By: Tayler Sherman
On December 22, 2020, the Securities and Exchange Commission (SEC) unleashed a bombshell on the cryptocurrency world by filing suit against Ripple Labs, Inc. and its current CEOs for raising more than $1.38 billion through the sale and distribution of XRP, a digital asset. Ripple is a blockchain company providing a digital payment network for international financial transactions and offers XRP, its cryptocurrency. Ripple “operates on an open-source and peer-to-peer decentralized platform that allows for a seamless transfer of money in any form, whether [U.S. dollars], Yen, litecoin, or bitcoin.” There are more than 45 billion outstanding XRP tokens, making XRP one of the largest digital assets, worth more than $21 billion.
Cryptocurrency is an encrypted form of digital currency that is not backed by real assets or tangible securities. It is decentralized, meaning no one entity controls, allowing it to function outside of agency or governmental control. Cryptocurrency uses digital tokens, similar to a physical coin, which are scarce and the control over each digital token is transferable. The cryptocurrency network is based on blockchain technology – a database that stores information in blocks that are connected by unique chains.
The SEC’s complaint alleges that Ripple uses XRP as a means to raise funds to operate their company instead of using XRP as a currency. Essentially, the SEC claims that the sale and distribution of XRP constitutes an unregistered securities offering. The SEC alleges that Ripple sold 14.6 unregistered XRP tokens since 2013. The heart of the SEC’s case stands on whether XRP is a currency or a security. Currency is “a medium of exchange and store of value, like dollars, gold, or frequent flier miles” whereas a security “is a financial investment contract, typically tradeable, like a stock or bond.” This distinction is crucial because securities are subject to SEC regulation.
The SEC regulates the issuance of securities through the Securities Act of 1933 (Securities Act) and regulates the trading of securities pursuant to the Securities Exchange Act of 1934 (Exchange Act). Companies that sell securities to the public market must register securities with the SEC. The Securities Act defines a security broadly to encompass stocks, bonds, profit-sharing interests, and a catch-all term, investment contracts. In the Supreme Court’s 1946 decision in SEC v. W.J. Howey Co., the Court established the Howey Test to determine whether an asset falls under the Securities Act’s investment contract definition. A contract, transaction, or scheme is considered an investment contract and subject to SEC regulation if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
Since the development of bitcoin and other cryptocurrencies, there is confusion as to whether these digital assets are a security and thus fall under the SEC’s jurisdiction. In July 2017, the SEC issued the DAO Report recognizing that digital tokens are subject to the Howey Test and under certain circumstances, may be considered a security. In the DAO Report, the SEC limited its findings to DAO tokens and concluded that DAO tokens were securities, and the issuance of the tokens is a violation of federal securities laws.
These findings shocked the cryptocurrency industry because they did not view such coin offerings as securities. In a 2018 interview with CNBC, former SEC Chairman, Jay Clayton, clarified that bitcoin is not a security and went on to explain that “[c]ryptocurrencies…are replacements for sovereign currencies, replace the dollar, the euro, the yen with bitcoin.” However, the SEC has indicated that some cryptocurrencies are securities if they are sold to investors as tokens through initial coin offerings (ICOs) because the tokens have value similar to that of a share in stock.
The Ripple case is vital to the cryptocurrency industry because if the SEC wins, the XRP will be deemed a security under the Howey Test. If XRP is found to be a security, this will be a major step in the regulation of cryptocurrencies, subjecting similar cryptocurrencies to SEC regulation. In Ripple’s response denying the SEC’s accusations that XRP is a security or an investment contract, Ripple also filed a Freedom of Information (FOI) request with the SEC. Ripple’s FOI request seeks documents associated with the SEC’s determination that Ethereum (ETH), a cryptocurrency, is not a security. Experts in the field are questioning why the SEC filed a lawsuit claiming XRP is a security when it shares numerous similarities with ETH.
At the parties first pretrial hearing on February 22, 2021, Ripple’s counsel indicated that they are considering a motion to compel the SEC to turn over documents relating to internal and third-party discussions about whether XRP is an investment contract.
Based on the information provided on the case so far, I believe that Ripple has a strong case that XRP is not a security but rather a digital asset similar to Bitcoin and Ether, which the SEC has determined. It appears that XRP does not meet the common enterprise requirement of the Howey test because there is no pooling of XRP sale proceeds.
Student Bio: Tayler Sherman is a third-year law student at Suffolk University Law School and serves as a Staff Member on the Journal of High Technology Law. Tayler holds a Bachelor of Science in Criminal Justice from Endicott College.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
