On December 22, 2020, the U.S. Securities and Exchange Commission (“SEC”) filed an action against Ripple Labs Inc. (“Ripple”), Christian Larsen, the company’s co-founder, executive chairman of its board, and former CEO; and Bradley Garlinghouse, the company’s current CEO (together, the “Defendants”) for conducting an unregistered securities offering with a total value of US$1.38 billion.
The Defendants have sold over 14.6 billion units of Ripple’s digital asset known as “XRP” to investors in the U.S. and worldwide for cash or other considerations since the beginning of 2013.
The SEC has taken the position that XRP are “investment contracts” and therefore securities under the Securities Act of 1933. Because the Defendants did not view XRP to be a security, they did not seek to register XRP with the SEC and accordingly failed to meet the SEC’s requirements for securities offerings. Similar to the previous enforcement actions against Kik Interactive Inc., the SEC is seeking a permanent injunction, disgorgement of ill-gotten gains, and civil penalties against the Defendants.
This case holds implications for participants throughout the entire crypto asset industry. Issuers of digital assets are faced with yet another conservative interpretation of the Howey Test, a 75-year old test believed by many to be ill-suited for crypto assets. Crypto exchanges and brokerages are left in limbo, uncertain whether to continue supporting a popular and well-performing asset for fear of attracting regulatory scrutiny themselves.
Ripple was founded in 2012. It developed and manages the XRP ledger, an underlying peer-to-peer database on which the XRP tokens operate. As a digital asset, XRP is different from Bitcoin or Ethereum in that the latter two are minted through an ongoing process called mining. The supply of XRP, on the other hand, was fixed in advance at 100 billion XRP in 2012, 80 billion of which was to be held in reserve for scheduled allotments, and the remaining 20 billion XRP is held by individuals, including the two executives. Since then, Ripple has gradually released XRP pursuant to the alleged unregistered described above.
The SEC alleges that Ripple began its efforts of increasing speculative demand and trading volume for XRP in 2013 and pursued those efforts through multiple avenues: 1) Ripple conducted a “Market Sale” through intermediaries who sold XRP to public investors; 2) Ripple offered and sold XRP to at least 26 institutional investors through its “Institutional Sale”; 3) Ripple distributed and transferred XRP to third parties as compensation, service fee, commission and incentives with no restrictions on the resale of XRP; and 4) Ripple provided incentives in XRP to at least 10 digital asset trading platforms for listing XRP and meeting certain trading volume metrics. According to the SEC, prior to the distribution, Ripple was fully aware that XRP could be considered an “investment contract” (thus a security) and was warned by its lawyers regarding the risk should the SEC made such a finding.
In 2018, Ripple developed a use case for XRP – the “On-Demand Liquidity” (ODL) product. The ODL network enables money transmitting businesses to make cross-border payments through XRP as an intermediary between two local fiat currencies. Ripple issued 324 million XRP to entities associated with ODL.
XRP, sold as a “security”, for “use”, or as “currency”?
The SEC claims XRP is a security because money was invested in a common enterprise with a reasonable expectation of profit to be derived from the entrepreneurial or managerial effort of others (this analysis is commonly referred to as the “Howey Test”, after the 1946 US Supreme Court case SEC v. W.J. 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 considerations worth over 1.38 billion USD.
- Purchasers of XRP made an investment into a common enterprise because the gain and loss of XRP were tied to Ripple’s success and failure in driving the demand and price of XRP. Ripple, as an entity, not only manages the public market of XRP, it also shares a common interest with the investors as it holds a significant amount of XRP and uses proceeds from XRP sale to fund its operation.
- The Defendants promised to undertake significant efforts to develop, monitor, and maintain a public market and a secondary market for XRP with a goal to increase trading volume and resale opportunities. The Defendants made repeated public statements highlighting its business development effort that will drive demand, adoption and liquidity of XRP.
- Ripple held itself out as the primary source of information regarding XRP. These efforts led investors to reasonably expect that Ripple’s entrepreneurial and managerial effort would drive 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 XRP is not sold for its utility function within the ODL network. According to the SEC, ODL was not commercially available until 2018, and even after its launch, usages of XRP by money transmitters were heavily incentivized by Ripple. XRP was sold and traded in an amount that “far exceeds any potential use of XRP as a medium to transfer value”. Furthermore, the SEC denied the possibility that XRP as “currency” because “using XRP as a ‘bridge’ between two real fiat currencies does not bestow legal tender status on XRP”.
The SEC also alleged that Ripple manually controlled XRP’s trading activity by “selectively disclosing information” to investors. The SEC further alleges that Ripple manipulated the price and liquidity of XRP to maximize the amount of money Ripple could raise.
Implications and Impact
This lawsuit marks another high-profile case in the SEC’s continued enforcement activities against unregistered offerings of crypto tokens. XRP is among the top five most traded cryptocurrency with a market cap of $12.1 billion.. Different from other digital tokens, XRP is held by a large number of institutional investors and money transmitters like banks. According to Ripple’s CEO Brad Garlinghouse, who is also a defendant to the complaint, Ripple will fight back and “prove their case in the court.”. Garlinghouse argued the legal action against the XRP is “an assault on crypto at large” and will have a “snowball effect” on the industry as a whole..
Crypto-asset exchange platforms like CoinDesk have delisted XRP pending the result of this litigation. Given the regulatory uncertainty, Ripple is also considering moving its headquarters outside the US to a country that does not consider XRP as a security.
Industry participants who hold XRP or have business dealing in XRP should proceed with caution and re-evaluate the potential implications of the SEC succeeding with this lawsuit. Industry participants who seek to deal exclusively in assets that are not securities might find themselves subject to securities regulatory requirements in the event the lawsuit is determined in favour of the SEC.
We will continue to monitor the development of this case and encourage issuers and stakeholders to consult advisors and securities commissions for further guidance.