripple, who is also a defendant on the complaint, Ripple will strike back and “prove their case in court.” Garlinghouse argued that legal action against the XRP is “an attack on crypto in general” and will have a “snowball effect” across the industry.
Crypto asset exchange platforms such as CoinDesk have removed XRP from the list pending the outcome of this legal dispute. Given the regulatory uncertainty, Ripple is also considering moving its headquarters outside of the United States to a country that doesn’t see XRP as a security.
Industry participants who hold or do business with XRP should proceed with caution and reassess the potential impact of the SEC succeeding in this lawsuit. Industry participants who wish to trade only in assets that are not securities may be subject to regulatory requirements in the event that the lawsuit is resolved in favor of the SEC.