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Creates a wave: SEC files lawsuit over alleged unregistered offering of XRP

On December 22, 2020, the US Securities and Exchange Commission filed a lawsuit against Ripple Labs Inc. (“Ripple”), Christian Larsen, co-founder, chairman and former CEO of the company; and Bradley Garlinghouse, the Company’s current CEO (collectively the “Defendants”) for the execution of an unregistered security offering totaling $ 1.38 billion.

Defendants have sold over 14.6 billion units of Ripple’s digital asset, known as “XRP”, to investors in the US and around the world for cash or other consideration since early 2013.

The SEC has held that XRPs are “investment contracts,” and therefore securities, under the Securities Act of 1933. Since Defendants did not view XRP as a security, they did not attempt to register XRP with the SEC and accordingly failed to meet the SEC’s requirements for securities offerings. Similar to previous enforcement actions against Kik Interactive Inc., the SEC is seeking permanent injunction, the surrender of unlawful profits, and civil penalties against the defendants.

This case has implications for participants across the crypto asset industry. Digital asset issuers are faced with yet another conservative interpretation of the Howey test, a 75-year-old test that is viewed by many as unsuitable for crypto assets. Crypto exchanges and brokers are in limbo unsure of whether to continue supporting a popular and high performing asset for fear of government scrutiny themselves.

background

Ripple was founded in 2012. It develops and manages the XRP Ledger, an underlying peer-to-peer database on which the XRP tokens are operated. As a digital asset, XRP differs from Bitcoin or Ethereum in that the latter two are shaped by an ongoing process called mining. The supply of XRP, on the other hand, was set in advance at 100 billion XRP in 2012, of which 80 billion should be held in reserve for planned allocations, and the remaining 20 billion XRP are held by individuals, including the two executives. Since then, Ripple has gradually released XRP in accordance with the alleged unregister described above.

The SEC claims that Ripple began its efforts to increase speculative demand and trading volume for XRP in 2013 and pursued those efforts in a number of ways: 1) Ripple conducted a “market sale” through middlemen who sold XRP to public investors; 2) Ripple has offered and sold XRP to at least 26 institutional investors as part of its “Institutional Sale”; 3) Ripple has distributed and transferred XRP to third parties as compensation, service fee, commission and incentive with no restrictions on reselling XRP; and 4) Ripple has incentivized at least 10 digital asset trading platforms in XRP to list XRP and meet certain trading volume metrics. According to the SEC, prior to the distribution, Ripple was fully aware that XRP could be viewed as an “investment contract” (ie, a security) and was warned by its attorneys of the risk should the SEC make such a determination.

In 2018, Ripple developed a use case for XRP – the product “On-Demand Liquidity” (ODL). The ODL network enables money transfer companies to make cross-border payments using XRP as an intermediary between two local fiat currencies. Ripple has issued 324 million XRP to companies affiliated with ODL.

XRP sold as “collateral”, for “use” or as “currency”?

The SEC contends that XRP is a security because money has been invested in a joint venture with a reasonable expectation of gain stemming from the business or managerial efforts of others (this analysis is commonly referred to as the “Howey Test,” according to the USA from 1946). Supreme Court Case SEC v WJ Howey Co.). In its analysis, the SEC highlighted the following aspects of the offering that led to the conclusion:

  • Ripple distributed XRP for cash or other consideration worth over $ 1.38 billion.
  • XRP buyers invested in a joint venture because XRP’s profits and losses were tied to Ripple’s success and failure in increasing the demand and price of XRP. As a company, Ripple not only manages the public market for XRP, but shares a common interest with investors as it holds a significant amount of XRP and uses the proceeds from the XRP sale to fund its operations.
  • Defendants pledged to make significant efforts to develop, monitor, and maintain a public market and secondary market for XRP in order to increase trading volume and resale opportunities. Defendants have repeatedly made public statements highlighting their business development efforts that will fuel the demand, adoption, and liquidity of XRP.
  • Ripple has emerged as the primary source of information regarding XRP. These efforts resulted in investors reasonably expecting that Ripple’s corporate and managerial efforts would fuel the success or failure of Ripple’s XRP project.

After concluding that XRP is an investment contract under the Howey Test, the SEC further argued that XRP is not being sold for its utility within the ODL network. According to the SEC, ODL wasn’t commercially available until 2018, and even after its launch, the use of XRP was heavily promoted by Ripple money senders. XRP was sold and traded in quantities that “far exceeded any possible use of XRP as a medium for transferring value”. In addition, the SEC denied the possibility that XRP would qualify as “currency” because “the use of XRP as a“ bridge ”between two real fiat currencies does not give XRP legal tender status”.

The SEC also alleged that Ripple manually controlled XRP’s trading activities by “selectively disclosing information” to investors. The SEC further claims that Ripple manipulated the price and liquidity of XRP to maximize the amount of money Ripple could raise.

Impact and Impact

This lawsuit marks another high profile case in the SEC’s continued enforcement activities against unregistered offers of crypto tokens. With a market capitalization of $ 12.1 billion, XRP is one of the five most traded cryptocurrencies. Unlike other digital tokens, XRP is held by a large number of institutional investors and money brokers such as banks. According to Ripple’s CEO Brad Garlinghouse, who is also the defendant in the lawsuit, Ripple will fight back and “prove her case in court.” Garlinghouse argued that legal action against XRP is “an attack on crypto as a whole” and will have a “snowball effect” across the industry.

Crypto asset exchange platforms like CoinDesk have removed XRP from the list pending the outcome of this litigation. Given the regulatory uncertainty, Ripple is also considering relocating its headquarters outside of the United States to a country that does not consider XRP a security.

Industry participants who own or do business with XRP should exercise caution and reassess the potential impact of the SEC’s success with this lawsuit. Industry participants who wish to trade only assets that are not securities may be subject to securities regulatory requirements if the lawsuit is resolved in favor of the SEC.

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