Author: Iva Todorova
The value of Ripple Labs Inc.’s XRP token which is the world’s third-largest cryptocurrency by market capitalization has been challenged lately, raising fundamental questions about the viability of the cryptocurrency. XRP payment protocol is considered superior to bitcoin because of its improved ledger and faster settlement speed, and the exchange network is a low-cost supplement to traditional payment networks like SWIFT.[1] Ripple was recently valued at $10 billion following a $200 million funding.
The Security and Exchange Commission (the “SEC”) announced on 22nd of December 2020 that it has filed a lawsuit against Ripple Labs Inc. and two of its executives, Christian Larsen, the company’s co-founder, executive chairman of its board, and former CEO, and Bradley Garlinghouse, the company’s current CEO, who are significant security holders.[2] The allegation is that the Ripple raised over $1.38 billion U.S. Dollars (“USD”) through the sale and distribution of its digital tokens XRP without registering their offers and sales with the SEC as required by the federal securities law. Interestingly, the allegation is not of fraud but for damages and it seeks to ban Ripple’s executives from participation in digital asset market trades because the SEC claimed they personally profited to the tune of $600 million by selling their XRP stash during upswings in its prices.[3] The case will be heard on the 22nd of February 2021.
Following the lawsuit, not only the XRP’s price crashed by 51 percent, in 24 hours after the news more than 63 percent, some trading was halted, XRP future contracts, worth billions of dollars have been liquidated, market makers, such as Jump Trading and Galaxy Digital have stopped trading and providing support[4], but a few days later other lawsuits followed. One of them is a proposed class action initiated by a Coinbase user against the cryptocurrency exchange Coinbase, seeking recovery for customers who paid commissions for XRP trading. The other one is a lawsuit by a U.K. investor Tetragon Financial Group against Ripple Labs Inc. that makes the XRP token and alleges that the digital assets were sold improperly.
Background
The software code – XRP ledger (a.k.a. Ripple Protocol) – operates as a peer-to-peer database, spread across a network of computers, that records data respecting transactions, among other things.[5] Its creation began in late 2011, early 2012. The Ripple company was established in San Francisco in September 2012. Upon the completion of the XRP Ledger in December 2012, its code was being deployed to the servers that would run it.[6] XRP is also a digital asset and the native token on the XRP Ledger.[7] In reality, the people who created the XRP are pretty much the same people who created Ripple and one of the reasons why Ripple was created is to distribute XRP.[8]
In the SEC claim is also stated that advice from a law firm was sought concerning the distribution and monetization of XRP. The law firm provided two memos and explicitly mentioned that there was a risk of considering XRP as an “investment contract”, thus security under the federal securities laws. The arguments include how Ripple promoted and marketed XRP to potential purchasers, the motivation of the latter, and Ripple’s other activities with respect to XRP.[9] Besides, if individuals purchased XRP “to engage in speculative investment trading” or if Ripple employees promoted XRP as potentially increasing in price, the Legal Memos advised that XRP units would be considered investment contracts, thus the company was obliged to contact the SEC.[10] Mr. Larsen was aware of all the concerns stated in the Legal Memos but he received XRP tokens upon Ripple’s founding and this payment constituted compensation for the risk he knew existed.[11] Later on, Ripple, Larsen, and after 2015 also Garlinghouse, offered, sold, and promoted XRP as an investment but never filed a registration with the SEC. Ripple also made a public statement regarding XRP which created in investors an expectation of profit.[12]
Although Ripple and XRP are separate, the company still manages partly the digital currency.
What is the difference with other cryptocurrencies?
The fundamental issue is how is XRP different from other cryptocurrencies. The answer lies within the corporate setup.
Bitcoin and Ethereum were released through a decentralized network of computers, thus they do not have one owner or company and cannot be considered securities. Unlike them, the legal status of XRP is debatable because the tokens were created and distributed by Ripple as a company and by its founders. Consequently, while Ripple argues that XRP is electronic money, the SEC claims it is a security and as such it must have been registered. If the SEC’s arguments prevail and the XRP is considered to be a security, it means that Ripple violated laws against selling unregistered securities and the digital tokens cannot be used as a currency. The SEC also states that XRP most likely would not be considered a currency because it is not backed by a central government.
Arguments in favor and against considering XRP a security
The debate about the legal status of XRP has been circulating for a couple of years. The question of whether XRP is a currency or security is central and of paramount importance because of the different laws and regulations that apply.
In May 2015, there was a settlement of charges brought by the U.S. Departments of Justice and Treasury and Financial Crimes Enforcement Network (FinCEN) for failing to register XRP as a “Money Services Business” under the Bank Secrecy Act[13], and the conclusion was that XRP is a currency. Ripple has been complying with the rules for virtual currencies, XRP ledger is decentralized and open-source, operation among a community of users and it can be used to create new products. Moreover, if investors want to invest in the company, they will buy Ripple’s shares, not XRP.[14] However, the determination was not convincing for the SEC that claimed the Ripple’s own internal policies treat XRP as securities.[15]
Under the Securities Act of 1933 and the Securities Exchange Act of 1934, transactions that qualify as “investment contracts” are considered securities. The Howey test is the methodology used to make the determination and qualification by the U.S. courts and refers to the 1946 U.S. Supreme case SEC v. W. J. Howey Co.[16] In its essence, it states a transaction can be regarded as an investment contract if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”.[17] In the same case, Congress defined “security” broadly to embody a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” 328 U.S. 293, 299 (1946).[18] According to the Howey test, the SEC concluded that Ripple’s practices with XRP amount to investment contracts, therefore securities.
However, Ripple released a rather vigorous response in which stated that the claims are not based on facts. One of the arguments was that XRP holders do not share in Ripple’s profits or receive dividends, nor they have voting rights or other corporate rights, thus the majority of XRP holders have no connection or relationship with Ripple. [19] Additionally, as stated above, Ripple has its own shareholders and if a person wants to invest in the company, he can buy shares in Ripple, not XRP. Lastly, XRP’s market value has not been correlated with Ripple’s activities, because the price of XRP is related to the movement of the other virtual currencies.[20] Moreover, both Mr. Larsen and Mr. Garlinghouse refused to settle charges separately because they believe they can prove their case in court.[21]
In the following weeks, Ripple will address the allegations. One of the arguments is that will be included is that there is a lack of regulatory clarity in the U.S. which puts cryptocurrency at disadvantage, and it affects innocent retail holders, traders, and markets. [22] The majority of XRP customers are not located in the U.S. and there are clear rules for using XRP volume in the UK, Japan, Singapore, and Switzerland.[23]
A proposed class-action lawsuit against Coinbase
Coinbase is a company established in San Francisco, California, the U.S., which provides digital currency wallet services that allow traders to buy and sell certain cryptocurrencies, including XRP. It is the biggest cryptocurrency exchange in the U.S. On the 28th of December 2020, Coinbase stated that it will suspend trading in XRP on January 19, 2021.[24]
A complaint[25] was filed in San Francisco federal court by a Coinbase user – Thomas Sandoval – seeking damages for him and other users for the commission they paid to the platform when trading XRP. The lawsuit argues that Coinbase violated California’s unfair competition laws because it “gained an unwarranted competitive advantage over digital asset exchanges that only sold commodities.”[26] The complaint also reads that “Coinbase sold the XRP token, the value of which was entirely linked to the success or failure of Ripple Co. and the managerial efforts of its executives. Indeed, Ripple Co.’s survival as a corporate entity depended on its sale of unlicensed XRP securities to the public to fund its business operations.”[27] As in the SEC claim, it is again claimed that XRP is a security and not a commodity because “Ripple has sole control over the purported cryptocurrency’s “nodes”[28], and is, therefore, a common enterprise for purposes of the federal securities laws.”[29] The lawsuit seeks unspecified compensatory damages, attorneys’ fees, and other relief.
Nevertheless, the allegations have yet to be proven as they rest more “on ‘information and belief’” rather than on actual proven facts.[30]
Tetragon Financial Group
On the 4th of January 2021, Tetragon Financial Group Ltd filed a lawsuit against Ripple after the SEC claims that the virtual tokens were sold improperly. The investment company stated that it seeks to “enforce its contractual rights to require Ripple to redeem” Series C preferred stock held by Tetragon and to block Ripple from using any cash or other liquid assets until the payment is made.[31] Furthermore, Tetragon asked the court for a temporary restraining order, a preliminary injunction, and an expedited trial.[32]
Ripple released a statement the next day. The company claimed that under provisions of its investment agreement, Tetragon has the option of having Ripple redeem their Ripple equity if XRP is deemed to be a security on a go-forward basis, however, there has been no such determination, therefore the lawsuit has no merit.[33] Ripple also said that they are disappointed that “Tetragon is seeking to unfairly take advantage of the lack of regulatory clarity here in the U.S” and they are confident their position will be confirmed in court.[34]
Conclusion
The next years are going to be definitive for the cryptocurrency, regulation, unfair competition, and compliance with the law. On the one side, classifying a cryptocurrency as a security likely goes sharply against the goals of the creators of that digital currency. On the other side, there are some credible arguments for categorizing XRP as security. Several cryptocurrency exchanges have delisted trading of the XRP token following the allegations of the SEC, the coin’s price dropped significantly, and it is just the beginning of more lawsuits initiated by investors or users of exchange platforms. Although the SEC’s lawsuit is against Ripple, not XRP, the digital token may never recover from the crash.
Even though according to analysts Ripple’s victory against the SEC is unlikely[35], there is still hope for a settlement. Whatever the outcome may be, the trial will certainly be one of the biggest of the century.
We will be closely following and analyzing recent updates concerning the topic.
[1] https://www.forbes.com/sites/roslynlayton/2021/12/29/sec-v-ripple-the-cryptocurrency-trial-of-the-century/
[2] https://www.sec.gov/news/press-release/2020-338
[3] https://www.investopedia.com/xrp-loses-support-as-sec-files-case-against-ripple-5093766
[4] https://www.theblockcrypto.com/linked/89083/jump-trading-galaxy-xrp-market-making
[5] SEC claim – paragraph 39.
[6] SEC claim – paragraph 45.
[7] SEC claim – paragraph 48.
[8] SEC claim – paragraph 47.
[9] SEC claim – paragraph 53.
[10] Ibid.
[11] SEC claim – paragraph 58.
[12] SEC claim – paragraph 62.
[13] SEC Claim – paragraph 353.
[14] https://www.forbes.com/sites/roslynlayton/2021/12/29/sec-v-ripple-the-cryptocurrency-trial-of-the-century/
[15] SEC Claim – paragraph 363.
[16] https://www.investopedia.com/terms/h/howey-test.asp
[17] Ibid.
[18] SEC Claim – paragraph 31.
[19] https://ripple.com/insights/the-secs-attack-on-crypto-in-the-united-states/
[20] Ibid.
[21] Ibid.
[22] https://ripple.com/insights/our-statement-to-recent-market-participant-activity/
[23] Ibid.
[24] https://blog.coinbase.com/coinbase-will-suspend-trading-in-xrp-on-january-19-2e09652dbf57
[25] https://www.scribd.com/document/489463141/cb-suit
[26] Ibid., paragraph 38.
[27] Ibid., paragraph 11.
[28] A node is a computer server that holds the transaction ledger for the currency and processes transactions as well as connects with other nodes.
[29] Ibid., paragraph 12.
[30] https://www.coindesk.com/coinbase-sued-ripple-xrp-sale
[31] https://www.bloomberg.com/news/articles/2021-01-05/ripple-investor-sues-to-force-stock-redemption-after-sec-claim?srnd=markets-vp&sref=zNmRQ0gk
[32] Ibid.
[33] https://ripple.com/ripple-press/ripples-statement-on-yesterdays-tetragon-filing/
[34] Ibid.
[35] https://www.bloomberg.com/news/articles/2020-12-30/coinbase-sued-over-xrp-commissions-after-sec-pursues-ripple