On December 2, the Securities and Exchange Commission filed a lawsuit against Ripple Labs, Inc. and two of its executives alleging they offered and sold over $1.38 billion of digital asset XRP without registration or exemption in violation of Section 5 of the Securities Act of 1933, seeking disgorgement of ill-gotten gains. Ripple filed an answer on January 29 denying that XRP is a security or that it violated the securities laws. At the heart of this case is the issue that’s been central to just about every other enforcement action brought by the SEC in the digital asset space: whether XRP is an “investment contract” and thus a security. The court in Ripple may have a unique opportunity to fill a regulatory vacuum and provide needed guidance to cryptocurrency network developers about how to launch digital currencies without triggering the securities laws. The decision in the Ripple case may indeed make waves throughout digital asset markets.
Ripple and XRP
Ripple operates a network that allows cross-border payments using the cryptocurrency XRP to facilitate currency transfers over the XRP network. XRP differs from Bitcoin or Ether, two cryptocurrencies acknowledged by the SEC to be non-securities, in that Bitcoin and Ether are minted through the mining process, whereas XRP’s supply was capped at 100 billion XRP when it was created in 2012, 20 billion of which was transferred to Ripple’s three co-founders and the remaining 80 billion was left in reserve for future issuances.
SEC enforcement actions in the digital asset space tend to focus on the last two prongs of Howey, namely whether purchasers had a reasonable expectation of profit, and if so whether the profit expectation was dependent on the efforts of others. Key factors relevant to the profit expectation prong include whether the promoter marketed the digital assets to prospective users for their functionality or alternatively to investors for the tokens’ speculative value. Important elements in determining the efforts of others prong have included whether the network was decentralized or fully functional.
For the past several years, crypto network developers have faced a regulatory Catch-22. Distributing tokens to people may violate the securities laws if the network isn’t functional or decentralized. But it can’t mature into a functional, decentralized network that isn’t dependent on the managerial and entrepreneurial efforts of a single group unless the tokens are distributed to and freely transferable among potential users and developers on the network.
This is where the Ripple case can provide much needed clarity. Prior cases have focused on whether the developer suggested the tokens will increase in value and whether it tried to support a secondary market. But a meaningful facts and circumstances analysis should really dig deeper. A developer’s touting of a token’s potential to increase in value certainly makes the token look like an investment contract, but it could also be explained more innocently as an expression of a desire that the network succeed and be used by lots of people. Some crypto network developers have proceeded with digital token offerings in the hope of being able to convince the SEC that its token is sufficiently functional and avoid being branded an investment contract, but this approach is risky because it’s difficult to prove that a token is functional before distributing it to lots of people for use on the network.
One alternative for a crypto network developer would be to bite the bullet, concede the securities issue and sell the tokens to investors under an exemption from registration. Several blockchain network developers have done so under Rule 506 of Regulation D, but that approach has severe limitations inasmuch as the issuer is limited to selling only to accredited investors. Further, if the offering is under Rule 506(c), which is expected because the offering would likely involve general solicitation efforts, the seller would need to use enhanced methods of verification of accredited investor status, which isn’t practical. Another exemption pathway would be a mini-public offering under Regulation A+. But that is a more expensive process that involves intermediaries, which would undercut one of the primary advantages of a blockchain network, namely that it is decentralized with people transacting directly with each other without the need for intermediaries.
Another alternative would be to distribute the tokens only outside the U.S. in jurisdictions that would allow it. The risk here is that the tokens could easily find their way back to the U.S. And from a public policy perspective, a regulatory regime that incentivizes entrepreneurs to operate outside the U.S. denies Americans and U.S. markets the opportunity to participate in an innovative opportunity.
Last year, SEC Commissioner Hester Peirce proposed a safe harbor for blockchain network developers that would entail a three-year grace period during which they could develop a functional or decentralized network exempt from registration, so long as certain disclosure, intended functionality, liquidity and notice conditions are met. I blogged about the proposal here. It represents a sensible, practical solution to the blockchain developers’ regulatory Catch 22, although it hasn’t been formally proposed by the SEC.
The SEC’s Claims
The SEC alleges that from at least 2013 through the present, Ripple, its Chairman and its CEO sold over 14.6 billion XRP in return for nearly $1.4 billion in cash or other consideration to fund Ripple’s operations and enrich themselves. They did so despite two memos from Ripple’s lawyers telling the company in 2012 that XRP may be considered an investment contract, that XRP differed from Bitcoin because Ripple had identified itself as responsible for the distribution, promotion and marketing of the network XRP traded on and that it should seek guidance from the SEC on how to distribute XRP without triggering the securities laws. Further, Ripple promised during the offering that it would engage in efforts to increase the value of XRP, and then engaged in extensive entrepreneurial and managerial efforts with proceeds from the offering. It also touted the potential future use of XRP by certain specialized institutions while simultaneously selling XRP widely into the market.
The SEC asserts that XRP is an investment contract and thus a security under the Howey Test, which is met when there’s an investment of money in a common enterprise with a reasonable expectation of earning profit through the efforts of others. Ripple promised to undertake significant efforts to develop, monitor and maintain a secondary market for XRP with a goal of increasing trading volume and resale opportunities. It made repeated public statements highlighting its business development effort that will drive demand, adoption and liquidity of XRP, and held itself out as the primary source of information regarding XRP. The SEC alleges these factors led investors reasonably to expect that Ripple’s entrepreneurial and managerial efforts would drive the success or failure of Ripple’s XRP network.
Ripple’s response to the SEC’s lawsuit is multifaceted. In its answer to the complaint, it notes the SEC’s action comes five years after the DOJ and FinCen determined in a separate proceeding that XRP is a virtual currency. It states that inasmuch as the SEC has previously deemed Bitcoin and Ether not to be securities, this action would amount to the SEC picking virtual currency winners and losers. It asserts the mere filing of the lawsuit has caused immense harm to XRP holders, with an estimated $15 billion in damage to those the SEC purports to protect.
Ripple asserts it never conducted an initial coin offering, never offered or contracted to sell future tokens as a way to raise money to build an ecosystem, has no explicit or implicit obligation to any counterparty to expend efforts on their behalf and never explicitly or implicitly promised profits to any XRP holder. For these reasons, Ripple concludes XRP holders cannot objectively rely on Ripple’s efforts. Further, Ripple has its own equity shareholders who purchased shares in traditional venture capital funding rounds and who, unlike purchasers of XRP, did contribute capital to fund Ripple’s operations, do have a claim on its future profits and obtained their shares through a lawful (and unchallenged) exempt private offering.
Ripple seems to be signaling it knows it’s in trouble as it appears to be going above and beyond in asserting it is being treated differently than other cryptocurrency initiatives which have not been targeted with an SEC enforcement action. Ripple filed a Freedom of Information Act request seeking all SEC communications regarding other cryptocurrencies, and its legal team includes such heavyweights as former SEC Chairwoman Mary Jo White and the former Director of Enforcement at the SEC, Andrew Ceresney, both now of Debevoise & Plimpton.
Why Ripple is Potentially Significant
Whether or not cryptocurrencies are investment contracts and thus securities remains an unresolved issue vexing crypto network entrepreneurs, and there could be some meaningful case law to emerge from Ripple on this. Although Commissioner Peirce’s safe harbor recommendation seems like a good way to promote innovation in this space without hammering entrepreneurs right off the bat with onerous securities regulatory requirements, there’s no reason to believe it will be formally proposed by the SEC given the new administration’s paternalistic emphasis on investor protection. Cryptocurrencies cannot be launched in a decentralized manner. Like network effects in economics, cryptocurrency networks need to hit a critical mass of participants for the network to be economically viable. Most cryptocurrencies are considered decentralized with no central authority governing the blockchain. Whether or not Ripple has that kind of central authority is what this case seems to be hinging on.
Right now we’re in a regulatory vacuum in which the SEC has not provided enough formal guidance to cryptocurrency developers and their lawyers about how to launch digital currencies without triggering the securities laws. If it doesn’t settle, Ripple could be a seminal case in the cryptocurrency arena and an opportunity to set forth clear, objective standards which could hopefully be followed by well-intentioned crypto network developers. If that happens, Ripple could make waves in the digital asset space.