SEC VS. RIPPLE

The judgement could provide clarity on the legal status of crypto assets and other virtual digital assets - which could help establish a regulatory framework for the Web 3.0 industry

After the 2017 Initial Coin Offerings’ craze died down, the United States’ Securities and Exchange Commission (“SEC”) stopped smelling the coffee and initiated multiple enforcement actions. Ripple Labs Inc. (“Ripple”), a blockchain company that created and manages the ‘XRP’ crypto asset, was one of the major players that got caught in the crosshairs of the SEC’s seemingly unending enforcement against crypto.

The case centres on the question of whether XRP is a ‘security’, and has significant implications for the crypto industry as a whole. In this article, we have tried to explore the legal nuances at the heart of this case and its potential impact on the crypto industry.

Contents of the SEC Complaint

On December 22, 2020, the SEC filed a complaint in the United States Southern District Court of New York against Ripple, the issuer of XRP, and two of its executives, Bradley Garling house, and Christian A. Larsen (the “Executives”), also significant holders of XRP (the “Complaint”). At that time, XRP was already trading on more than 200 crypto exchanges.

The Complaint alleged:

a) Sale of over 14.6 billion units of a XRP from 2013 to 2020 in return for cash or other consideration such as labour and market-making services worth over USD 1.38 billion to fund Ripple’s operations and enrich its executives;

b) Personal unregistered sales of XRP totalling approximately USD 600 million by the executives; and

c) Failure to register their offers and sales of XRP or satisfy any exemption from registration, in violation of Sections 5(a) and 5(c) of the Securities Act of 1933 (“Securities Act”) reproduced below:

“SEC. 5. (a) Unless a registration statement is in effect as to a security, it shall be unlawful for any person, directly or indirectly—

(1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise; or

(2) to carry or cause to be carried through the mails or in interstate commerce, by any means or instruments of transportation, any such security for the purpose of sale or for delivery after sale.

…

(c) It shall be unlawful for any person, directly or indirectly, to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to offer to sell or offer to buy through the use or medium of any prospectus or otherwise any security, unless a registration statement has been filed as to such security, ...”

Ripple’s Response

Ripple officially filed its para-wise response on January 29, 2021 citing two primary defenses:

a) XRP is Not a Security: Ripple mentioned that they did not violate Section 5 of the Securities Act because XRP is not an “investment contract” since, inter alia:

(i) The economic reality is that XRP is a virtual currency and functions as a store of value, a medium of exchange and a unit of account and not a share in Ripple’s profits;

(ii) The functionality and liquidity of XRP are incompatible with securities regulation;

(iii) The U.S. Department of Justice and U.S. Department of the Treasury’s Financial Crimes Enforcement Network have in the past determined that XRP is lawfully used and traded in the marketplace as a virtual currency;

(iv) XRP holders do not acquire any claim to the assets of Ripple, hold any ownership interest in Ripple, or have any entitlement to share in Ripple’s future profits;

(v) Ripple never held an ICO and has never had a relationship with the majority of XRP holders who primarily purchased XRP from third parties on the open market; and

(vi) Proceeds from the sale of XRP are not pooled in a common enterprise.

In light of the above reasons, Ripple justified that the distribution or sale of XRP by Ripple did not require registration under Section 5 of the Securities Act.

b) Lack of Due Process and Fair Notice: The SEC failed to provide Ripple fair notice that its conduct was in contravention of law, thus violating Ripple’s due process rights.

Proceedings So Far

As per the Opinion and Order dated April 9, 2021 in the said case, in order to establish the fact that ‘XRP’ is an unregistered security, the SEC will need to demonstrate:

a) Howey Test: ‘XRP’ is an investment contract under the Howey test (S.E.C. v. W.J. Howey Co., 328 U.S. 293, 298–99 (1946)) that defined “security” as an “investment contract . . . means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party. . .”); and

b) Economic Reality Test: In light of the economic reality and the totality of circumstances, the customers were making an investment as held in S.E.C. v. Aqua-Sonic Products Corp., 687 F.2d 577, 582 (2d Cir. 1982) and Glen-Arden Commodities, Inc. v. Costantino, 493 F.2d 1027, 1034 (2d Cir. 1974).

Both Ripple and the SEC have asked for the grant summary judgement in the case.

Per Ripple’s recent Q1 2023 financial report released on Apr 27, 2023, the decision on summary judgement is expected before the end of 2023.

Impact of the Judgement

The implications of the judgement in this case for the larger Web 3.0 industry, though limited in scope given the fact-specific nature of the case, will have wide-ranging implications for the wider crypto industry. The judgement could provide clarity on the legal status of crypto assets and other virtual digital assets - which could help establish a regulatory framework for the Web 3.0 industry. This clarity would provide the much-needed guidance for entrepreneurs and investors in this space.

The Complaint caused some investors to pull out of the XRP market, and could further erode confidence in the crypto industry, if the verdict is not in Ripple’s favour. If the SEC’s allegations against Ripple are upheld, it could have a chilling effect on innovation in the Web 3.0 industry and may make startups and entrepreneurs hesitant to launch new projects due to the risk of facing similar regulatory action. In case of a verdict in favour of the SEC, a barrage of similar actions against other crypto projects can be expected, in fact have started, dampening market sentiment and further adoption of the underlying technology.

There were speculations of settlement that stemmed from the fact that in common law jurisdictions, settlements after summary judgement are often preferred for their precedential value. Litigation with regulatory bodies such as the SEC often results in settlements because businesses view it as a cost-benefit analysis. The inclusion of allegations against Ripple executives and their failure to obtain dismissal may lead to more aggressive litigation or incentivise cooperation in negotiation. Ripple executives have expressed interest in a settlement conditioned on obtaining “clarity” from the SEC on XRP’s status. However, the parties’ external actions make it unclear whether settlement is likely. Ultimately, while limited information on possible negotiations exists, settlement cannot be ruled out as a likely possibility.

The court’s judgement in this case is much awaited and will provide useful insights for the Web 3.0 industry as a whole!

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.