With the potential to change how digital assets are regulated in the U.S., as well as how DeFi and blockchain technology develop and are adopted in the future — What is going on with one of the most high-profile cases in the crypto industry?
Another day, another crypto-firm-related lawsuit or investigation, and likely the U.S. Securities and Exchange Commission is also involved. But the case of SEC v. Ripple is nothing like the trial of FTX, the charging of Terraform Labs and founder Do Kwon, or the SEC’s case against Gemini and bankrupt-Genesis. So what makes this lawsuit, its parties, and the awaited outcome so significant?
What’s going on?
The long-running SEC v. Ripple lawsuit is a legal case in which the United States Securities and Exchange Commission (SEC) has sued Ripple Labs Inc. and two of its executives, Brad Garlinghouse and Chris Larsen, for allegedly selling unregistered securities in the form of XRP cryptocurrency.
The SEC filed the lawsuit on December 22, 2020, in the Southern District of New York, alleging that Ripple Labs had raised over $1.3 billion through the sale of XRP since 2013. The SEC claims that XRP is a security and, as such, should have been registered with the agency.
Ripple, on the other hand, argues that XRP is a cryptocurrency and not a security. According to Ripple, XRP has a specific use case as a digital asset and is not an investment contract that would qualify as a security under U.S. law.
The case has been closely watched by the cryptocurrency industry and has significant implications for the regulation of digital assets in the United States. If the SEC prevails, it could set a precedent for other cryptocurrencies, potentially leading to a significant shift in how they are regulated and traded.
The case is ongoing, and as of February 2023, the court has not yet issued a final ruling. However, the parties have engaged in settlement talks, and Ripple has recently requested that the court postpone the trial date to give them more time to reach a settlement with the SEC.
Sabotage, equivocate or cadge: What is the SEC?
The SEC, or the U.S. Securities and Exchange Commission, is an independent agency of the federal government of the United States. It was created by the Securities Exchange Act of 1934 to help protect investors and maintain the integrity of the securities markets.
The primary mission of the SEC is to enforce federal securities laws and regulate the securities industry, which includes securities exchanges, broker-dealers, investment advisers, and mutual funds. The SEC aims to promote transparency and fairness in the securities markets, and to help prevent fraud and other types of misconduct.
The SEC’s responsibilities include:
- Requiring public companies to disclose financial information to investors
- Regulating the trading of securities on U.S. exchanges
- Investigating potential violations of securities laws and prosecuting those who violate them
- Regulating investment advisers and mutual funds
- Educating investors about how to make informed investment decisions
The SEC is headed by five commissioners who are appointed by the President of the United States and confirmed by the Senate. The SEC also has a staff of attorneys, economists, and other professionals who help carry out its mission. The current Chairman of SEC is Gary Gensler, a professor of economics, business executive, and experienced multi-millionaire investor.
The company, the protocol, the coin: What is Ripple Labs?
Ripple Labs Inc. is a technology company that was founded in 2012 and is headquartered in San Francisco, California. The company has developed a blockchain-based payment network, the XRP ledger (XRPL), that allows for the seamless and instantaneous transfer of money anywhere in the world.
The network uses a digital asset called XRP as a means of facilitating cross-border payments. XRP is designed to be a fast and efficient way to move money, with transaction times of just a few seconds and low fees.
The nature of XRP is the focal point of the lawsuit, with the SEC alleging that Ripple Labs and its two founders violated federal securities laws by selling XRP without properly registering it as a security with the SEC.
The SEC argued that XRP should be considered a security because it was sold as an investment to fund Ripple’s operations, and its value was closely tied to the success of the company. The SEC also claimed that Ripple Labs had not taken sufficient measures to prevent XRP from being used for illegal activities, such as money laundering.
Ripple Labs has denied the SEC’s allegations and argued that XRP is a cryptocurrency and not a security. The company has also claimed that the SEC’s lawsuit has caused harm to XRP holders and the broader cryptocurrency market.
But the question remains: is XRP, and by extension, are cryptocurrencies securities?
What is a cryptocurrency and what is a security?
Did you know that a “cryptocurrency” and a “token” are not the same thing? Although they are often used interchangeably, they actually refer to different things.
A cryptocurrency is a type of digital or virtual currency that uses cryptography for security and operates independently of a central bank. Bitcoin, Ethereum, and Litecoin are examples of cryptocurrencies.
A token, on the other hand, represents an asset or utility on a blockchain or distributed ledger technology (DLT) platform. Tokens can be used for a variety of purposes, such as to represent ownership in an asset, access to a service, or voting rights. Tokens are often issued through initial coin offerings (ICOs), initial exchange offerings (IEOs), or security token offerings (STOs).
While some cryptocurrencies, such as Ethereum, have native tokens on their platforms, not all cryptocurrencies are tokens. Some cryptocurrencies, such as Bitcoin, function solely as a means of exchange and do not have a native token.
By definition and functionality, XRP, the native token of XRPL, is closer to a commodity, like Bitcoin, than a security. But in the SEC’s eyes, it depends on the equivocating results of the ambiguous Howey Test.
To determine whether something is a security or not, the SEC relies on the Howey Test
The Howey Test is a legal test used by the United States Securities and Exchange Commission (SEC) to determine whether an asset qualifies as an investment contract, which is a type of security. The test is named after the 1946 US Supreme Court case SEC v. W. J. Howey Co.
Under the Howey Test, an investment contract exists if all of the following conditions are met:
- There is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profits come from the efforts of a promoter or third party
If an asset meets all of these criteria, it is considered a security and is subject to SEC regulations. This means that issuers of such assets may be required to register with the SEC and provide detailed financial and other disclosures to investors. Additionally, sales of such assets may be subject to various restrictions and requirements to ensure investor protection.
By criteria of the Howey Test, Bitcoin, the first and most well-known cryptocurrency, is generally considered not to be a security because it does not meet the definition of an investment contract under the Howey Test. Bitcoin is not issued or controlled by a central entity, and its value is primarily determined by market supply and demand rather than the efforts of a promoter or third party.
A commodity is generally defined as a raw material or primary agricultural product that can be bought and sold, such as gold, oil, or wheat. While Bitcoin is not a physical commodity, it can be traded on commodity exchanges and is subject to price fluctuations based on market supply and demand, similar to other commodities.
Additionally, the CFTC has allowed for the trading of Bitcoin futures contracts, which allows investors to speculate on the future price of Bitcoin. This further supports the classification of Bitcoin as a commodity.
Other cryptocurrencies, such as some initial coin offerings (ICOs) and tokens, may meet the definition of a security under the Howey Test, depending on their specific characteristics and the circumstances surrounding their issuance and sale.
As of now, the SEC has not provided clear guidance on whether specific cryptocurrencies are securities or not, and the determination of whether a particular cryptocurrency is a security can be complex and fact-specific. The case against Ripple Labs may become the deciding factor in legally classifying cryptocurrencies in the U.S.
What will happen in the end?
The potential outcomes of the SEC v. Ripple lawsuit are uncertain, and the final decision will be up to the court. However, there are a few potential outcomes based on the arguments presented by both parties:
1. The court rules in favor of the SEC
If the court agrees with the SEC’s argument that XRP is a security, it could require Ripple Labs to register XRP as a security and impose penalties for the company’s past unregistered sales. On a larger scale, this outcome will have significant consequences for the cryptocurrency industry, as it could lead to more regulation of cryptocurrencies as securities.
In September 2022, Gary Gensler, the Chairman of the US Securities and Exchange Commission (SEC), stated that numerous cryptocurrencies could be considered securities. This position was reinforced by a proposed legislation introduced in June 2022 by U.S. Senators Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (D-N.Y.), which aims to classify most cryptocurrencies as commodities. If this bill is passed, it would grant the SEC regulatory authority over the entire sector, while the Commodity Futures Trading Commission (CFTC) would be responsible for managing the trading and derivatives aspect.
This outcome changes the entire regulatory outlook for the crypto industry. With more regulation, more crackdowns following the lawsuit, and likely many more penalties and fees, the crypto industry may be hit hard, decentralization included.
2. The court rules in favor of Ripple Labs
If the court agrees with Ripple Labs’ argument that XRP is not a security, it could result in the case being dismissed, and Ripple Labs would not be required to register XRP as a security. This outcome would likely be seen as a victory for Ripple and the broader cryptocurrency industry, as it could provide more clarity and flexibility for cryptocurrency projects in terms of regulation.
In this event, the U.S. Commodities and Futures Trading (CFTC) may still swoop in to replace the SEC and demand its own regulations.
The SEC and the CFTC are both independent regulatory agencies in the United States that are responsible for overseeing different aspects of the financial markets, and their agenda likely aligns.
The parties could reach a settlement before the court reaches a decision. A settlement would likely involve Ripple Labs agreeing to certain terms, such as registering XRP as a security or paying a fine, in exchange for the SEC dropping the lawsuit. The terms of any settlement would be subject to approval by the court.
Unfortunately, lawsuits are expensive. Even in the “relatively positive” outcome, the reinstatement of XRP on exchanges like Coinbase won’t help the development company recover from financial losses.
Beyond regulation in the U.S., the result of this lawsuit is likely to become a precedent for crypto regulation in the numerous countries dubious about digital currencies.
The Silver Lining
The lawsuit against Ripple is not the SEC’s first, although it may become the last and decisive of its kind. On January 30, 2023, Attorney John Deaton ruled in favor of blockchain platform LBRY, an outcome many in the crypto community are calling significant for the case of Ripple.
SEC v. LBRY is a lawsuit filed by the US Securities and Exchange Commission (SEC) against LBRY, Inc., a blockchain-based content distribution platform, and its founders in March 2021. The SEC alleged that LBRY’s sale of its digital asset, LBC, was an unregistered securities offering and that LBRY had made false and misleading statements in connection with the sale.
According to the SEC, LBRY had raised around $11 million through the sale of LBC tokens in 2016, which the SEC alleged were securities because they met the definition of an “investment contract” under the Howey Test. The SEC argued that LBRY had marketed LBC tokens as a means of raising funds for the development of its platform and had promised investors that they would profit from the increased value of LBC tokens as the platform grew.
LBRY disputed the SEC’s allegations, arguing that LBC tokens were not securities but rather a means of accessing the company’s platform and services. LBRY also claimed that the SEC’s position threatened the innovation and development of blockchain technology in the United States.
Attorney Deaton has ruled against the SEC’s overreach regulation, stating that LBC tokens are only considered securities at the time of direct sale, as well as that ‘secondary sales aren’t securities’.
This case, although possibly financially fatal for LBRY, served to showcase the SEC’s lack of clear guidelines when it comes to classification and regulation of cryptocurrency and tokens.
Conclusion: Unclear, unfortunately
It remains near clear that the SEC is overreaching. It’s somewhat unclear what cryptocurrencies are securities, commodities, or something other. The Howey Test, previously the SEC’s standard for classification, is outdated and ineffective.
The crypto community continues to root for Ripple Labs. A favorable outcome, even using the SEC’s logic, seems likely. After all, Ripple didn’t sell tokens to retail investors, and is a private company the shares of which XRP owners are not entitled to. These facts already fail points of the Howey Test.
Then arrive the odd machinations. Why did the SEC essentially give Ether a pass on the same securities issue, and then backtracked when Ripple Labs wanted to use the Hinman speech in the case? What outcome and benefit is the SEC after, and who is due to said benefit?
In their pursuit to order and control everything, the SEC, like many dry branches of the government, impedes and directly attacks innovation, all while lacking enough knowledge and understanding of said technology to strategize said attack. As an organization which ‘first and foremost’ protects investors, who is the SEC serving with this?