December 26, 2020 – The U.S. Securities and Exchange Commission (SEC) has filed an enforcement lawsuit against Ripple Labs Inc. and two of its executives, CEO Bradley Garlinghouse and Ripple Labs co-founder Christian A. Larsen, for the sale of digital assets known as XRP in unregistered securities offering to investors in the U.S. and worldwide.

The SEC claims that at all relevant times during the offerings and sales, XRP was an investment contract and therefore a security subject to the registration requirements of federal securities laws. And by failing to register, XRP violated Sections 5(a) and 5(c) of the Securities Act.

As the SEC has explained, the registration provisions of the Securities Act contemplate that the offer or sale of securities to the public must be accompanied by the “full and fair disclosure” afforded by registration with the SEC and delivery of a statutory prospectus containing information necessary to enable prospective purchasers to make an informed investment decision.[1]

The SEC’s complaint was filed in U.S. District Court for the Southern District of New York. The agency is seeking injunctive relief, disgorgement with prejudgment interest, and civil penalties.

This is an interesting case, one that the entire crypto world will be following. The complaint contains facts weighing in the SEC’s favor, but there are also facts weighing against. An initial reading, though, delivers one clear result – more regulatory uncertainty for Altcoins.

Ripple Labs & The Ripple Network

Ripple Labs, founded in 2012, created the Ripple payments network, which is “a real-time gross settlement system, currency exchange and remittance network” that is intended to “improve the speed, cost and reliability” of cross-border payments. The Ripple network utilizes blockchain and digital asset technology, and supports fiat currency, cryptocurrency, commodities, and other units of value. XRP is the native digital asset to the Ripple blockchain.

The SEC Complaint

In the complaint, the SEC alleges that from at least 2013 through the present, the Defendants sold over 14.6 billion units of a XRP, in return for cash or other consideration worth over $1.38 billion U.S. Dollars, to fund Ripple’s operations and enrich Larsen and Garlinghouse. The SEC alleges that at all relevant times during the offerings and sales, XRP was an investment contract and therefore a security subject to the registration requirements of the federal securities laws. By selling XRP, the SEC alleges, the Defendants engaged in and are currently engaging in the unlawful offer and sale of securities in violation of Sections 5(a) and 5(c) of the Securities Act of 1933 (15 U.S.C. §§ 77e(a)and77e(c)). The SEC claims Larsen and Garlinghouse aided and abetted Ripple’s violations of the Securities Act provisions.

It’s important to note that some of Ripple’s offerings and sales began prior to the SEC’s release of the DAO Report, FinCEN’s guidance on Application of Regulations to Certain Business Models Involving Convertible Virtual Currencies, and the SEC’s letter to Cipher Technologies Bitcoin Fund. Also, the SEC’s lawsuit also comes five years (five years!) after the SEC’s settlement with Ripple Labs Inc.’s wholly-owned subsidiary, XRP II LLC, concerning its failure to register as a Money Service Business while engaging in the sale of convertible virtual currency known as XRP.

2012 Legal Advice Warns Ripple That Sales Of XRP May Be Considered An Investment Contract

According to the complaint, Ripple engaged a law firm to provide guidance on potential legal risks associated “with the distribution and monetization of XRP.” That guidance warned Ripple in 2012 that “there was some risk that XRP would be considered an “investment contract” (and thus a security) under the federal securities laws depending on various factors,” such as how Ripple promoted and marketed XRP to potential purchasers, the motivation of purchasers of XRP, and Ripple’s other activities with respect to XRP. The law firm warned Ripple it “would face an increased risk that XRP units would be considered investment contracts” under two circumstances: if individuals purchased XRP “to engage in speculative investment trading;” or if Ripple employees promoted XRP as potentially increasing in price. Also, both memos warned that XRP was unlikely to be considered “currency” under the Exchange Act because, unlike “traditional currencies,” XRP was not backed by a central government and was not legal tender. As the SEC points out in the complaint, Ripple ignored this legal advice (from 2012, when there was little to no existing SEC case law or firm regulatory guidance on crypto, right?).

Sale Of XRP – Investment Contract

The SEC alleges the sale of XRP is equivalent to an investment contract. Investment contract = security. The SEC’s determination is based on the Howey test – the test created by the Supreme Court in SEC v. W.J. Howey Co. for determining the existence of an investment contract:

The test of whether there is an “investment contract” under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. If that test be satisfied, it is immaterial whether the enterprise is speculative or nonspeculative, or whether there is a sale of property with or without intrinsic value.

Stated another way, “[i]nvestment contracts are instruments through which a person invests money in a common enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of others.”[2]

Here, the SEC alleges individuals purchased XRP on speculation that Ripple would create a market and use for XRP, thus increasing the value of XRP. In other words, XRP’s potential value during the years it was sold was based on the efforts of Ripple.

Ripple needed “to create a market for and sell XRP to the public to monetize its holdings and finance its operations.” This translates to sell XRP and use the profits to develop a use case, therefore increasing the value of XRP. Sounds kinda like an investment contract.

Also, Ripple and Ripple executives have owned and controlled a majority of the entire supply of XRP since its creation, which, according to the SEC, enabled Ripple to control XRP supply and demand in the resale market, and thus manage and control liquidity for a future use case.

The way the SEC tells it, the sale of XRP was speculative. Ripple decided in 2015 it would seek to make XRP a universal digital asset for banks and other financial institutions to effect money transfers. This was to be (and is) XRP function, and what would (does) make XRP valuable. But, this use case also required the creation of an active, liquid XRP secondary trading market. Here’s how the SEC described what Ripple did:

 “Ripple made it part of its “strategy” to sell XRP to as many speculative investors as possible. While Ripple touted the potential future use of XRP by certain specialized institutions, a potential use it would deploy investor funds to try to create, Ripple sold XRP widely into the market, specifically to individuals who had no “use” for XRP as Ripple has described such potential “uses” and for the most part when no such uses even existed.”

The point here is that the SEC claims all of this supports a finding of an investment contract. There are other allegations in the complaint that stick out:

Ripple executives acknowledged in non-public communications that the principal reason for anyone to buy XRP was to speculate on it as an investment;

Ripple and Ripple executives made many public statements about XRP that could be interpreted by XRP investors as creating an expectation of profit based on Ripple’s efforts; and

In response to XRP investors’ concern that Ripple could sell its XRP holdings in the market at any time, causing XRP’s price to crash, in May 2017 Ripple announced it would place 55 billion XRP (most of its current holdings) into a cryptographically-secured escrow that would restrict Ripple to accessing only one billion XRP every month (the XRP Escrow).

Again, the SEC says all of this adds up to a finding that a person investing in XRP “reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of [Ripple].”

SEC Says XRP Are Not “Currency” Under the Federal Securities Laws

Likely in anticipation of Ripple’s expected response to the suit, the SEC claims XRP is not “currency” under federal securities laws. Obviously, XRP is not fiat nor is it backed by any country, government of central bank. The SEC also gives these reasons: “A ‘native currency’ that operates, for example, on Ripple’s decentralized network of blockchain technology is a specialized instrument for a particular computer network, not legal tender. Similarly, using XRP as a ‘bridge’ between two real, fiat currencies does not bestow legal tender status on XRP. The SEC then says Ripple has never offered or sold XRP as “currency,” restricted sales of XRP solely to purchasers who had a need for alternatives to fiat currencies, or promoted XRP as an instrument for consumers to purchase goods or services. For good measure, the SEC says even Ripple internally referred to XRP as a security.

But, as mentioned earlier, the SEC’s lawsuit also comes five years after the SEC’s settlement with Ripple Labs Inc.’s wholly-owned subsidiary, XRP II LLC, concerning XRP II LLC’s failure to register as a Money Service Business while engaging in the sale of convertible virtual currency known as XRP. Wait, the SEC said XRP was a virtual currency in 2015, but now says it’s not!? This seems very strange to me, but I’ll admit I haven’t gone into depth with that ruling.

The Price Of XRP Is In The Toilet

Following the announcement that the SEC is suing Ripple, the price of XRP has been on a steady decline. It started the month of December around $0.65-0.68, the high for the month, but dropped to $0.21 the day the lawsuit was announced. Overall, XRP has been on a sharp decline since December 1st, and now sits around $0.29.

Ripple’s Response: The SEC’s Attack on Crypto in the United States

Ripple’s CEO Brad Garlinghouse posted a response on Ripple’s blog, which is a copy of an email he sent to Ripple’s employees just prior to the SEC filing its lawsuit. He says “XRP is a currency, and not a security,” and describes the lawsuit as an attack on cryptocurrency. Also, he says he and Chris Larsen turned down SEC settlement offers.

Mr. Garlinghouse says Ripple has had an ongoing discussion with the SEC for nearly three years on why XRP is a currency, and not a security. He lists three reasons, noting there are more:

1. XRP is not an “investment contract.” XRP holders do not share in the profits of Ripple or receive dividends, nor do they have voting rights or other corporate rights. Purchasers receive nothing from their purchase of XRP except the asset. In fact the vast majority of XRP holders have no connection or relationship with Ripple whatsoever.  

2. Ripple (our company) has shareholders; if you want to invest in Ripple, you do not buy XRP but rather shares in Ripple.

3. Unlike securities, the market value of XRP has not been correlated with Ripple’s activities. Instead, the price of XRP is correlated to the movement of other virtual currencies.

Mr. Garlinghouse then criticizes the SEC, calling the lawsuit “an assault on crypto at large.” The SEC’s heavy hand, he warns, could push the crypto industry, and its innovations, outside the U.S., something Ripple is seriously considering. Anyway, Ripple will fight the SEC’s lawsuit.

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[1] See Securities And Exchange Commission, Release No. 81207, Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, p. 11 (July 25, 2017).

[2] See United Housing Found., Inc. v. Forman, 421 U.S. 837, 852-53 (1975) (The “touchstone” of an investment contract “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”).