Nine years ago a startup that would eventually be called Ripple Labs came onto the fintech scene with a promising plan to provide financial institutions with fast, low-cost clearance of trans-border money transfers. To make it happen, the company set up a network on which transactions sped across the globe in the form of a cryptocurrency called XRP, which was specially created for the task.
But thanks to its eventual popularity outside of that application, XRP has turned out to be a sort of time bomb with a very long fuse for Ripple. That bomb finally went off last year when the SEC filed suit against Ripple and its current and former CEOs, claiming that selling XRP constituted the offering of an unregistered security—essentially an illegal IPO.
As the case drags on with no clear resolution yet in sight, Ripple’s legal woes have become emblematic of the murky regulation enveloping digital currency, reflecting the mismatch between laws largely developed during the Great Depression and today’s burgeoning fintech ecosystem. While opinions differ on whether the SEC has a strong case against Ripple, almost everyone agrees that the underlying problem is a lack of clarity over how cryptocurrency can be regulated in ways that don’t sabotage the industry or unfairly target companies and investors who may have had little way of knowing they were running afoul of regulators. “It’s now been more than a decade since this new asset class has been around, and we’ve yet to start focusing on creating regulations targeted to it,” said Carol Goforth, a professor at the University of Arkansas School of Law who studies cryptocurrency. Here’s why crypto investors are watching this case so closely and what it could mean for the rest of the industry.
Behind the SEC’s beef with Ripple
Ripple was founded in 2012 under the name NewCoin—later calling itself OpenCoin before finally settling on its current name—to offer a leading-edge alternative to the big-bank-owned SWIFT cross-border money-transfer network. The process of clearing funds on SWIFT can take as long as days, thanks in part to the need to convert among multiple currencies. To skip that delay, the SEC charges that the company created the roughly Bitcoin-like XRP digital tokens, along with software that allows banks to almost instantly convert funds into XRP for transfer, and then just as quickly convert it back to local currencies at the other end. (Ripple denies that it created XRP, arguing that only one of its two co-founders created the cryptocurrency.)
Unlike Bitcoin, which is painstakingly “mined” over time one by one by those with high-powered computer equipment, XRP tokens—100 billion of them—were created out of thin air primarily by three developers, one of which is a co-founder of Ripple. Most of those tokens are either owned by the co-founders or held in escrow by the company, but tens of billions of XRP tokens have been sold to the public, constituting what the SEC says is an “initial coin offering,” or ICO, a means for a company both to raise money and get its cryptocurrency into circulation.
XRP would go on to become by early 2018 the second most popular cryptocurrency behind Bitcoin, with a market cap of more than $120 billion. Though its value would fall from that high, XRP remained a top-three cryptocurrency until the suit hit, at which point its value tanked, and Ripple, along with many others, cried foul. “Whenever the SEC brings an action that has a negative impact on the price of an asset, investors wonder why they needed the SEC’s protection,” said Joe Dewey, an attorney with law firm Holland & Knight who edited a book on cryptocurrency regulation. Former Rep. George Nethercutt Jr. fumed in an article that the action against Ripple is “a glaring example of regulatory overreach.”
The lawsuit didn’t exactly come out of nowhere. The SEC has been breathing down the necks of crypto firms for years, occasionally lashing out with warnings, lawsuits, and penalties. The first serious action took place in 2013, when the agency closed down Bitcoin Savings and Trust as a Ponzi scheme; the man behind it, Trendon Shavers, was sentenced to 1.5 years in prison.
That action confirmed the obvious: Fraud is fraud, whether in dollars or cryptocurrency. And in fact most of the 75 cryptocurrency operations that the SEC would go after between 2013 and 2020 were relatively small, dubious schemes that were little more than digital updates of classic security scams and violations. But starting in 2017, regulatory clouds started to gather over larger, seemingly legitimate, more mainstream ICOs. That’s when the SEC released a report in response to the collapse of “The DAO,” an organization with crowdsourced management that had issued digital currency only to see a third of it whisked away by hackers.
Though the SEC took no action against The DAO’s founders, its report made it crystal clear the agency was closely eyeing popular ICOs as possible sales of unregistered securities, and was likely to go after some of them—without offering detailed criteria for which companies might come into its crosshairs. Bitcoin was likely safe, the agency allowed, because no company issued or controlled it, and so was Ether, the second most popular cryptocurrency, because the foundation that originally issued it was a nonprofit and all control over the currency had since been entirely decentralized. But other existing or future issuers of digital currencies were put on notice.
The first to be stung, if mildly, was Block.one, whose 2017 $4 billion sale of “EOS” tokens—to this day the world’s largest ICO—earned the company an SEC investigation resulting in a $24 million settlement. That relatively small slap likely owed to the fact that Block.one had warned U.S. investors to stay away and had declared the currency would be nontransferable after the ICO, discouraging speculation.
In 2019 the SEC really started lowering the unregistered-securities boom. In June of that year the agency filed suit against Canadian messaging-app company Kik Interactive, which had two years earlier netted nearly $100 million from an ICO for its Kin digital tokens, about half of it from U.S. investors. Kik, later acquired by MediaLab, was ultimately forced to pay a $5 million fine. Later that same year the SEC forced the Telegram Group, which runs the Telegram messaging service, to halt its ongoing ICO, and eventually made the company return $1.2 billion to those who had bought into it and pay a penalty of $18.5 million.
Enter “the Howey test”
Kik and Telegram had both been tripped up by one key question: Were buyers of the companies’ tokens truly getting a commodity-like asset whose value would be entirely determined by market forces, or were they to some extent counting on the company that sold the tokens to help raise their value? That’s called the Howey test, named after a 1946 Supreme Court case in which the SEC went after a citrus grove company that claimed its investors were buying shares of real estate whose value was independent of the company’s grove business, even though the company leased most of the land back from investors and farmed on it.
The court backed the SEC’s contention that investors were really investing in the business, and not just real estate, making the sales an unregistered securities offering. The agency has since been applying the Howey test to go after any company that sells anything to the public that even indirectly represents a way to bet on the future success of the company’s operations—unless, of course, the company registers the sales as a securities offering and meets the exhaustive public-disclosure requirements that go along with it.
By the SEC’s reckoning, Kik’s and Telegram’s unregistered cryptocurrency offerings failed the Howey test, meaning the values of the tokens each had issued were to some extent tied to the fortunes and management decisions of Kik and Telegram, respectively, and thus weren’t true commodities. And it ultimately decided Ripple and XRP were in the same boat.
Ripple, for its part, has loudly begged to differ. In its filings and public statements the company asserts it had nothing to do with XRP’s creation or how the cryptocurrency is managed and maintained—or at least no more than any other owner of the tokens. In 2018, Ripple’s regulatory relations director Ryan Zagone testified to Britain’s Parliament, saying, “XRP is open source and it was not created by our company, so that existed as an open-source technology. We created a company that was interested in modernizing payments and then began using that open-source tech to do so…We didn’t create XRP…We do own a significant amount of XRP, it was gifted to us by some of the open-source developers that created it. But there’s not a direct connection between Ripple, the company, and XRP.”
But that’s a wild stretch based on Ripple Labs trying to distance itself from its earlier incarnations as NewCoin and OpenCoin, said Preston Byrne, an attorney at law firm Anderson Kill specializing in cryptocurrency, who is not directly involved in the case. “XRP tokens didn’t spring out of the ground like gnomes,” said Byrne. “They were created by Ripple’s predecessor entity OpenCoin.”
In fact, notes Byrne, Ripple and its founders and managers have left their footprints all over XRP, and to this day many investors and institutions, including Nasdaq, refer to the currency as Ripple or Ripple XRP. He points out that while control over XRP is in fact somewhat decentralized, it’s not nearly as decentralized as Bitcoin and Ether. Ripple owns much of the software that remains essential to maintaining the smooth processing and validation of XRP transactions, as well as the financial network software that makes the most use of it. In that sense, the company’s success as a software developer could be seen as spilling into XRP’s value, a key element of failing the Howey test.
What’s more, notes the SEC, because the company and executives own most of the cryptocurrency themselves, they are in a unique position to impact the price of XRP by deciding when to sell new, large, potentially market-moving chunks of tokens, without any warning to outside XRP holders. In naming Ripple CEO Brad Garlinghouse and former CEO and cofounder Chris Larsen as defendants in the suit, the SEC noted that Garlinghouse has personally sold 321 million XRP tokens to the public, and Larsen has sold 1.7 billion. (Ripple disputes these claims in its response to the SEC suit.)
Goforth of the University of Arkansas School of Law agrees that Ripple probably flunks the Howey test. “They own such a huge portion of the tokens, and have done so much to develop the use case and functionality of XRP, you have to believe that Ripple affects the value of the token,” she said. “If it didn’t, the suit wouldn’t have hurt the token’s price.” In fact, XRP lost three-quarters of its value over an 11-day period starting just before suit was publicly announced, falling from 59 cents to 22 cents. (Speculative surges in the seven months since have sent it as high as $1.80, but today it stands at 60 cents.)
The security vs. currency debate
Why, then, the outcry over the SEC’s Ripple action? It’s mostly because the SEC had seemingly shrugged off Ripple and XRP for more than seven years. That long silence may well have led the company and XRP investors to assume—in the absence of any other XRP-specific signs from the SEC—that either the value of XRP tokens was deemed sufficiently insulated from Ripple’s doings to escape being considered a security, or else the agency had essentially grandfathered XRP in. After all, XRP had already been around for four years even back when the SEC issued its initial cryptocurrency-as-unregistered-securities guidance via the 2017 DAO report. (Asked to respond, an SEC spokesperson noted in an email that the SEC lawsuit claims that “Larsen and Ripple received actual notice in 2012 of the risk that the federal securities laws could apply.”)
Outside of the SEC there seems a growing consensus that XRP and other major cryptocurrencies ought to be regulated as currencies, not securities. XRP is already treated entirely as a currency by regulators in a number of countries, including the U.K., Japan, and Switzerland, and is enlisted as a form of money by hundreds of banks, companies, and consumer apps. Even the U.S. Treasury Department considers XRT to be a currency. That determination came out of a 2015 run-in that Ripple had with Treasury’s Financial Crimes Enforcement Network, or FinCEN, which claimed Ripple wasn’t fully hewing to banking regulations. Under the terms of a settlement, Ripple paid a $700,000 fine and tightened up its bank-transfer operations. That settlement specifically acknowledged that in the Treasury’s eyes, XRP is a currency, not a security. It’s a decision that wouldn’t have been binding on the SEC, but it certainly adds to the sense that Ripple might reasonably feel blindsided by the SEC’s sudden insistence years later that XRP is a security.
It’s not just Ripple and its principals who have felt blindsided. In addition to the impact of the suit on XRP’s value, some 50 cryptocurrency exchanges delisted XRP or suspended trading in it. Many, perhaps even most, of the XRP holders burned by the plunge had never even heard of Ripple Labs, let alone intended to invest in the company. Or so, at least, plausibly claims John Deaton, managing partner at the Deaton Law Firm, who is representing some 19,000 XRP holders who are seeking legal standing in the SEC suit. “A lot of them knew just enough about digital currency to want to invest in the top currencies, so they bought Bitcoin, Ether, and XRP,” said Deaton. “They bought XRP to diversify, without knowing a thing about Ripple and its executives.”
The SEC suit is seen by some as chilling to the entire cryptocurrency industry—an explosively growing and already deeply influential one, with the combined market cap of digital currencies currently standing at nearly $2.5 trillion. “The growth curves are crazy,” said Byrne. “One to two percent of the population holds cryptocurrency, but at current growth rates we’re not far from the day it’s 70%.” If the Ripple suit contributes to the perception that the U.S. government is unfriendly to cryptocurrency, a lot of valuable business will go elsewhere. It would certainly add to the already intense concerns over China’s hopes to dominate the global market via its central bank’s Digital Yuan, which China claims has already racked up more than $5 billion in transactions. “The lack of regulatory clarity in the U.S. is problematic for all market participants in the digital asset industry,” said Ripple general counsel Stuart Alderoty in an emailed statement. “This is not just a Ripple problem.”
It’s hard to predict how the SEC suit will play out. Ripple is currently fighting it out with the agency in the U.S. Court for the Southern District of New York. The case is in discovery now, under a magistrate who has so far proved friendly to some of Ripple’s pointed requests—most notably the company’s bid to depose William Hinman, who was director of the SEC‘s Corporate Finance Division during the time the SEC was preparing to file suit. Ripple is arguing that Hinman had a serious conflict of interest, in that he was paid some $15 million while at the SEC by Simpson Thacher, a law firm that has ties to the Ether cryptocurrency; in 2018 Hinman gave an official speech declaring the SEC wouldn’t consider Ether to be a security, which helped drive the cryptocurrency to an all-time high. He left the SEC to join Simpson Thacher just weeks before the SEC filed suit against Ripple. Ripple has also cast an unflattering spotlight on former SEC Chairman Jay Clayton, who had himself in 2018 publicly stated that Bitcoin wouldn’t be considered a security, only to later join a hedge fund that had taken a large position in Bitcoin just before the Ripple suit was filed on Clayton’s last day in office. Meanwhile, the magistrate denied the SEC’s request to pull in eight years’ worth of the Ripple executives’ personal finance records.
Whatever the ultimate court decision or settlement, the outcome is certain to impact the cryptocurrency world. The case is already turning up pressure on both the SEC and Congress to clarify the law and regulation governing cryptocurrency, particularly in terms of when a cryptocurrency is or isn’t a security. “We keep trying to shoehorn cryptocurrency into preexisting regulatory processes, when it’s abundantly clear it doesn’t fit well,” said Goforth. “We’re long overdue in fixing it.”
The fixes are doubtless coming, but it remains to be seen whether any of them will happen in time to help Ripple and the XRP investors.
Clarification, July 29, 2021: This article has been updated to clarify that Ripple denies involvement in creating XRP.
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