It’s a busy new year for lawyers representing Ripple Labs Inc. (“Ripple”), as they prepare to face off with American regulators in the “Cryptocurrency Trial of the Century”. On December 22, 2020, the U.S. Securities and Exchange Commission launched an action against Ripple Labs Inc. and two of its executives alleging the violation of federal securities laws.
What is Ripple?
Ripple is an American technology firm which sells enterprise solutions software to financial institutions. More famously, Ripple developed a digital ledger (XRP Ledger) and associated digital token (XRP). Ripple is not like Bitcoin.
- Unlike Bitcoin, Ripple does not aim to be a substitute for fiat currency for the masses. Rather, it was meant to be used as a universal digital asset for banks to transfer money.1
- Unlike Bitcoin, XRP coins are not mined. The entire supply of 100 billion coins was created at inception (“minted”) by its developers.
- Unlike Bitcoin, Ripple does not run on a decentralized blockchain. Only trusted validators can finalize transactions, and Ripple directly controls many of these nodes.
Of the fixed supply of 100 billion XRP coins, 20 billion were kept by the founders. The rest is intermittently released into circulation.
Is a digital asset a “security”?
Under federal securities laws, any securities that are sold or offered must be registered with the SEC, absent certain exemptions. After registration, an issuer is required to make periodic public disclosures (including annual and quarterly reports) describing its financials and disclosing significant business events.
The SEC has taken the position that digital assets2 (including but not limited to virtual currencies, coins and tokens) qualify as securities if they have the characteristics of “investment contracts”. Investment contracts are analyzed by applying the U.S. Supreme Court’s Howey3 test, which held that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
Details of the U.S. complaint
The SEC Complaint alleges that from 2013 to the present, Ripple raised over $1.38 billion through the unlawful offer and sales of securities in violation of Sections 5(a) and 5(c) of the Securities Act of 1933. The individual defendants include Christian Larson, co-founder and former CEO, and Bradley Garlinghouse, the current CEO of Ripple.4
It is alleged that the sales of XRP coins were made to fund Ripple’s operations and enrich its executives. The overwhelming majority of Ripple’s revenues came from XRP offerings and Ripple’s management personally profited by about $600 million from the unregistered sales. In total, approximately 14.6 billion XRP coins were sold and distributed.
The Complaint accuses Ripple of creating an “information vacuum” where they could pick-and-choose what information was disclosed to shareholders. This information asymmetry resulted in a market “that possessed only the information Defendants chose to share about Ripple and XRP”, creating substantial risks to investors.
The SEC alleges that Ripple had been warned as early as 2012 by its lawyers that XRP could be deemed a security under federal securities laws. Despite this warning, Ripple never filed a registration statement with the SEC and began selling XRP to public markets.
The Complaint alleges that XRP was sold or offered through four types of distribution:
- Market Sales: Sales through online digital asset trading platforms;
- Institutional Sales: Sales to blockchain-focused private investment funds;
- Other XRP Distributions: Distributions for executive compensation and third-party incentives, for example; and
- Individual Defendants’ XRP Sales: Sales by Larsen and Garlinghouse of their personal holdings.
The SEC claims that the Defendants controlled the XRP trading markets by using algorithms to automate sales activities, paying incentives to market makers for meeting volume targets, directing market makers to place buy and sell orders, and paying crypto-asset exchanges to list XRP coins. The Complaint alleges that the Defendants did not publicly disclose all of the actions taken to support XRP’s price. Such actions reflected Ripple’s “significant entrepreneurial and managerial efforts, including to create a liquid market for XRP, which would in turn increase demand for XRP and therefore its price.”
The SEC argues that the Howey test is satisfied because:
- Purchasers of XRP invested money in a common enterprise…
- As the price of XRP would rise and fall for all XRP investors equally, the fortunes of investors were tied to one another.
- With a reasonable expectation that they could expect to profit…
- Based on Ripple’s public statements and actions, it was reasonable for investors to believe that Ripple would create demand for XRP and they would profit on the resale of their XRP into public markets.
- From Ripple’s efforts on behalf of XRP.
- There existed an identifiable actor – Ripple – which held itself out as responsible for helping to increase the value of XRP, and which actually made “extensive entrepreneurial and managerial efforts” to do so. By contrast, investors were not in any position to grow the XRP ecosystem.
The SEC is seeking a permanent injunction prohibiting Defendants from continuing in the unregistered offerings, as well as disgorgement of the gains and other relief.
Ripple has denied the allegations and accused the SEC of “an attack on the entire crypto industry here in the United States” and of damaging “countless innocent XRP retail holders with no connection to Ripple”. David Schwartz, CTO at Ripple Labs, tweeted that the “[t]he United States is one of the few countries where regulators will, after years of you operating in full light of day and frequently updating them on everything you’re doing, turn around and tell you that you should have known you were breaking decades old laws all along.”
In the wake of the allegations, multiple cryptocurrency exchanges have delisted XRP and the coin has been described as “one foot in the grave” following industry moves to suspend trading. A pretrial conference has been scheduled for February 22, 2021, and it remains to be seen if Ripple will defend the allegations or settle.
Other actions against Ripple
The SEC Complaint is not the first litigation against Ripple. In 2018, a putative class action was launched against Ripple and its CEO Garlinghouse. The case alleged that Garlinghouse misrepresented the scope and character of his XRP holdings in multiple public interviews5 despite allegedly selling millions of XRP in the background. The case also alleged that the defendants violated federal and California state securities laws for the sale of unregistered securities. That class action survived a second motion to dismiss filed against its amended complaint.
More recently, Ripple was sued by an investment company in Delaware Chancery Court seeking to force redemption of certain preferred stock held by the plaintiff.
The possibility of Canadian regulatory action
The Howey test has been adopted by the Canadian Supreme Court6 and has been applied to digital assets by Canadian securities regulators. The CSA Staff Notice 46-307 on Cryptocurrency Offerings indicated regulators would focus on substance over form:
Although a new technology is involved, and what is being sold is referred to as a coin/token instead of a share, stock or equity, a coin/token may still be a “security” as defined in securities legislation of the jurisdictions of Canada.
The Ontario Securities Commission has been actively policing this area. For example, in July 19, 2019, the OSC entered into a settlement with CoinLaunch Corp., a service provider operating in the digital asset sector (“CoinLaunch Settlement”). The CoinLaunch Settlement related to claims that CoinLaunch had facilitated unregistered offerings of tokens7 which constituted securities. CoinLaunch admitted that “it engaged in and held itself out as engaging in the business of trading in securities, without being registered to do so and where no exemption to the registration requirement of Ontario securities law was available”8. Additionally, the OSC participated in conjunction with 40 securities regulators across North America in “Operation Cryptosweep”, raising awareness about fraudulent and unregistered cryptocurrency investments.
It is unclear if Ontario regulators would take similar enforcement action against Ripple. But the CoinLaunch Settlement and Operation Cryptosweep suggests that Ontario regulators are actively monitoring the area.
1 While this was the stated purpose of XRP, the SEC alleges in its Complaint that “little to no “use” existed until Ripple subsidized some “use” operations in recent months” and it was not until mid-2018 that Ripple first earnestly began testing use cases.
2 “Digital asset” means an asset that is issued or transferred using distributed ledger or blockchain technology.
3 Securities and Exchange Commission v. W. J. Howey Co., 328 U.S. 293 (1946).
4 The claims against the individual defendants are aiding and abetting violations of Securities Act Sections 5(a) and 5(b).
5 For example, in one interview dated December 14, 2017, Garlinghouse responded to a question about his personal investments in XRP that “I’m long XRP, I’m very, very long XRP as a percentage of my personal balance sheet.”.
6 Pacific Coast Coin Exchange v. OSC,  2 SCR 112.
7 The tokens at issue were the BCZERO and ECOREAL tokens, which the OSC considered “investment contracts”.
8 CoinLaunch paid an administrative penalty of CAD$30,000 and disgorged CAD$12,223.06.