Courtesy of Lindsay Martin
Founded in 2012, Ripple sought to revolutionize global payments using blockchain technology and digital assets. Members of the Ripple network can quickly transfer funds to other members of the network in a secure, real-time settlement process. Ripple’s native currency is XRP, and members of the Ripple network can transfer XRP to each other as an intermediate currency. In such a transaction, the payment sender’s currency is converted to XRP, and then the XRP is converted to the receiver’s native currency. Ripple’s founders initially created 100 billion XRP in 2013, and the company still owns roughly sixty per cent of the tokens. The company sells 1 billion XRP per month to fund the network’s growth and development.
Recognizing Ripple as a convenient alternative to the traditional international payment system, over two hundred financial institutions have joined the Ripple network. Traditional international payment systems typically require financial institutions to use the Society for Worldwide Interbank Financial Telecommunication (SWIFT) messaging network and hold accounts at correspondent banks in foreign countries to settle payments. With Ripple, financial institutions can transfer money across borders by using XRP as an intermediate currency, minimizing the need to keep deposits at foreign banks.
Due to recent legal developments, Ripple faces an existential threat. On May 3, 2018, an XRP purchaser filed a class action lawsuit against Ripple Labs on behalf of all XRP purchasers, claiming that Ripple illegally offered and sold XRP as an unregistered security in violation of federal securities laws. Several other class action lawsuits making similar claims followed, resulting in consolidation in In re Ripple Labs Inc. Litigation. This post examines the legal issues leading up to the Ripple litigation and explains why XRP is most likely a security. It concludes with a discussion of the SEC’s likely approach to Ripple’s unregistered initial coin offering (ICO) given Ripple’s unique position and the SEC’s past treatment of unregistered ICOs.
Securities Regulation and Digital Currencies
To raise money to develop networks for digital assets, companies often sell tokens or coins in an initial coin offering. The main issue surrounding all ICOs is whether they qualify as investment contracts. Under the Securities Act, if a company issues an investment contract, it must file a registration statement with the SEC.
The Supreme Court laid out a test for determining what constitutes an investment contract subject to regulation by the SEC under the Securities Act in Securities and Exchange Commission v. W.J. Howey Co. The four criteria of the “Howey test” have been broken down as (1) an investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profit, and (4) profit is derived solely from the efforts of others. If all four of these factors are met, the transaction is an investment contract and therefore a security that needs to be registered with the SEC or qualify for an exemption from SEC registration requirements.
In July of 2017, the SEC provided some guidance on how they view ICOs when they released a report of investigation that looked at one specific ICO known as the Decentralized Autonomous Organization (DAO). The DAO was created by a group of people working for a company called Slock.it, who wrote the smart contract that ran the DAO. Between April 30th and May 28th of 2016, the DAO offered and sold approximately 1.15 billion digital tokens in exchange for a total of approximately 12 million ether, which had a value of $150 million at the time. After the funding period, the DAO began to operate, whereby various people made proposals to the DAO on how to spend the funds raised, and the members who bought the tokens voted to approve these proposals. If these proposals were profitable, DAO token holders were entitled to a proportional share of the reward.
The SEC assessed the facts and circumstances around the DAO and determined that it was an investment contract according to the Howey test.While the SEC chose not to pursue enforcement action due to a hack that shut down the DAO, the report put potential ICO issuers on notice that failure to comply with securities regulations may lead to enforcement action.
The SEC’s report of investigation on the DAO, while not an official regulation, served as the primary guidepost for all other ICO issuers until the SEC released its Framework for ‘Investment Contract’ Analysis of Digital Assets in April 2019. According to the SEC, “the framework is not intended to be an exhaustive overview of the law, but rather, an analytical tool to help market participants assess whether the federal securities laws apply to the offer, sale, or resale of a particular digital asset.” Overall, the Framework charts a narrow course by which a token could not be a security and emphasizes that the principal determinants of whether a given ICO qualifies as a security are whether (1) an ICO purchaser has a reasonable expectation of profits and (2) said profits are derived from the efforts of others. For both of these Howey factors, the SEC lists a number of characteristics that increase the likelihood a given ICO meets the threshold condition for each factor.
The Framework notes that an expectation of profit may exist if:
- The digital asset gives the holder rights to share in the enterprise’s income or profits, or to realize gain from capital appreciation of the digital asset;
- There is little apparent correlation between the purchase/offering price of the digital asset and the market price of the particular goods or services that can be acquired in exchange for the digital asset; and
- The digital asset is transferable or traded on or through a secondary market or platform, or is expected to be in the future.
An expectation of profit may not exist if:
- The value of the digital asset has shown a direct and stable correlation to the value of the good or service for which it may be exchanged or redeemed, and
- The trading volume for the digital asset corresponds to the level of demand for the good or service for which it may be exchanged or redeemed.
In order for the profit to be derived from the efforts of others, the Framework finds that the essential question is: Is the person, or company, or group that launched the ICO—which the SEC calls an “Active Participant” or “AP”—essential to the continuing operation of the network? The answer is likely yes if:
- An AP plays a lead or central role in deciding governance issues, code updates, or how third parties participate in the validation of transactions that occur with respect to the digital asset;
- An AP creates or supports a market for, or the price of, the digital asset; and
- There are essential tasks or responsibilities performed and expected to be performed by an AP, rather than an unaffiliated, dispersed community of network users (commonly known as a “decentralized” network).
While the principal takeaway from the SEC’s “Framework for “Investment Contract” Analysis of Digital Assets” is that most ICOs are in fact securities and need to be registered as such, it was notable that the Framework also supported the view that a digital asset sold as a security may not always continue to be a security, based upon a re-evaluation of the digital asset subsequent to its initial sale. This provided a degree of regulatory cover for cryptocurrencies, like ether, which were established by conducting what was essentially an ICO, (investors submitted bitcoin to the Ethereum Foundation in exchange for ether), but have since become decentralized to the point where no one entity is critical for their ongoing success.
In re Ripple Labs Inc. Litigation Overview
On May 3, 2018, in California state court, Ryan Coffey filed a class action lawsuit on behalf of all investors who purchased XRP issued and sold by Ripple against Ripple Labs and its co-conspirators. In his complaint, Coffey alleged that XRP had all the requisite characteristics of a security, but that Ripple Labs did not register XRP as a security in accordance with federal securities laws. Coffey requested that he and the other members of his class receive damages and that Ripple Labs be prevented from continuing to violate securities laws through the unregistered sale of XRP.
Although he voluntarily dismissed his case, Coffey’s complaint provided a strong foundation for future lawsuits against Ripple. In the months following Coffey’s original class action, Vladi Zakinov, David Oconer, and Avner Greenwald filed class actions against Ripple in California state court, making similar allegations to Coffey’s.
The California state court consolidated the Zakinov, Oconer, and Greenwald class actions and renamed them In re Ripple Labs Inc. Litigation. Ripple later removed the class action to the United States District Court for the Northern District of California. Following the consolidation and removal, the plaintiffs filed an amended complaint with new arguments. A notable difference between the new complaint and the previous complaint is that the new complaint cited the SEC’s framework for determining whether a digital asset is a security. The plaintiffs claimed that XRP is a security based on the SEC’s framework, arguing that XRP purchasers invested money in a common enterprise with a reasonable expectation of profits and that the success of XRP required the efforts of Ripple. Ripple responded to the amended complaint by filing a motion to dismiss the class action on September 19, 2019. Rather than arguing why XRP is not a security, Ripple claimedthat the plaintiffs were unable to raise their federal securities claims due to a three-year limitation in the statute. Ripple only addressed whether XRP was a security in a footnote, arguing that XRP was not an investment contract under Howeybecause (1) purchasing XRP did not constitute an investment in Ripple and (2) there was not a common enterprise between Ripple and XRP purchasers. Ripple also argued that it did not promise to generate profit for XRP holders and that the XRP Ledger was decentralized.
Predicted Classification of XRP
The pending class action lawsuit and its broader consequences pose an existential threat to Ripple Labs. Even if Ripple wins this particular lawsuit, it will remain a constant target for lawsuits and regulatory action due to XRP’s ambiguous security status.
XRP and the HoweyTest
XRP likely qualifies as a security subject to regulation by the SEC under Howey. First, XRP involves an investment of money because individuals can purchase XRP through a variety of exchanges using fiat currencies or cryptocurrencies. The Ripple website even provides a list of thirty exchanges on which individuals can purchase XRP.
Second, an investment in XRP constitutes an investment in a common enterprise because the fortunes of the XRP purchasers can been linked to the success of Ripple’s efforts. Ripple previously noted that it “sells XRP to fund its operations and promote the network,” but the website featuring this statement has been removed. Moreover, the SEC concluded that a common enterprise typically exists when evaluating a digital asset.
Third, XRP purchasers reasonably expected profits from their investment. XRP possesses many of the characteristics that the SEC lists as increasing the likelihood that there is a reasonable expectation of profits. For example, individuals may purchase XRP on a variety of secondary exchanges, and they may realize a gain from the appreciation of XRP by selling XRP on one of those secondary exchanges. Additionally, XRP is broadly offered to potential purchasers because anyone with access to cryptocurrency exchanges may purchase the digital asset.
Finally, XRP purchasers relied on the efforts of Ripple’s managers for the success of the entire enterprise. Ripple supports the market for XRP by controlling the creation and issuance of XRP and limiting its supply. In the fourth quarter of 2017, Ripple cryptographically-secured 55 billion XRP in an escrow account to control the supply of XRP. In each of its XRP quarterly markets reports, Ripple shares updates on the XRP market “to continually improve the health of XRP markets globally,” indicating support for the market of the digital asset. Further, in distinguishing itself from other cryptocurrencies in a 2017 XRP report, Ripple noted that: “it’s clear Ripple’s consistent and steadfast support of XRP is a major advantage as the payments industry continues to seriously consider it as an alternative liquidity solution.” Hence, before the litigation began, Ripple presented its control over XRP as a strength. Even taking into account the SEC’s recognition that it’s possible for digital assets to transform over their lifespan, Ripple is not sufficiently decentralized to escape classification as an investment contract. XRP purchasers still expect Ripple employees to carry out essential functions, and Ripple’s managers are still a key factor in determining the network’s success.
New Legal Precedent
Given the recency of the ICO market, case law determining whether a digital asset qualifies as an investment contract under Howey is limited. However, within the past year, several lawsuits have been filed on behalf of plaintiffs who purchased digital assets that were not registered as securities. In many of these cases, the courts were quick to classify the digital asset as a security, foreshadowing a similar outcome for In re Ripple Labs Inc. Litigation.
Balestra v. ATBCOIN LLC
ATBCOIN, or ATB, was a technology start-up company launched to facilitate rapid, inexpensive digital financial transactions through blockchain technology. The founders of the company offered digital ATB Coins to the general public in exchange for other digital assets without filing a registration statement with the SEC. The purpose of this ICO was to provide funding to create and launch the network for the coins to operate. On December 21, 2017, purchasers of ATB Coins filed a class action lawsuit in New York federal district court, claiming that the founders of ATB violated the Securities Act by offering and selling unregistered securities. In response to the defendants’ motion to dismiss for failure to state a claim, the court provided an analysis of ATB coins within the context of the Howey test. Concluding that the plaintiffs plausibly alleged facts supporting their case that the coins were an “investment contract,” the court denied the defendants’ motion to dismiss. While the Balestra case is not yet resolved, the recent denial of the motion to dismiss has troublesome implications for the pending ruling on Ripple’s motion to dismiss. Moreover, the parallels between XRP and the ATB Coin – both are digital assets meant to be used on a digital payment network – foreshadows a similar fate for XRP.
Hodges v. Harrison
Monkey Capital, LLC scheduled an ICO and solicited investors in its token, representing to investors that the token would increase in value. Monkey Capital was promoted as a decentralized hedge fund invested in SpaceX contracts and digital assets. The hedge fund did not register the token with the SEC or obtain an exemption from registration requirements. The ICO never took place, and individuals who contributed cryptocurrency worth millions of dollars in advance of the ICO filed a lawsuit in Florida federal district court. Concluding that the token satisfied all of the requirements of an investment contract under Howey, the district judge granted the plaintiffs’ motion for summary judgment regarding Monkey Capital’s offer and sale of unregistered securities in violation of the Securities Act.
Solis v. Latium Network Inc.
Latium was a tasking platform that allowed users to pay each other with its own cryptocurrency, LatiumX tokens. Latium conducted an ICO, and investors could purchase the tokens with either U.S. dollars or ether. On June 6, 2018, one of the investors filed a class action against Latium, alleging that the founders violated the Securities Act by offering and selling unregistered securities in the form of LatiumX tokens. The judge for the federal district of New Jersey concluded that the plaintiffs had adequately alleged that LatiumX tokens were investment contracts under Howey. Accordingly, the court denied the defendants’ motion to dismiss.
Prominent cryptocurrency exchanges, including Coinbase Inc., Kraken, Circle Internet Financial Ltd., and Bittrex, Inc., have cooperated to create the Crypto Rating Council (CRC). The CRC developed a system to rate digital assets according to how strongly the asset resembles the legal definition of a security. A rating of one means the digital assets has “few characteristics that are consistent with the Howey test factors” and a rating of 5 having the most characteristics. The CRC gave XRP a rating of 4, citing the securities-like language used by Ripple, its centralized development, the sale of XRP prior to its utility, and on-demand liquidity for holders of XRP.
The SEC has responded to several unregistered ICO issuances similar to Ripple’s offering of XRP. Hence, there is a potential template in place for the SEC’s resolution of Ripple’s illegal ICO.
SEC’s Treatment of Past Unregistered ICOs
The SEC’s first cases imposing civil penalties exclusively for ICO securities offering registration violations were resolved in November 2018. The SEC settled charges against two companies, Airfox and Paragon Coin Inc., that sold digital tokens through ICOs without registering in accordance with federal securities laws. Airfox and Paragon’s ICOs raised approximately $15 million and $12 million, respectively. The SEC’s orders imposed $250,000 in penalties against each company and required them to compensate harmed investors who purchased the digital assets in illegal offerings. The companies were also required to register their digital assets in accordance with federal securities laws and file periodic reports with the SEC for one year.
On June 4, 2019, the SEC sued Kik Interactive Inc. for conducting a $100 million ICO without registering its tokens. According to the SEC, Kik marketed its tokens as an investment opportunity. The SEC requested that the court enjoin Kik from violating securities laws, order Kik to disgorge their gains from the ICO, and order Kik to pay civil penalties.
On September 18, 2019, the SEC filed a complaint against ICOBox and its founder for conducting a $14 million ICO without proper registration. In their complaint, the SEC requested that the court prevent ICOBox from violating federal securities laws, order ICOBox to disgorge funds received through their illegal ICO, and order ICOBox to pay civil penalties.
On September 30, 2019, the SEC announced that it settled charges against Block.one for conducting an unregistered ICO in violation of federal securities laws. Block.one had raised approximately $4 billion in an ICO to raise capital for general expenses and to develop software and promote blockchains based on that software. Block.one agreed to pay a $24 million civil monetary penalty.
On October 11, 2019, the SEC announced that it had filed an emergency action and obtained a temporary restraining order against Telegram Group and its subsidiary TON Issuer Inc. for conducting a $1.7 billion unregistered ICO in violation of federal securities laws. The SEC’s emergency action was intended to prevent Telegram from introducing the illegally sold digital assets to United States markets. On January 15, 2020, SEC and Telegram both filedan extensive series of competing summary judgment motions.
Unique Position of Ripple
In contrast to the ICO issuers that have been the target of recent SEC enforcement actions, Ripple is a large, influential company. The XRP token is also highly integrated within the cryptocurrency sector, so a change in its regulatory status will have significant effects on other cryptocurrencies. The characteristics of XRP have been known since 2013, and the SEC has not yet implemented any action against Ripple. Thus, it may be inferred that the SEC is reluctant to bring charges against Ripple because it recognizes the broader implications such charges would have for a prominent company and the cryptocurrency sector.
It may also be the case that the SEC has, thus far, gone after the low-hanging fruit; using its limited resources to address illegal ICOs where the issuer can be easily identified, funds can be returned to investors, and enforcement would be beneficial to the public. The SEC may also be prioritizing more recent illegal ICOs. Nevertheless, it is important to note that these conjectures about the SEC’s approach to Ripple’s unregistered ICO are speculative.
Ripple’s Lobbying Campaign
Ripple’s aggressive lobbying efforts are a clear indication they are worried about the SEC potentially classifying XRP as a security. After Democrats on the House Financial Services Committee demanded an immediate moratorium on Facebook’s Libra, Ripple CEO Brad Garlinghouse and executive Chris Larsen drafted an open letter to Congress. In their letter, the executives explained that digital assets offer opportunities for innovation, financial inclusion, and economic growth. They urged lawmakers to support “regulatory clarity” to avoid disadvantaging United States companies that use these emerging technologies.
In addition, prominent former members of the regulatory community have joined Ripple’s Board of Directors, such as Ben Lawsky, the former New York Superintendent of Financial Services. As Superintendent, Lawsky established the BitLicense, a first of its kind state licensing regime specifically for virtual currency businesses. Then, in October 2019, Ripple opened an office in Washington, D.C.to increase its lobbying presence and hired Susan Friedman, a former senior advisor to Commodity Futures Trading Commission Chairman Heath Tarbert, and Ron Hammond, a former senior advisor to Congressman Warren Davidson, to work out of the new government relations office. At the same time, Ripple also announced that Craig Phillips, former Counselor to the Treasury Secretary, would join its Board of Directors and that the company was joining the Blockchain Association, a lobbying group that advocates on behalf of blockchain-based businesses.
In June 2018, Ripple launched the University Blockchain Research Initiative (UBRI) to support academic research in blockchain, cryptocurrency, and digital payments. As part of the initiative, Ripple partners with universities around the world that focus on teaching, researching, and developing blockchain, cryptocurrency, digital payments, and related subjects. Ripple provides partner universities with financial resources, access to Ripple technology and tools, and the opportunity to collaborate with Ripple team members. To date, Ripple has contributed $50 million to UBRI.
Overall, Ripple’s recent efforts indicate that its goal is to improve public and regulatory perception of its services. By adding former members of the regulatory and policymaking community to its team, Ripple has strengthened its ties with regulators, lawmakers, and governments and made it more difficult for current regulators to take actions that could harm the firm, lest these regulators upset their former colleagues. Ripple’s partnership with prominent universities through the UBRI may engender support among the academic community as well. Through these efforts, Ripple hopes to obtain “regulatory clarity,” and avoid the fate of previous ICO issuers.
The SEC’s Approach to Ripple and its Impact
When asked whether the SEC would implement enforcement actions against Ripple, SEC Chairman Jay Clayton refused to comment, stating that “there are a number of factors that go into the assessment of any remedial action.” Although the SEC has not yet filed a complaint against Ripple, its historic treatment of unregistered ICOs indicates that it will likely take steps to resolve Ripple’s unregistered sale and issuance of XRP. Further, Ripple’s recent campaign for “regulatory clarity” implies that the company recognizes that such enforcement action is possible and a major threat to its future. Even if Ripple succeeds in its motion to dismiss the most recent class action, the SEC may still launch an investigation. It is not uncommon for both the SEC and private plaintiffs to initiate an action against a securities issuer.
The SEC’s approach to Ripple would likely begin with a complaint filed against the company for selling XRP without registering their offer and sale as required by federal securities laws. In the complaint, the SEC would request that the court prevent Ripple from continuing to sell XRP in violation of the Securities Act, order Ripple to relinquish any profits it made from the unregistered sale of XRP, and order Ripple to pay a civil monetary penalty. In reality, the SEC would likely settle charges with Ripple, and the resolution would resemble settlements reached with other unregistered ICO issuers. To continue selling XRP, the SEC would require Ripple to register XRP as a security pursuant to the Securities Act. Through the registration process, Ripple would be required to disclose essential financial information to the SEC, including a description of Ripple’s properties and business, a description of XRP, information about the management of Ripple, and financial statements certified by independent accountants. Ripple may also be required to file periodic reports with the SEC for one year to ensure that it continues to comply with federal securities laws.
Determining the amount of civil penalties that the SEC would impose against Ripple presents a greater challenge. Since its first quarterly markets report, Ripple has received $1.2 billion in funding from the sale of XRP. The market capitalization of XRP is $9.4 billion based on the current circulating supply, and there are still approximately 49 billion XRP locked in escrow for Ripple Labs, with a current value of about $10.6 billion. Hence, it follows that Ripple’s benefit from previous XRP sales combined with future sales at the current price is approximately $11.8 billion. Following the same approach the SEC applied to Airfox, Paragon, and Block.one, the civil penalties applied to Ripple may be between $70.8 million and $247.8 million. Given that Ripple has recently been selling 1 billion XRP per month, at current prices, Ripple would be able to pay off the maximum predicted penalty in just over a month.
In addition to civil money penalties, the SEC required other ICO issuers to return funds to harmed investors. The financial obligation of returning the funds raised from 43 billion XRP would devastate Ripple and likely threaten its existence. Given Ripple’s scale, the SEC would more likely impose a fine reflecting a small percentage of funds raised through the sale of XRP.
Beyond the previously discussed monetary penalties, classifying XRP as a security subject to regulation by the SEC would have significant long-term effects on the future of Ripple. If the SEC classified XRP as a security, XRP owners would own shares of the company. Most analysts believe that current XRP owners would sell their holdings en masse in the wake of such uncertainty, causing the price to drop dramatically. Even if the price of XRP eventually recovered, XRP would be less effective for use in international payments due to liquidity restrictions resulting from its security classification.
Given that a security classification would threaten both Ripple’s finances and XRP’s utility in its payment system, an SEC enforcement action may sound the death knell for Ripple. However, it is worth noting that XRP’s characteristics have been apparent for several years, and the SEC has not yet initiated action despite its actions against several other unregistered ICOs. Recognizing the potential detrimental impact of the collapse of Ripple, the SEC may be delaying enforcement action. As more ICO-related securities class actions arise however, and disgruntled XRP purchasers continue to publicize its troublesome status, the SEC may have no choice but to bring an enforcement action against Ripple.