SEC v. Ripple: Legal Takeaways and Potential Consequences
The legal battle between the U.S. Securities and Exchange Commission (SEC) and Ripple Labs, Inc. (Ripple) could soon come to an end. Summary judgment motions have been filed by both the SEC and Ripple, and a decision from the Southern District Court of New York is expected in the next few months.
But what is it all about?
Released in 2012, Ripple is a blockchain-based digital payment network and protocol which enables a payment settlement system and currency exchange network that can process transactions globally. XRP is the native cryptocurrency on the Ripple network, and it consistently lists among the top 10 cryptocurrencies by market capitalization. Ripple employs a consensus mechanism using a collection of servers owned by banks to confirm transactions rather than mining on a blockchain.
On December 22, 2020, the SEC filed a lawsuit against Ripple and two of its executives, alleging that it raised over US $1.3 billion through the sale and distribution of the XRP in an unregistered securities offering to investors in the U.S. and worldwide.
And what it all boils down to?
The outcome of the case, which could potentially set a new legal precedent, highly depends on the technicalities of the examination of the facts and legal arguments in order to establish whether the offering of XRP qualifies indeed as a security.
Does the offering of XRP meet the traditional criteria of the test that the SEC is usually conducting to establish if U.S. securities laws apply? This article will discuss the arguments and facts put forward by the parties in an attempt to further highlight and anticipate the novel complexities of this case and the challenge of the district judge to make the final call.
Latest developments of the case
On September 21, 2022, the U.S. District Judge Analisa Torres reviewed and granted the request for the Chamber of Digital Commerce, an American advocacy group for blockchain technology, to file an amicus curiae brief. The brief does not proffer any opinions on litigants’ arguments; instead, it aims to ensure that the decision on the case creates a consistent precedent for industry members to follow.
Most recently, Judge Torres ordered the SEC to hand over certain documents regarding a June 14, 2018 speech given by William Hinman, the then-director of the SEC’s Division of Corporation Finance, at the Yahoo Finance All Markets Summit, in which he said that Ether was not a security. According to Reuters, Hinman said:
[p]utting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of Ether, the Ethereum network and its decentralised structure, current offers and sales of Ether are not securities transactions […].
The Hinman documents could be a crucial piece of evidence for Ripple as they could strengthen its position that XRP is not a security. The SEC’s case rests, in fact, on the argument that Ripple has conducted an unregistered securities offering, on the assumption that XRP, the cryptocurrency at issue, is a security falling under the scope of the Securities Act and, accordingly, the SEC’s jurisdiction.
The ‘Howey Test’ in the context of digital assets
The SEC based its allegations on the so-called Howey Test, which establishes certain criteria for identifying whether an asset constitutes a security. Specifically, in SEC v. Howey the Supreme Court set a precedent and provided a framework for determining whether certain assets are “investment contracts”, the broadest category of securities (Section 3(a)(10) of the Securities Act).
Digital currencies are notoriously difficult to categorize due to their complexity and, at times, the technology involved. As such, this qualification by the SEC has generated an enormous interest and debate within the cryptocurrency and blockchain community, given that a new legal precedent and guardian might be established for cryptocurrency.
In view of the potential consequences of the outcome of this case, this article looks at how Howey plays out in the context of XRP, and in particular, at the arguments concerning the analysis and scrutiny of XRP sale to determine whether it has the characteristics of any product that meets the definition of security under the federal securities laws.
Without contending, disputing or setting any conclusions on the arguments and factual assessment (or their truthfulness or authenticity) put forward by the SEC or Ripple, this article intends to outline some of the main points highlighted by both parties to support their allegations around the Howey Test. The SEC and Ripple provided extensive evidence and level of details which will be ultimately weighed by the Southern District Court of New York.
The parties shaped their arguments around the key elements of the Howey Test, according to which an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” As such, there are three criteria for determination:
- the investment of money;
- common enterprise; and
- reasonable expectation of profits derived from the efforts of others.
The SEC’s main arguments on the merit of the case
In its complaint, the SEC argues that at all relevant times during the offering, XRP was an investment contract and therefore a security subject to the registration requirements of the federal securities laws. Such an allegation relies on the U.S. Supreme Court’s view that the definition of whether an instrument is an investment contract and therefore a security is a:
“flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”.
Based on a thorough scrutiny of an extensive collection of internal documentation, correspondences between employees, public statements, markets reports, information on the Ripple’s website, Twitter and other social media channels and diverse sources, the SEC argued that:
A. Ripple (and for the purposes of this article including also individual defendants, where applicable as per the SEC’s complaint) led investors to reasonably expect that Ripple’s and its agents’ entrepreneurial and managerial efforts would drive the success or failure of Ripple’s XRP projects:
- Ripple promised to undertake significant efforts to build value for XRP;
- Ripple promised to undertake significant efforts to develop and maintain a public market for XRP investors to resell XRP;
- Ripple touted the ability of its team to succeed in its promised efforts;
- Ripple publicly touted the extensive entrepreneurial and managerial efforts that it did actually undertake;
- Economic reality dictates that XRP purchasers have no choice but to rely on Ripple’s efforts for the success or failure of their Investment (economic reality has also led reasonable investors to expect that Ripple and its agents will undertake significant efforts to increase the price of XRP).
B. Purchasers of XRP invested into a Common Enterprise:
- Arguments include: investors who purchased XRP in the offering invested into a common enterprise with other XRP purchasers, as well as with Ripple; Ripple’s success or failure in propelling trading of XRP drives demand for XRP, which will dictate investors’ profits or losses; the price of XRP rises and falls for XRP investors together and equally for all investors; Ripple did not segregate or separately manage proceeds from different XRP purchasers in the offering; Ripple is responsible for the distribution of XRP and the promotion and marketing functions of the Ripple network (an identifiable actor who held itself out as responsible for making efforts with respect to XRP).
C) Ripple led investors to reasonably expect a profit from their investment derived from defendants’ efforts:
- Defendants’ publicly stated goal was to increase “demand” for XRP through their entrepreneurial and managerial efforts;
- Ripple assured investors Ripple would protect the trading markets for XRP;
- Ripple touted investors’ ability to easily buy and sell XRP;
- Ripple touted XRP as an investment, including by highlighting XRP price increases;
- Ripple’s privately-stated goal was to increase speculation on the price of XRP;
- XRP’s characteristics, as constructed by Ripple, reasonably fueled purchasers’ expectations of profiting.
Ripple’s main arguments on the merit of the case
In its turn, while not denying the sale of XRP, Ripple has disputed the SEC’s allegations, arguing the following:
I. The SEC has failed to prove the essential ingredients of investment contracts
- There are no contracts setting forth: (i) rights and obligations between Ripple (arguably promoter) and purchasers (arguably investors), (ii) post-sale obligations on the Ripple to take specific actions for the purchasers’ benefit and (iii) the purchasers’ right to share in profits from Ripple’s efforts to generate a return on the use of purchasers’ funds;
- Examples include: donations, giveaways, and purchases using XRP with no contractual relationship at all between defendants and the XRP recipients or where contracts with Ripple did exist, those contracts imposed no post-transaction obligations on Ripple or rights on XRP recipients.
II. The criteria of the Howey Test is not met
- The SEC takes a mix-and-match approach, as it mixes and matches different categories of defendants’ transactions over an eight-year period with different Howey elements, not all present at the same time.
A) The SEC has failed to prove an Investment of Money
- In many instances, defendants did not offer and sell XRP for money (also giveaways, donations);
- There were no expectations of ultimate XRP purchasers in the secondary market, as for virtually all XRP purchasers on the secondary market money paid by them for XRP went to someone other than defendants, thus rather strangers buying from strangers;
- For sales of XRP in which buyers paid money to the defendants, it was for purposes of “swiftly” converting that XRP into a fiat currency (consumptive use) and not to invest in any common enterprise or to take on a risk of investment loss.
B) The SEC cannot prove a Common Enterprise
- The SEC’s shifting Common-Enterprise theories all fail as a matter of law because they amount to broad vertical commonality (a common enterprise cannot be established by a “mere showing that the fortunes of investors are tied to the efforts of the promoter” – that is broad vertical commonality);
- The SEC cannot show horizontal commonality: Ripple did not pool its funds from XRP sales, it rather sold XRP through distinct subsidiaries with distinct bank accounts and distinct business efforts; No undivided interests were present here; Ripple was under no obligation to expend funds it received from its sales of XRP for the benefit of XRP purchasers;
- The SEC cannot show strict vertical commonality: no interdependence of both profits and losses of the investment, as XRP holders can experience losses on their XRP holdings even when Ripple has positive income, and Ripple’s equity can increase in value even as XRP decreases in price (opposite also being true); No “pledge” by Ripple to purchasers of XRP that bound anyone to do anything specific with the XRP; XRP had an important use case to pay transaction fees on the XRP Ledger.
C. The SEC cannot establish that XRP holders reasonably expected profits from defendants’ entrepreneurial and managerial efforts
- A mere expectation of profit, standing alone, is insufficient to create an investment contract: there was no commitment of Ripple to take actions to return a profit to the purchasers of XRP;
- Defendants’ public statements are insufficient as a matter of law to create a reasonable expectation of profits from defendants’ efforts: statements of Ripple argued by the SEC relied on snippets – generally taken out of context – from isolated tweets, press releases, internal emails that no outside “investor” would have access to and other non-contractual materials over an eight-year period; “Touting” and “promoting” XRP’s potential is materially different from undertaking an obligation to use its efforts to increase XRP’s price; No “actual commitments to perform specific services” were undertaken by Ripple in exchange for investor funds;
- The SEC’s reliance on cases concerning ICOs is again misplaced (some cited cases did involve contractual rights and obligations – not the case for Ripple);
- At a minimum, there is a genuine dispute of material fact regarding whether XRP purchasers reasonably expected profits from defendants’ efforts: to the extent XRP owners have obtained profits, those profits resulted primarily from market forces of supply and demand not from the “efforts of others” element of Howey; Ripple’s touting of its expertise” is “not determinative of defendant’s crucialness to the success or failure of the enterprise’’; SEC invoked a selective “sampling” of defendants’ public and non-public statements generally taken out of context, hand-pick declarations that ignores contrary evidence in the record; Schwartz’s “legally obligated” statement was accompanied by him saying that Ripple makes “absolutely…no promises or representations about the value of XRP’’. Under Howey, what matters is not whether the alleged promoter promised it would put in efforts but whether purchasers had a reasonable “expectation that they would earn a profit solely through the efforts of the promoter.”
In addition, Ripple argued that the widely held belief that XRP was not a security was reinforced when the U.S. Department of Justice (“DOJ”) and FinCEN publicly described XRP as a “virtual currency” and required a Ripple subsidiary to register as a “money services business” – a designation that is mutually exclusive with SEC regulation.
There is significant uncertainty and lack of clarity as to what regulatory regime – if any – would apply to sales of XRP or XRP-like cryptocurrencies.
The assessment above illustrates the difficulty to assess the elements of the Howey test with cryptocurrencies due to its various complex and novel elements and as a matter of the disruptive blockchain technology. Is the Howey Test in its current form still adequate as a precedent?
Guidance is needed to properly deal with classification of the sector of decentralized finance as investment securities.
Classification of a certain cryptocurrency or digital asset is significantly dependent on the characteristics of such cryptocurrency or digital asset itself and its administrative structure such as algorithms, profit derivation, etc.
Furthermore, is it reasonable or even adequate to apply securities regulations to digital assets that have millions of international ever-changing independent investors and users? Can something be said about a potential tendency of over-arching jurisdiction of the SEC?
Undoubtedly, SEC v. Ripple represents an opportunity to shape the legal framework and rules of the road ahead for the digital assets industry and potentially to set a new legal precedent for the digital asset space in the United States and the jurisdiction of the SEC.
Finally, this sort of legal challenges, as a result of the decentralized nature of cryptocurrency, will become more and more present in corporate and civil lawsuits as cryptocurrency use continues to rise.
About the authors.
Oana-Jeanina Astilean, Co-founder and Administrator of MetaverseLegal and General Counsel at JTC Group. Oana has a focus on private equity transactions, corporate governance and corporate law issues and is engaged in developing digital assets services involving blockchain technologies. Oana is currently pursuing a Blockchain Regulator Certification Program at the University of Nicosia, Cyprus.
Daniele Pellegrini, co-administrator of MetaverseLegal, is a qualified corporate lawyer (Italy) holding a Ph.D. in legal studies (University of Florence, School of law). Daniele is frequently engaged in cross-border transactions and regularly advises clients on asset management and private investment matters, including private equity and venture capital, M&A, divestitures and recapitalizations. He is currently pursuing a Blockchain Regulator Certification Program at the University of Nicosia, Cyprus.