SEC stumbles in case of ripple, lost in a maze of its own making

When the US Securities and Exchange Commission filed its multi-billion dollar lawsuit against blockchain technology company Ripple and two executives in December, the timing was doubly peculiar. The complaint alleged that sales of Ripple’s XRP cryptocurrency from 2013 to the present were illegal and unregistered security offers, rather than the distribution of a digital token to build a payment network. The SEC’s seven-year wait to make this claim with billions of XRP tokens now circulating in the secondary crypto markets was quite strange. But the case was also dismissed in the final hours of SEC President Jay Clayton, and then dumped on an equally divided commission towards a new government.

Looking at the torrent of filings heating up the agenda, it became clear that the SEC’s decision to sue Ripple was wrong. And in the past few days, a series of events is beginning to make it look like a disastrous mistake that the presumed new president, Gary Gensler, will have to resolve.

The SEC probably did not expect the storm that Clayton’s final act unleashed and exposed the weakness inherent in the decision to sue. It all started on January 1, when a group of XRP holders led by Rhode Island attorney John E. Deaton struck back at the agency.

Deaton, a personal injury lawyer with experience in class action, filed a petition with the United States District Court in his home state to force the SEC to exclude its XRP holdings from being defined as a title. He says he did not buy XRP as an investment contract and never considered it a security, and the SEC’s action against Ripple unfairly harmed him when it plummeted and forced crypto exchanges to begin removing the token. After filing his suit, Deaton it says he was inundated with requests from thousands of other XRP retail owners who wanted to join his case.

Last Friday, the SEC’s response to Deaton landed in Rhode Island. For those watching the Ripple case in New York, he carries an astonishing argument: the SEC asked to reject Deaton’s petition because no determination has yet been made on whether XRP is a title. Adding two and two, the SEC is saying that Ripple and its two top executives should have had reasonable knowledge of something seven years ago that the agency itself was not sure of last Friday. One wonders what part of the 1933 Securities Act the SEC will use to argue that Ripple is required to have psychic powers to operate legally in the United States.

Co-defendants Brad Garlinghouse and Chris Larsen, top executives at Ripple, sent letters to the New York judge on March 3, anticipating their own motions to end the case with arguments around “fair notice and due process”. Two days later, the SEC’s response to Deaton only made his arguments even more obvious. Don’t SEC staff lawyers attend Zoom meetings to coordinate? No wonder Ripple filed for Freedom of Information Act (FOIA) requests for SEC documents and internal communications that could show that, while seven years of high-profile developments were taking place related to XRP, the agency’s actions were just as unclear and confusing. Sort of like the contradictory documents they made two days apart in New York and Rhode Island.

On March 8, the SEC appeared to panic. He fired a letter to the New York judge demanding that she attack the “fair warning” defense of the Ripple case, calling it “inappropriate” and “spurious” and seeking an immediate hearing to decide on it. If the judge disagrees, we can only ask ourselves what is hidden in the SEC’s internal communications that Ripple can discover from that FOIA request and other discovery measures. What internal work was done in the 2018 announcement by the then Director of Corporate Finance William Hinman that ether (ETH) is not a title, given its similarities to XRP? Which crypto exchanges asked for clear guidance from the SEC on the legal status of the XRP before listing the token and what were the agency’s internal discussions and responses? How many opportunities has the SEC given since 2013 to give Ripple and XRP holders a fair warning about XRP status, and what went into each decision to let those opportunities pass?

I called this case the cryptocurrency trial of the century in December, and I am being justified with each development. Not only is the future of the United States’ crypto industry at stake, but so is the arrogance of rampant regulators who make policies through law enforcement. The SEC has made it clear that it does not care how many investors it harms or how many companies it runs abroad, in seeking to extend its authority beyond common sense. The result of what appears to be a collective action against the SEC on this issue confirms the reaction against its exaggeration.

The most encouraging development this week was the introduction of bipartisan legislation by Rep. Patrick McHenry (R-NC), senior Republican on the House’s Financial Services Committee, to establish a public-private working group led by the SEC and Commodity Futures Trading Commission (CFTC) to start building a clear regulatory framework for digital assets. I participated in a Real Clear Policy panel discussion in January with McHenry on crypto regulation, and he spoke of his determination to end the agency’s hype. It was on the same day that President Biden appointed Gary Gensler to chair the SEC.

Gensler said at his Senate confirmation hearing in February that he thinks the SEC should only use its oversight capabilities when it can resolve major problems in the markets. So it stands to reason that the new president will solve the biggest problem in the crypto markets by investing SEC resources in McHenry’s working group, rather than in Jay Clayton’s misguided process, which could explode in the agency’s face.