What to Know About the SEC vs. Ripple Lawsuit
On December 22, 2020, the Securities and Exchange Commission (SEC) filed a lawsuit against Ripple Labs Inc., and its executives, Chris Larsen and Brad Garlinghouse, alleging that they raised over $1.3 billion through an “unregistered, ongoing digital asset securities offering.” The enduring battle has continued for almost two years now, and will result in a decision that will set precedent on whether cryptocurrency is a security.
Grounds for the Suit
Ripple Labs was founded in 2012 with the purpose of providing low-cost and quick clearance for cross-border payments and transfers. The company created the RippleNet network to transact in the form of cryptocurrency, XRP. XRP, however, slowly grew outside the initial purpose of the application. The company’s founders used the digital asset to raise funds in 2013.
According to the complaint, the SEC alleges that the sale of XRP was used to “enrich Larson and Garlinghouse,” and was undertook without registering their offers with the SEC as required by federal securities law. The complaint furthers that this affected personal unregistered XRP transactions — totaling around $600 million — utilized to support the company’s business. Defendants failed to file for any exemption from registration, in violation of federal registration restrictions.
The Claims
The root argument is that XRP is a security. According to the Securities Act of 1933, a security is:
any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement…or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
In laymen terms, a security is a financial instrument representing ownership in a corporation or similar entity, but has no inherent utility. Shares and common stock fall under securities by publicly listed firms in order to obtain financing. XRP was used to fund Ripple’s platform, and the sale enriched the platform’s management, hence the basis for the suit. It is important to note that the SEC has stated that Bitcoin is not a security.
The court uses a precedent set under United States SEC vs. Howey test, established in 1946, to define whether a transaction falls under the Securities Act of 1933’s definition of an investment contract. Under the Howey Test, and investment contract exists if “there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
The SEC determined that XRP satisfied the Howey test because:
1. The business, Ripple Labs, sold $1.38B worth of token;
2. That token was purchased by investors who assumed it was a joint venture investment; and,
3. Ripple’s marketing efforts and alleged supply manipulation made investors believe the price of the token would climb as a result of company activities.
Ripple’s Response
The SEC settles most of its lawsuits. Companies facing SEC legal action tend to submit and pay penalties to continue operating. While this is the action taken by most, Ripple opted to pursue legal action against the SEC’s claims. Since the lawsuit was filed other crypto companies, such as Coinbase, have also taken legal action against the SEC’s recent actions against crypto firms.
Ripple’s lawyers have claimed that the SEC never notified the organization that XRP could be classified as a security, an argument the SEC conceded. The plaintiffs also claimed that the SEC was biased in applying the securities definition to digital assets. If the court rules in favor of Ripple, this would be a huge blow to the SEC’s authority and credibility.
Recent Rulings
This week, a district judge denied another attempt from the SEC to shield internal documents related to the drafting of a 2018 speech on cryptocurrencies by former Division of Corporation Finance Director Bill Hinman.
The U.S. regulator appealed a prior judge’s decision to hand over the materials as part of its legal case with Ripple. Much of the case has centered around these documents on Hinman’s speech, which sought to create regulatory space for some digital tokens to be exempted from securities regulation.
Ripple requested the emails and memos relating to this speech multiple times. Magistrate Judge Sarah Netburn sided with Ripple, denying the SEC’s requests in both February and April. In July, the SEC objected again, appealing the decision to District Judge Analisa Torres. This week Torres overruled the objection, directing the SEC to comply with orders to produce the internal documents.
Netburn claimed the SEC has made conflicting arguments regarding the documents. The SEC initially claimed Hinman’s speech consisted of personal views on cryptocurrency rather than agency-wide policy. Later in the case, the SEC tried to shield the documents claiming they were part of his duties and therefor protected under a statue that provides privacy for internal deliberations by regulatory agencies.
Nerburn said the SEC can’t have it both ways, and the conflicting arguments suggested “that the SEC is adopting its litigation to further its desired goal, and not out of a faithful allegiance to the law.”
Ripple Effects
Many are joking the case will have a “Ripple” effect in the crypto industry. They’re not wrong. In the event Ripple prevails, crypto firms will have precedent to argue that their token is not, and should not be considered, a security. This would prove a massive blow to the SEC.
Should the SEC prevail, Chair Gary Gensler will finally be able to prove his dogged attacks at the crypto industry was not in vain. It would also open up plenty of legal room for the SEC to pursue other Initial Coin Offerings (ICOs) and crypto projects for securities violations.
“Ripple is fighting this lawsuit on behalf of the entire crypto industry,” Stu Alderoty, general counsel at Ripple Labs, told Axios. “This case will reaffirm the legal limits of the SEC’s jurisdiction to securities,” he added. “The SEC does not have free roaming authority over crypto.”
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