The SEC v. Ripple and the Future of Crypto
The crypto-world has exploded in popularity in 2021 as evidenced by the value of Bitcoin surpassing $50,000,[1] Non-Fungible Tokens selling for millions of dollars,[2] and major celebrities like Elon Musk endorsing the technology.[3] For many, the recent craze resembles the 2017 crypto-boom and subsequent bust, and though there are reasons to believe this recent surge in popularity has greater staying power,[4] the industry’s future remains uncertain. From a legal standpoint, the most significant unanswered question moving forward are the circumstances in which digital assets are considered “investment contracts” and thus securities, requiring compliance with onerous federal securities regulations. For years, crypto-entrepreneurs, lawyers, and commentators have been left without significant guidance in making this determination, but the SEC’s recent lawsuit against Ripple and two of the company’s executives, Brad Garlinghouse and Christian Larsen, may provide some much-needed legal clarity.
The SEC initiated the Ripple lawsuit on December 22, 2020 by filing a complaint in the Southern District of New York.[5] The crux of the complaint is the allegation that Ripple, Garlinghouse, and Larsen offered and sold $1.38 billion of a digital asset, XRP, through transactions which constituted investment contracts.[6] These transactions were not registered with the SEC, thus violating federal securities laws.[7] The term investment contract was defined by the Supreme Court in United States v. Howey as an investment of money into a common enterprise with a reasonable expectation of earning profit through the efforts of others.[8] The crucial question in assessing whether digital assets like XRP meet this definition is determining whether the “efforts of others” are required to operate the asset or whether the asset’s operation is decentralized to the point where no individual or entity is necessary for its functioning.[9]
In arguing XRP’s functioning required the efforts of Ripple and its executives, the SEC cites promises by Ripple to undertake significant efforts to build value for XRP as well as to develop, monitor, and maintain a secondary market for XRP with a goal of increasing trading volume and resale opportunities.[10] Repeatedly, Ripple touted the ability of its team to succeed in these promised efforts, as well as emphasizing efforts undertaken, while holding itself out as the primary source of information relating to XRP.[11] These actions, the SEC alleges, left purchasers of XRP no choice but to rely on the efforts of Ripple for the success of their investments.[12] Arguably, the most damaging piece of evidence the SEC cites are two memos received by Ripple from their lawyers in 2012 advising them efforts of this nature may lead to XRP being deemed an investment contract and to contact the SEC for further guidance.[13] Instead of heeding this advice, Ripple and its executives proceeded with the unregistered offering, assuming the risk of violating federal law.[14]
By going forward with the offer and sale of XRP without filing a registration statement, the SEC argues the defendants “created an information vacuum such that Ripple and the two insiders with the most control over it—Larsen and Garlinghouse—could sell XRP into a market that possessed only the information Defendants chose to share about Ripple and XRP.”[15] Controlling information in this manner allowed Ripple, Garlinghouse, and Larsen to create hype and “monetize their XRP while using the information asymmetry they created in the market for their own gain, creating substantial risk to investors.”[16] The complaint exemplifies this manipulation with statements from the executives in which they publicly claimed to be “very long” on XRP while at the same time selling significant portions of their individual holdings without disclosure.[17]
Ripple has vehemently denied these allegations and filed an answer on January 29, 2021, asserting various counter arguments.[18] The first of these arguments presented is that XRP is not a security because among other reasons, it operates on a fully decentralized network whose continued functioning is in no way dependent on Ripple.[19] Instead of a security, Ripple claims XRP is a store of value and a medium of exchange, citing determinations in the United Kingdom, Japan, and Singapore where regulators have deemed this to be the case.[20] Further, Ripple argues “[t]he SEC’s filing… amounts to picking virtual currency winners and losers”[21] and has separately filed a Freedom of Information Act (“FOIA”) request with the SEC to obtain documents from the Commission about their determinations that Ethereum and bitcoin are not securities.[22] With the FOIA request, Ripple appears to be attempting to dig up internal SEC communications showing the lawsuit against them is arbitrary and unfair.[23] Finally, Ripple brings various policy arguments against designating XRP as a security including, the harm to XRP holders by causing the price to decline, driving crypto entrepreneurs outside of the United States, and damaging the country’s competitiveness and ability to innovate “at a time when the United States has national security concerns about China’s efforts to control bitcoin and ether.”[24] Separately, Larsen and Garlinghouse have filed motions to dismiss the charges against them, claiming the SEC has not pled sufficient facts to prove the requisite state of mind for personal liability.[25]
Many commentators see Ripple’s focus on XRP’s treatment in other countries, cries of being singled out, and use of various policy arguments as signals the company realizes its legal position is weak.[26] However, as it stands, neither party has expressed a willingness to settle[27] and a fight in court seems likely. If a trial does occur, the result will be significant both for the precedent it sets as well as for the opportunity it will provide to glean how the new SEC chair, Gary Gensler, will treat digital assets going forward. Gensler, a former Professor at MIT who taught courses on blockchain and digital assets, brings a level of knowledge and expertise in the area the agency has not had to date.[28] Whether crypto-knowledge equates to crypto-friendly, however, remains an open question and how the SEC approaches the Ripple case may provide an answer. Regardless of the outcome, solid precedent could provide much-needed clarity to crypto-entrepreneurs and their lawyers, giving them the ability to structure their assets and businesses in compliance with the result, potentially shaping the industry for years to come.
Footnotes
