The SEC and the Ripple Effects
Setting the stage
Ripple Labs Inc operates the RippleNet and XRP payment protocol and is the issuer of the XRP token. Founded in 2012, the technology was considered by some to be superior to Bitcoin as a means of exchange with its faster settlement speed and extremely low transaction cost. It embarked on a mission to develop real-economy products via the revolutionary blockchain and was tipped to replace the likes of MoneyGram, Western Union and even potentially rival the SWIFT settlement system.
...And then came along the Securities and Exchange Commission ("SEC") politely put, it threw a spanner in the works in December 2020 when it filed a lawsuit alleging the offering of the XRP token amounted to offering unregistered securities, in turn deeming XRP to be a security. This event sent shockwaves through the industry and had a global impact with investors pondering "Is my token an unregistered security?" and legal commentators philosophically questioning "what is a security?".
Gary Gensler, Chair of the SEC stated in a video from a lecture in 2018 that Bitcoin, Ethereum, Litecoin and Bitcoin cash are "not securities", it's a far cry from his current position on the issue. As recently as February 2023, Gensler expressed in an interview with New York Magazine that "everything other than bitcoin" is a security.
A security is a financial investment contract, which can take the form of shares of stocks, bonds and/or options, typically tradeable, which in Europe we call "financial instruments". The case hinged on the determination that XRP amounts to an investment contract under the Howey Test, and thus required disclosure as a "security". The Howey Test is a legal principle derived from the 1946 Supreme Court case, SEC v W.J. Howey Co which determined that a transaction is an investment contract if it involved the investment of money in a common enterprise with the expectation of profit predominantly from the efforts of others.
Flight or fight.... Ripple decided to fight and prepared a robust defence to the accusations, noting that the XRP ledger is decentralised and open-source, operating on community consensus; with XRP not acting as an investment contract in their company nor something they control. Aptly stating that if investors wanted to invest in Ripple, they would buy shares in the company itself, not the XRP token.
In the meantime, the SEC continued its war of attrition against the crypto industry whilst the Ripple case played out in court, the agency brought over 100 enforcement actions against the industry, claiming a wide range of tokens as securities, with a vast majority capitulating to the agency and settling. In all cases that went to court, judges agreed with the SEC that the issuers must be registered with the SEC and required disclosures. As Congress remained mute with a lack of regulatory framework, the SEC painted the town red, the rapid assault adding uncertainty, fear, and damage which the industry may find hard to undo.
As an observer, it highlights the danger of having various agencies with conflicting interests, fighting a regulatory "turf war", a commodity, security, or currency – that is the question.
The ambiguity gave rise to a fascinating paradox with the U.S. government utilising Coinbase as its choice of exchange to sell Bitcoin seized from the Silk Road wire fraud case, whilst at the same time, the SEC charges Coinbase for illegally offering unregistered securities. The prima facie of the Coinbase defence, "what exactly is a security?" which the agency repeatedly refused to answer, even refusing to clearly answer to the Chairman of the House Financial Services Committee in April 2023, with Rep. Patrick McHenry and Rep. Tom Emmer grilling Gensler on its lack of transparency and approach to the crypto-asset industry, refusing more than once to answer whether Ethereum, the 2nd largest crypto-asset, is a security.
A complex ruling
Investors and commentators were upbeat about Thursday's ruling, but it's not a clear-cut victory. Judge Torres stated categorically that a token is not automatically an investment contract, "XRP, as a digital token, is not in and of itself a contract transaction or scheme" that embodies the Howey requirements of an investment contract and further ruled that programmatic sales to the general public of XRP did not form unregistered securities offerings. This is a clear victory for Ripple, investors and the rest of the industry with a precedent now set, albeit an intermediate ruling in a larger case.
Judge Torres however found that Ripple's sales of XRP to institutional investors were in fact unregistered securities offerings on the basis that institutional investors were more likely to be aware of XRP's securities-like traits with the SEC viewing this judgment as a win, this could potentially have implications for the industry with several other institutional backed initial coin offerings ("ICO"s) in the spotlight.
In the decision, the differing treatment is based on the institutional buyer knowingly purchasing XRP directly from Ripple, pursuant to a contract, with the economic reality of a programmatic buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what It was paying its money.
Another matter is the SECs insistence that crypto exchanges like Coinbase need to register as securities exchanges, with the SEC being clear that most crypto-assets being traded should in fact be considered securities. However, the court didn't reach a conclusion on the matter which was another win for Ripple.
It's a historic landmark win, the first cryptocurrency company to win a case brought by the U.S. Securities and Exchange Commission, however the case is far from over with a trial soon expected and an energised agency, keen to set the record straight.
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