On December 2, the Securities and Exchange Commission filed a process against Ripple Labs, Inc. and two of its executives, claiming that they offered and sold more than $ 1.38 billion in XRP digital assets without registration or exemption, in violation of Section 5 of the Securities Act of 1933, seeking restitution of illicit earnings . Ripple presented a answer on January 29, denying that XRP is a security or that it has violated securities laws. At the heart of this case is the issue that has been central to almost all other enforcement actions brought by the SEC in the digital asset space: whether XRP is an “investment contract” and, therefore, a security. The court in Curling may have a unique opportunity to fill a regulatory void and provide the necessary guidance for developers of cryptocurrency networks on how to launch digital currencies without triggering securities laws. The decision in the Ripple case may indeed make waves in all digital asset markets.
Ripple and XRP
Ripple operates a network that allows international payments using its XRP cryptocurrency to facilitate currency transfers over the XRP network. XRP differs from Bitcoin or Ether, two cryptocurrencies recognized by the SEC as non-bonds, in which Bitcoin and Ether are coined through the mining process, while XRP supply was limited to 100 billion XRP when it was created in 2012, 20 billion of which has been transferred to Ripple’s three co-founders and the remaining 80 billion has been left in reserve for future issues.
Regulatory Scenario
SEC enforcement actions in the digital asset space tend to focus on the last two Howey, that is, whether buyers had a reasonable expectation of profit and, if so, whether the expectation of profit depended on the efforts of third parties. The main factors relevant to the expected profit include whether the promoter marketed the digital assets to potential users for its functionality or, alternatively, to investors for the speculative value of the tokens. Important elements in determining other endeavors’ efforts included whether the network was decentralized or fully functional.
In recent years, developers of cryptographic networks have faced a regulatory Catch-22. Distributing tokens to people can violate securities laws if the network is not functional or decentralized. But it cannot mature in a decentralized functional network that does not depend on the management and business efforts of a single group, unless the tokens are distributed and freely transferable between potential users and developers on the network.
This is where the Ripple case can provide the necessary clarity. Previous cases have focused on whether the developer suggested that the tokens will increase in value and whether he tried to support a secondary market. But a meaningful analysis of facts and circumstances must really dig deeper. The developer’s disclosure of a token’s potential to increase in value certainly makes the token look like an investment contract, but it could also be explained more innocently as an expression of a desire for the network to succeed and be used by many people. Some cryptographic network developers have continued to offer digital token offerings in the hope of convincing the SEC that their token is sufficiently functional and avoiding the branding of an investment contract, but this approach is risky because it is difficult to prove that a token is functional before distribute it to many people for use on the network.
An alternative for a cryptographic network developer would be to bite the bullet, grant the bond issue and sell the tokens to investors with no registration. Several developers of blockchain networks have done this in accordance with Rule 506 of Regulation D, but this approach has severe limitations, since the issuer is limited to selling only to accredited investors. In addition, if the offer complies with Rule 506 (c), which is expected because the offer would likely involve general solicitation efforts, the seller would need to use improved methods of verifying the status of the accredited investor, which is not practical . Another way of exemption would be a mini-public offering under Regulation A +. But this is a more expensive process that involves intermediaries, which would undermine one of the main advantages of a blockchain network, namely that it is decentralized with people transacting directly with each other, without the need for intermediaries.
Another alternative would be to distribute the tokens only outside the United States in jurisdictions that allow it. The risk here is that tokens can easily find their way back to the USA. And from a public policy perspective, a regulatory regime that encourages entrepreneurs to operate outside the U.S. denies Americans and U.S. markets the opportunity to participate in an innovative opportunity.
Last year, SEC Commissioner Hester Peirce proposed a safe haven for blockchain network developers that would imply a three-year grace period during which they could develop a functional or decentralized network that is exempt from registration, provided certain conditions of disclosure, intended functionality, liquidity and notification are met. I blogged about the proposal on here. It represents a practical and sensible solution for the catch 22 regulatory blockchain developers, although it was not formally proposed by the SEC.
SEC claims
The SEC claims that from at least 2013 to the present, Ripple, its president and its CEO have sold more than 14.6 billion XRP in exchange for nearly $ 1.4 billion in cash or other consideration to finance Ripple’s operations and enrich themselves. They did this despite two memos from Ripple’s lawyers telling the company in 2012 that XRP can be considered an investment contract, that XRP differed from Bitcoin because Ripple identified itself as responsible for the distribution, promotion and marketing of the negotiated XRP network and that it must seek SEC guidance on how to distribute XRP without triggering securities laws. In addition, Ripple promised during the offering that it would engage in efforts to increase the value of XRP and then engage in extensive business and administrative efforts with the proceeds of the offering. He also praised the potential future use of XRP by certain specialist institutions, while simultaneously selling XRP widely on the market.
The SEC claims that XRP is an investment contract and therefore a security under the Howey test, which is satisfied when there is an investment of money in a joint venture with a reasonable expectation of making a profit through the efforts of others. Ripple has pledged to make significant efforts to develop, monitor and maintain a secondary market for XRP with the aim of increasing turnover and resale opportunities. She made repeated public statements highlighting her business development effort that will drive XRP demand, adoption and liquidity, and stood out as the primary source of information about XRP. The SEC claims that these factors have led investors to reasonably expect that Ripple’s corporate and managerial efforts would lead to the success or failure of Ripple’s XRP network.
Reply from Ripple
Ripple’s response to the SEC filing is multifaceted. In his response to the complaint, he notes that the SEC’s action comes five years after the DOJ and FinCen determined in a separate lawsuit that XRP is a virtual currency. It states that, since the SEC previously held that Bitcoin and Ether are not bonds, this action would be tantamount to the SEC choosing virtual currency winners and losers. He claims that the mere filing of the lawsuit has caused immense damage to XRP holders, with an estimated loss of $ 15 billion for those the SEC wants to protect.
Ripple claims that it has never made an initial coin offering, has never been offered or contracted to sell future tokens as a way to raise money to build an ecosystem, has no explicit or implicit obligation with any counterparty to spend effort on its behalf and never promised to explicitly or implicitly profits for any XRP holder. For these reasons, Ripple concludes that XRP holders cannot objectively rely on Ripple’s efforts. In addition, Ripple has its own shareholders who bought shares in traditional venture capital financing rounds and who, unlike XRP buyers, contributed capital to finance Ripple’s operations, are entitled to their future profits and have obtained their shares through an (and not contested) exempt private offering.
Ripple seems to be signaling that it knows it is in trouble as it seems to go further by claiming that it is being treated differently from other cryptocurrency initiatives that have not been the subject of an SEC oversight action. Ripple has filed for a Freedom of Information Act seeking all SEC communications about other cryptocurrencies, and its legal team includes heavyweights such as former SEC president Mary Jo White and former SEC chief executive officer, Andrew Ceresney, both now from Debevoise & Plimpton.
Because Curling is potentially significant
Whether or not cryptocurrencies are investment contracts and therefore securities remain an unresolved issue that bothers entrepreneurs in the crypto network, and there may be some significant case law to emerge Curling on this. While Commissioner Peirce’s recommendation seems like a good way to promote innovation in this space without hammering entrepreneurs face expensive regulatory requirements for securities, there is no reason to believe that it will be formally proposed by the SEC given the paternalistic emphasis of the new government on protecting investor. Cryptocurrencies cannot be launched in a decentralized manner. Like network effects on the economy, cryptocurrency networks need to reach a critical mass of participants for the network to be economically viable. Most cryptocurrencies are considered decentralized, with no central authority governing the blockchain. Whether or not Ripple has that kind of central authority is what this case seems to depend on.
We are currently in a regulatory vacuum in which the SEC has not provided sufficient formal guidance to cryptocurrency developers and their lawyers on how to launch digital currencies without triggering securities laws. If it doesn’t, Curling it could be a seminal case in the cryptocurrency arena and an opportunity to establish clear and objective standards that could be followed by developers of well-intentioned cryptographic networks. If that happen, Curling could make waves in the space of digital assets.
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