The Ripple Effect: SEC v. Ripple Labs, Inc. and the Potential Impact on the Digital Asset Marketplace
On December 22, 2020, the U.S. Securities and Exchange Commission sent shockwaves through the digital asset industry with a Southern District of New York action alleging that Ripple Labs, Inc. improperly raised over $1.3 billion through a years’ long unregistered securities offering.[1] This client alert examines the analysis applied by the SEC and the potential impact on the digital asset market in 2021 and beyond.
BACKGROUND
Ripple principally markets blockchain-based networks for use in facilitating rapid and low-cost payments between financial institutions. XRP is a digital asset used in part to represent the transfer of value across the networks, and to provide liquidity for its transactions. The SEC alleges that from 2013 to the present, Ripple sold billions of units of XRP for cash or other consideration worth more than $1.38 billion, and that its initial and current CEOs have personally benefitted to the tune of over $600 million from sales of XRP.
XRP is heavily traded in the secondary market, and at the time of the SEC’s filing, it was the fourth largest digital asset by market capitalization, with over 45 billion tokens in circulation worth more than $21 billion. The SEC’s 71-page, 404-count Complaint contains detailed factual allegations regarding Ripple’s history, and the claimed efforts of its management to promote the adoption of XRP. At bottom, however, SEC v. Ripple alleges that the distribution of XRP amounts to an illegal unregistered securities offering, aided and abetted by its CEOs.
IS HOWEY SATISFIED?
Notwithstanding the cutting edge technology at issue, the SEC has traditionally looked to the 1946 Supreme Court ruling in SEC v. W.J. Howey to determine whether a digital asset should be considered an investment contract under securities law, as opposed to another instrument (such as a commodity).[2]
The question presented by Howey is whether the offer of an investment in a citrus grove, with profits to be derived from the work of the grove owner/seller, constituted an investment contract. Howey has given rise to what is commonly referred to as the “Howey Test,” which asks whether a financial instrument represents:
- An investment of money;
- In a common enterprise;
- With a reasonable expectation of profits;
- Derived solely from the efforts of others.
The SEC has applied this analysis since what is commonly referred to as the “DAO Report”—the SEC’s July 2017 Report of Investigation regarding a blockchain-based project which established that the Howey Test applied to digital assets.[3]
Here, the SEC alleges that Ripple meets the four requirements of Howey, claiming that “the principal reason for anyone to buy XRP was to speculate on it as an investment,”[4] that Ripple’s “entrepreneurial and managerial efforts” reflected a common enterprise,[5] and that investors reasonably expected to profit from those efforts. It is a near certainty that Ripple will challenge the SEC’s complaint on the basis that XRP should not be considered a security.
To that end, Ripple is expected to argue that XRP is a convertible virtual currency instead of an investment contract (and thus, not a security). Generally speaking, a convertible virtual currency is one that has an equivalent value in real currency, or that acts as a substitute for real currency.[6] Because XRP is used as a substitute for real currency to facilitate financial transactions, Ripple is likely to claim that firmly removes XRP from the purview of U.S. securities law.
Ripple’s anticipated argument is bolstered by the fact that in 2015 the Department of Justice and the Financial Crimes Enforcement Network of the Department of the Treasury (FinCen) both stated that XRP was a convertible virtual currency.[7] It should be noted, however, that this position pre-dated the SEC’s DAO report by roughly two years. Additionally, the alleged conduct being addressed in 2015—namely, the failure to comply with regulatory requirements related to Ripple’s role as a money services business—is different than the conduct at issue in the SEC action (XRP’s use as a speculative investment).
Ripple also may argue that any expectation of profit in XRP is not derived solely from the efforts of Ripple. For example, Ripple may respond that by utilizing a decentralized blockchain in its network that is not controlled by any single party (including Ripple), and because XRP is traded globally by independent actors, any expectation of profit from XRP is derived at least in part by the actions of third parties. Here, the Southern District of New York will have to weigh whether cases to follow Howey have followed or expanded the “solely” component of the 1946 opinion.
Regardless of the outcome, SEC v. Ripple will be followed closely by industry observers, as any determination on XRP’s status as a security will guide the treatment of other digital assets.
IMPACT ON THE DIGITAL ASSET MARKETPLACE
Looking to the broader market, it must first be noted that the SEC has already indicated that Bitcoin—the largest digital asset by market capitalization—is not a security. Likewise, many other digital assets are unlikely to be deemed securities given their specific characteristics (e.g., a stablecoin generally has no expectation of profit; an asset may be marketed or designed to promote a functional use (as opposed to speculative value, etc.)).[8] As such, there is little concern that the digital asset market as a whole would be imperiled by SEC enforcement, and in fact, Bitcoin nearly doubled in value in the weeks following the Complaint.
That said, the SEC’s complaint has caused a number of secondary market reactions, as a number of major digital asset exchanges have moved to delist XRP in the weeks following the SEC’s filing, and the price of XRP has dropped significantly from its pre-December 22nd level. Both were predictable outcomes, and the SEC almost certainly considered that this action would send a clear message that financial institutions offering or facilitating U.S. investment in digital assets must scrutinize whether those assets are in compliance with U.S. law, or risk their own liability.
Reading the tea leaves, it is possible that the Ripple action may also signal increased future enforcement activity with regard to prominent digital assets already in the market, as part of an overall U.S. priority of increasing investor protection and market stability in this space. Over the last several years, the SEC has significantly advanced investor protection through the policing of unregistered Initial Coin Offerings (“ICOs”), and in turn, the number of such offerings to U.S. investors have dramatically decreased. Having demonstrated its resolve as to ICOs, it is possible that the SEC is now turning to major assets already being bought, sold, and held by U.S. investors. By targeting XRP, the SEC has likewise sent a message that even very prominent digital assets may be targeted for violation of the securities laws, and that surviving the ICO stage is no guarantee of safety for non-compliant assets.
Likewise, the SEC’s Complaint alleges that Ripple’s officers personally profited from the sale of XRP to the tune of hundreds of millions of dollars. The SEC has long targeted individual promoters who personally profited from ICOs, and the alleged sales of XRP personally owned by Ripple’s officers was no doubt a relevant consideration in the SEC’s decision to bring an enforcement action. Businesses in the digital asset space would therefore be wise to scrutinize their internal controls, particularly where, as here, executives are compensated with a native digital asset.
Finally, the U.S. has repeatedly signaled concern with digital assets that offer an immediate and widespread ability to facilitate cross-border payments. For example, Congress aggressively responded to the proposed rollout of two payment tokens associated with Facebook (Libra and Diem) as well as by other companies such as Apple or JP Morgan.[9] Similarly, U.S. law enforcement agencies have continually expressed strong concern regarding the potential use of digital payments to conceal illicit financial activity. Whether this was a contributing factor in the SEC’s decision to bring an action against Ripple now, and whether other digital assets primarily used to facilitate payments will be targeted by the U.S. in 2021, remains to be seen.
Butzel Long continues to track, analyze, and advise on a variety of issues regarding the legal and regulatory landscape facing digital assets.
William Kraus
734.213.3434
krausw@butzel.com
George Donnini
313.225.7042
donnini@butzel.com
[1] Securities and Exchange Commission v. Ripple Labs, Inc., Bradley Garlinghouse, and Christian A. Larsen, 1:20-cv-10832 (S.D.N.Y. Dec. 22, 2020).
[2] 328 U.S. 293.
[3] Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The DAO, Securities and Exchange Commission, Release No. 81207 (July 25, 2017), available at https://www.sec.gov/litigation/investreport/34-81207.pdf (last accessed January 11, 2021).
[4] Complaint at ¶ 207.
[5] Id. at ¶ 213.
[6] IRS Notice 2014-21, IRB 2014-16, available at https://www.irs.gov/pub/irs-drop/n-14-21.pdf (last accessed January 11, 2021).
[7] Press Release, “Ripple Labs Inc. Resolves Criminal Investigation,” U.S. Dept. of Justice (May 5, 2015), available at: https://www.justice.gov/opa/pr/ripple-labs-inc-resolves-criminalinvestigation (last accessed January 11, 2021); Press Release, “FinCEN Fines Ripple Labs Inc. in First Civil Enforcement Action Against a Virtual Currency Exchanger,” U.S. Dept. of the Treasury, Fin. Crimes Enf’t Network (May 5, 2015), available at: https://www.fincen.gov/news/news-releases/fincen-fines-ripple-labs-inc-first-civil-enforcement-action-against-virtual (last accessed January 11, 2021).
[8] In this regard, the SEC’s April 3, 2019 Framework for “Investment Contract” Analysis of Digital Assets outlines additional non-dispositive considerations in assessing whether a given asset may be a security. Available at https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_ednref9 (last accessed January 11, 2011).
Other third-parties, such as the Crypto Rating Council, LLC, have established an independent framework for assessing the features of certain assets under Howey. CRC Asset Ratings, available at https://www.cryptoratingcouncil.com/asset-ratings (last accessed January 11, 2021). Any legal determination of whether a given digital asset may, or may not be, an investment contract—and thus a security—is a highly fact-dependent analysis that goes beyond the scope of this article.
[9] Tlaib, García and Lynch Introduce Legislation Protecting Consumers from Cryptocurrency-Related Financial Threats, https://tlaib.house.gov/media/press-releases/tlaib-garcia-and-lynch-stableact (last accessed January 11, 2021)
