On Dec. 22, 2020, the Securities and Exchange Commission (SEC or the Commission) filed an action against Ripple Labs Inc. (Ripple or the Company) and two of its executives, alleging that they violated Section 5 of the Securities Act of 1933, as amended (Securities Act) by raising over $1.3 billion through an unregistered, ongoing securities offering of the digital asset XRP, beginning in at least 2013. The SEC seeks to permanently enjoin the defendants from violating Sections 5(a) and 5(c) of the Securities Act, to disgorge the defendants’ alleged ill-gotten gains, and to impose civil money penalties on the defendants.

The SEC’s Allegations

The SEC’s complaint alleges that beginning in 2013, Ripple raised funds through the sale of XRP in an unregistered securities offering to investors in the U.S. and abroad. The SEC further alleges that Ripple distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services. Specifically, the SEC avers that from at least 2013 through the present, the defendants sold over 14.6 billion units of XRP in return for cash or other consideration worth over $1.38 billion. According to the complaint, in addition to structuring and promoting XRP sales used to finance the company’s business, the executives also effected personal unregistered sales of XRP totaling approximately $600 million. The complaint alleges that the defendants failed to register their offers and sales of XRP or satisfy any exemption from registration, in violation of the registration provisions of the federal securities laws.

The SEC sets forth the following allegations corresponding to the factors of the Howey test.

  • Investment of Money. As to the first prong, an investment of money, the SEC states that purchasers obtained XRP with both cash and non-cash consideration, constituting an investment of money.
  • Common Enterprise. As to the second prong, that the investment be in a common enterprise, the complaint alleges that Ripple pooled the funds it raised in the securities offering and used them to fund its operations, including to finance building out potential “use” cases for XRP and paying others to assist in developing a “use” case. (The SEC alleges what is referred to as horizontal and vertical commonality.) Further, the SEC states that the price of XRP rises and falls for XRP investors together and equally for all investors.
  • Expectation of Profits Based on the Efforts of Others. As to the third and fourth prongs, that investors had the expectation of profits based on the efforts of others, the SEC alleges that Ripple had an internal understanding and made public statements that it would undertake significant entrepreneurial and managerial efforts, including to create a liquid market for XRP, which would increase demand for XRP and therefore its price. The SEC avers that part of Ripple’s “strategy” is to sell XRP to as many speculative investors as possible, that the principal reason for anyone to buy XRP was to speculate on it as an investment, and that Ripple viewed institutional sales as the “lynchpin of its strategy to generate speculative interest in XRP from public investors.”

The SEC also alleges the following other factors that it appears to deem significant to its arguments under the Howey test.

  • Third-Party Sales. The SEC avers that Ripple engaged and paid four entities, including an SEC-registered broker-dealer, commissions for executing Ripple’s XRP sales to the public on digital asset trading platforms, and refers to one of these entities as the “Market Maker.” The SEC alleges that Ripple gave XRP to an affiliate, RippleWorks, to sell XRP into the public markets and enlisted the Market Maker to sell XRP to the public on RippleWorks’ behalf. The complaint further sets forth agreements that Ripple entered into with at least 10 digital asset trading platforms, in which Ripple paid platform fees and provided listing and trading incentives with respect to XRP. The SEC alleges that each of these steps exhibits Ripple’s intended purpose of “maximizing the amount of money Ripple could raise in the Offering.”
  • Source of Investor Information. The SEC alleges that throughout the offering, Ripple held itself out as the primary source of information on XRP, yet timed XRP sales and purchases to coincide with strategic announcements about Ripple without publicly disclosing its strategy. For example, Ripple’s website contained select information about how and where to buy XRP, XRP market data, and news and insights related to XRP. The SEC also references certain quarterly “Markets Reports” that Ripple allegedly began publishing in January 2017. In the Markets Reports for the third quarter of 2019, Ripple stated that it would “take proactive steps” to address the “spread of misinformation” about Ripple’s alleged “dumping” of XRP and to address the “fear, uncertainty, and doubt” about investing in XRP spread by others. The SEC views these statement as Ripple holding itself out as the legitimate source of information essential for investors, such that investors would rely on what Ripple chose to disclose.
  • Lack of Non-Investment Use. Significantly, the SEC focused on the lack of a significant non-investment use for XRP. According to the complaint, the first potential use of XRP that the defendants announced was as a “universal digital asset” and/or for banks to transfer money, which did not materialize. The SEC claims that Ripple has only one product that permits XRP use, its On-Demand Liquidity Product (ODL), but it did not launch this product until October 2018, five years after the first distribution of XRP, and ODL was not intended for individual use even though XRP was sold to individual investors. The SEC states that the potential “users” of ODL that Ripple is targeting are money transmitters; from October 2018 through July 26, 2020, only 15 money transmitters (none of which are banks) signed on to potentially use ODL; and ODL transactions comprised no more than 1.6 percent of XRP’s trading volume during any one quarter.
  • “Currency” Definition. The SEC acknowledged that in May 2015, Ripple and XRP II agreed to settle charges brought by the U.S. Department of Justice (DOJ) and the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury, for failing to register as a “Money Services Business” under the Bank Secrecy Act and agreed to comply with other regulatory requirements with respect to Ripple’s XRP sales, as a “virtual currency.” The complaint notes that XRP is not “currency” under the federal securities laws.

The complaint further states that Ripple internally treated XRP as a security based in part on a policy that resembles insider trading-prohibitive policies for securities transactions. In short, the SEC claims that based on Ripple’s representations, Ripple’s actions and the economic reality, XRP investors had a reasonable expectation of profiting from Ripple’s efforts to use investor funds to create a use for XRP and bring demand and value to their common enterprise.

A Preview of Ripple’s Defense

Ripple publicly shared a preview of its defense when it published a summary of its Wells submission. Among other arguments, the summary sets forth the following, which Ripple has also made in its recently filed answer to the SEC’s complaint.

  • Economic Realities. The summary states that the SEC’s investment contract analysis “ignores the economic reality that XRP is, and has long been, a digital asset with a fully functional ecosystem and a real use case as a bridge currency that does not rely on Ripple’s efforts for its functionality or price.” As a threshold matter, Ripple states that XRP is not an investment contract because there is no “contract” underlying any “investment contract.”
  • Currency Status. The summary sets forth that XRP is a currency, similar to bitcoin and ether, which SEC staff has already publicly stated are not securities. Ripple further notes that, in 2015, the DOJ and FinCEN determined that XRP was a convertible virtual currency and Ripple was a money transmitter of XRP, and the settlement of that case required Ripple’s XRP transactions to comply with laws that do not apply to securities transactions.
  • Pre-DAO Report. Ripple notes that XRP trading began in 2013, which is long before the SEC’s DAO Report of July 2017, and that no actions have been brought against unregistered offerings of digital assets that occurred prior to the DAO Report.
  • Common Enterprise. Ripple argues that under the Howey test there is no horizontal or vertical commonality. First, there has been no “pooling” of proceeds to support the investment that will result in the distribution of profits. Second, assuming arguendo that strict vertical commonality applies, the fortunes of XRP holders are not intertwined with Ripple and its efforts, but are instead impacted by independent market forces.
  • Expectation of Profits Based on the Efforts of Others. Ripple further states that under the Howey test there is no reasonable expectation of profits by XRP purchasers based on the efforts of Ripple. It is the objective nature of what the purchasers were actually offered or promised that controls, not the subjective intent of the XRP purchaser, and Ripple represents that it does not promise and has not promised to increase XRP’s prices in public statements. Ripple contends that its interaction with the XRP community does not constitute “efforts of others” and, moreover, that the XRP ledger’s decentralized nature precludes XRP purchasers from reasonably relying on Ripple’s efforts to increase the price of XRP.
  • Lack of Information Asymmetries. Ripple notes that information asymmetries are not part of the Howey analysis (but have been stated as a factor by SEC staff), but nonetheless addresses that issue, stating that there are no material asymmetries between Ripple and XRP holders.
  • Policy Arguments. Finally, Ripple argues that policy reasons weigh in favor of concluding that XRP is not an investment contract. Ripple claims that “[b]y alleging that Ripple’s distributions of XRP are investment contracts while maintaining that bitcoin and ether are not securities, the Commission is picking virtual currency winners and losers, destroying U.S.-based, consumer-friendly innovation in the process.” Ripple’s policy arguments include that “[i]nnovation in the cryptocurrency industry will be fully ceded to China,” “[a]n expansive application of Howey will have a chilling effect on the entire blockchain industry,” and XRP has not been classified as a security by any foreign regulator.

Takeaways

Following the SEC enforcement actions against Kik and Telegram, this action alleging XRP is a security is expected to be heavily litigated. The case is unique among other previous SEC enforcement actions not only because there are no allegations of fraud, but also because sales of XRP began prior to the SEC’s DAO Report, which was issued in July 2017. Notably, in Kik and Telegram, the SEC claimed that the companies were on notice that the digital assets in question could be, and were likely, subject to the federal securities laws due to the DAO Report.

Also significant is that Ripple has been complying with a separate regulatory regime by treating XRP as a virtual currency. Among other factors, this may become relevant to the case because the definition of a security sets forth a definition that applies “unless the context otherwise requires.” Additionally, the Supreme Court has held that when an alternative regulatory regime applies to an instrument, the securities regulations may be rendered unnecessary.

The Ripple facts are also distinguishable from a number of other cryptocurrencies, especially those that both had a usable product upon distribution of their cryptocurrencies and only made sales of their cryptocurrencies prior to that distribution and pursuant to an exemption from the securities registration requirements.

While the outcome of the Ripple case may remain unsettled for some time, one thing has already become clear. With its complaint against Ripple, the SEC now appears willing to bring enforcement actions with respect to any and all digital asset sales it sees as unregistered offerings violating the federal securities laws  – whether or not the sales occurred before the DAO Report, regardless of whether or not fraud is alleged, and irrespective of a company’s reputation or status in the blockchain industry.