Such regulation by enforcement does indeed run the risk of stifling important and valuable innovation in the crypto space.
he U.S. Securities and Exchange Commission has not been kind to crypto in the past year. In March 2020, in the SEC v. Telegram
case, the Commission won a worldwide injunction against the proposed
issuance of Grams by Telegram, undoing years of innovative work even in
the absence of any allegations of fraud. Then, on the last day of
September 2020, Judge Alvin K. Hellerstein dashed the hopes of Kik
Interactive by ruling in favor of the SEC’s motion for summary judgment
in SEC v. Kik Interactive,
halting the sale of Kin crypto tokens. Both of these actions were filed
in the Southern District of New York. On Dec. 22, 2020, the SEC decided
that it was time to initiate another high-profile action,
filing in the same district against Ripple Labs and its initial and
current CEOs, Christian Larsen and Bradly Garlinghouse, respectively,
for raising more than $1.38 billion through the sale of XRP since 2013.
The initial fallout from this action has been swift and severe: 24 hours after the lawsuit was filed, the price of XRP was down almost 25%. This still left XRP ranked fourth on CoinMarketCap, with a total market capitalization of over $10.5 billion.
The complaint
In
its complaint, the Commission paints a straightforward pattern of sales
of XRP that were never registered with the SEC or made pursuant to any
exemption from registration. From the perspective of the Commission,
this amounts to a sustained practice of illegal sales of unregistered,
non-exempt securities under Section 5 of the Securities Act of 1933.
For
readers not familiar with legal procedure, it might seem unusual for
the case to be brought in a New York federal court, especially since
Ripple is headquartered in California, and both named individuals reside
there. However, Ripple has an office in the Southern District of that
state, some statements were made by Garlinghouse while he was present in
New York, and significant sales of XRP were made to New York residents.
In legal parlance, this would make venues in the Southern District of
New York appropriate.
In addition, it might be surprising to some
that both Larsen and Garlinghouse were named personally in an action
that seeks primarily to recover for XRP allegedly sold illegally by
Ripple, through its wholly-owned subsidiary, XRP II LLC. They are named
both because they individually also sold significant volumes of XRP —
1.7 billion by Larsen and 321 million by Garlinghouse — and because the
SEC contends they “aided and abetted” Ripple in its sales.
Aiding
and abetting is a cause of action that depends on a primary violation by
a third party, in which the aider and abettor voluntarily and knowingly
participates with the goal of assisting in the venture’s success. In
this case, Ripple would be the primary violator, and both Larsen and
Garlinghouse are alleged to have substantially participated in the
pattern of Ripple’s XRP sales, with the goal of allowing the company to
raise funds without registering XRP under the federal securities laws or
complying with any available exemption from registration.
The
bulk of the complaint provides an overview of digital assets, details
the SEC’s version of the history of Ripple and its marketing efforts
with regard to XRP, illustrates how in the opinion of the Commission,
XRP satisfies the elements of the Howey investment contract test
under the federal securities laws, and seeks to demonstrate how Larsen
and Garlinghouse participated in the on-going sales efforts.
In
addition to disgorgement of all “ill-gotten gains,” the requested order
would permanently ban the named defendants from ever selling
unregistered XRP or participating in any way in the sale of
unregistered, non-exempt securities. It would also prohibit them from
participating in the offering of any digital asset securities, and it
seeks unspecified civil monetary penalties.
A brief history of Ripple and XRP
The
idea behind the current XRP dates back to late 2011 or early 2012,
before the company changed its name to Ripple. The XRP Ledger, or
software code, operates as a peer-to-peer database, spread across a
network of computers that records data about transactions, among other
things. In order to achieve consensus, each server on the network
evaluates proposed transactions from a subset of nodes it trusts not to
defraud it. Those trusted nodes are known as the server’s unique node
list, or UNL. Although each server defines its own trusted nodes, the
XRP Ledger requires a high degree of overlap between the trusted nodes
chosen by each server. To facilitate this overlap, Ripple publishes a
proposed UNL.
Upon the completion of the XRP Ledger in December
2012, and as its code was being deployed to the servers that would run
it, a fixed supply of 100 billion XRP was set and created at little
cost. Of those XRP, 80 billion were transferred to Ripple and the
remaining 20 billion XRP went to a group of founders, including Larsen.
At this point in time, Ripple and its founders controlled 100% of XRP.
Note
that these choices represent a compromise between the fully
decentralized, peer-to-peer network that was envisioned when Bitcoin (BTC)
was first announced and a fully centralized network with a single
trusted intermediary such as a conventional financial institution. In
addition, Bitcoin was never designed or intended to be held or
controlled by a single entity. In contrast, all XRP was originally
issued to the company that created it and that company’s founders. This
hybrid approach to a blockchain-based digital asset and more
conventional assets created and controlled by a single entity led some
crypto enthusiasts to complain that XRP was not a “true” cryptocurrency at all.
According
to the SEC’s complaint, from 2013 through 2014, Ripple and Larsen made
efforts to create a market for XRP by having Ripple distribute
approximately 12.5 billion XRP through bounty programs that paid
programmers compensation for reporting problems in the XRP Ledger’s
code. As part of these calculated steps, Ripple distributed small
amounts of XRP — typically between 100 and 1,000 XRP per transaction —
to anonymous developers and others to establish a trading market for
XRP.
Ripple then began more systematic efforts to increase
speculative demand and trading volume for XRP. Starting in at least
2015, Ripple decided that it would seek to make XRP a “universal
[digital] asset” for banks and other financial institutions to effect
money transfers. According to the SEC, this meant that Ripple needed to
create an active, liquid XRP secondary trading market. It, therefore,
expanded its efforts to develop a use for XRP while increasing sales of
XRP into the market.
At about this time, Ripple Labs, and its subsidiary, XRP II LLC, came under investigation by the U.S. Financial Crimes Enforcement Network, or FinCEN, acting pursuant to its mandates in the Bank Secrecy Act,
or BSA. Acting in conjunction with the U.S. Attorney’s Office for the
Northern District of California, the two companies were charged with
failing to comply with various BSA requirements, including failure to
register with FinCEN and failure to implement and maintain proper
Anti-Money Laundering and Know Your Customer protocols. According to
FinCEN, Ripple’s failure to comply with these FinCEN requirements was
facilitating the use of XRP by money launderers and terrorists.
This
action did not proceed to trial, with Ripple Labs settling the charges
by agreeing to pay a $700,000 fine and further agreeing to take
immediate remedial steps to bring the companies into compliance with BSA
requirements. The settlement was announced
by FinCEN on May 5, 2015. The major contention of FinCEN throughout its
investigation was that XRP was a digital currency. Ripple acceded to
this position and has since worked to comply with BSA requirements.
At
the same time, as noted in the SEC’s complaint, from 2014 through the
third quarter of 2020, the company sold at least 8.8 billion XRP in the
market and institutional sales, raising approximately $1.38 billion to
fund its operations. In addition, the complaint asserts that from 2015
through at least March 2020, while Larsen was an affiliate of Ripple as
its CEO and later chairman of the board, Larsen and his wife sold over
1.7 billion XRP to public investors in the market. Larsen and his wife
netted at least $450 million from those sales. From April 2017 through
December 2019, while an affiliate of Ripple as CEO, Garlinghouse sold
over 321 million XRP he had received from Ripple to public investors in
the market, generating approximately $150 million from those sales.
XRP is not like Bitcoin or Ether
The
preceding description paints a picture of a digital asset that is
widely held by persons scattered around the globe. In the case of both
Bitcoin and Ether (ETH),
this kind of decentralization was apparently enough to convince the SEC
that those two digital assets should not be regulated as securities. As
Director Bill Hinman of the SEC’s Division of Corporation Finance explained in June of 2018:
“If
the network on which the token or coin is to function is sufficiently
decentralized — where purchasers would no longer reasonably expect a
person or group to carry out essential managerial or entrepreneurial
efforts — the assets may not represent an investment contract. Moreover,
when the efforts of the third party are no longer a key factor for
determining the enterprise’s success, material information asymmetries
recede. As a network becomes truly decentralized, the ability to
identify an issuer or promoter to make the requisite disclosures becomes
difficult, and less meaningful. […] The network on which Bitcoin
functions is operational and appears to have been decentralized for some
time, perhaps from inception. Applying the disclosure regime of the
federal securities laws to the offer and resale of Bitcoin would seem to
add little value.”
This kind of analysis does not really
work for XRP, most of which continues to be owned by the company that
created it, where the company continues to have significant influence
over which nodes will serve as trusted validators for transactions, and
where the company continues to play a significant role in the
profitability and viability of the asset. Part of that role will now, of
course, involve responding to this latest SEC initiative.
The court’s probable reaction
Unfortunately
for Ripple and its former and current CEOs, the SEC has a strong case
that XRP fits within the Howey investment contract test. Derived from
the 1946 Supreme Court decision
in SEC v. W. J. Howey, this test holds that you have bought a security
if you: (1) make an investment (2) of money or something else of value,
(3) in a common enterprise, (4) with the expectation of profits, (5)
from the essential managerial efforts of others. Most of the purchasers
of XRP, or certainly a very large number of them, would appear to fit
within each of these categories.
Ripple raised more than $1.38
billion from the sale of XRP, so it is abundantly clear that purchasers
were paying something of value. Moreover, as there was no effort to
limit purchasers to the amount of XRP that they might reasonably “use”
for anything other than investment purposes, that element appears likely
to be present as well. The fact that the fortunes of all the investors
rise and fall together along with the value of XRP in the marketplace
should satisfy the commonality requirement.
The complaint
highlights a number of things that Ripple has done to promote
profitability, including statements that it has made, all of which
suggest that a reason for purchasing XRP is the potential for
appreciation. The limited functionality of XRP in comparison to its
trading supply is another reason to believe that most purchasers were
buying for investment, seeking to make a profit.
Finally, the
significant on-going involvement and role of the company, especially
given its huge continuing ownership interest in XRP, means that there is
a strong case to be made that the profitability of XRP is highly
dependent on the efforts of Ripple. All of this points to the reality
that, under the Howey Test, XRP is likely to be a security.
Ripple’s response to the SEC’s action
Ripple’s
response to the SEC’s enforcement action came even before the SEC’s
complaint was officially filed. On Dec. 21, Garlinghouse tweeted
out a condemnation of the SEC’s planned action, criticizing the agency
for picking favorites and trying to “limit US innovation in the crypto
industry to BTC and ETH.” Soon after, Ripple’s general counsel, Stuart
Alderoty, gave
a strong indication of how the company was likely to respond in the
pending matter by pointing out the 2015 FinCEN issue, which he claimed
was a government determination that XRP was a digital currency rather
than a security under the Howey Test.
Unfortunately,
classification as a digital currency does not necessarily preclude
regulation as a security. As another New York district court decided in
the 2018 case of CFTC v. McDonnell,
in the context of the Commodity Futures Trading Commission’s authority
to regulate digital assets, “Federal agencies may have concurrent or
overlapping jurisdiction over a particular issue or area.”
Thus,
even though FinCEN regulates crypto as a digital asset, the CFTC may
treat it as a commodity; the SEC may regulate it as a security; and the
Internal Revenue Service may tax it as property. All at the same time.
Conclusion
This
comment should not be taken as approval of the SEC’s current approach
and relative hostility to crypto offerings. As the SEC’s complaint
notes, the XRP sales that are now being questioned took place over many
years. The initial sales date back to 2013, which had happened
considerably before the SEC first publicly announced its position that
digital assets should be regulated as securities if they fit within the
Howey investment contract analysis, which did not come until 2017 with The DAO Report.
Moreover, since 2015, Ripple has been proceeding in accordance with the
settlement reached with FinCEN. Since that time, Ripple has worked to
bring its operations into compliance with BSA requirements, operating as
if XRP is a currency rather than a security.
source link : https://cointelegraph.com/news/sec-vs-ripple-a-predictable-but-undesirable-development
