On December 22, 2020, the Securities and Exchange Commission
filed a complaint in the Southern District of New York
(SDNY) against Ripple Labs, Inc., and Ripple executives
Bradley Garlinghouse and Christian A. Larsen in their individual
capacities.1
The complaint alleges that (i) the defendants engaged in
unregistered sales of securities in violation of Sections 5(a) and
5(c) of the Securities Act of 1933 through repeated sales of the
XRP token dating back as far as 2013, and (ii) Larsen and
Garlinghouse aided and abetted Ripple’s unregistered sales of
securities, dating as far back as 2013 and 2015 respectively, by
taking actions such as deciding when and how much XRP Ripple would
sell, establishing an escrow account holding most of Ripple’s
XRP to assuage investor concerns about sales,2 making
promotional statements about XRP and taking other actions intended
to increase demand from XRP. The SEC did not allege that any fraud
on investors occurred, but detailed how the defendants timed their
sales of XRP leveraging asymmetric information.3 The SEC
asked the SDNY (the same federal district that recently heard the
cases against both Telegram4 and Kik5) to
permanently enjoin the defendants from violating Sections 5(a) and
5(c), to disgorge ill-gotten gains and impose civil monetary
penalties, as well as to ban the defendants from participating in
any future offering of digital asset securities.
On January 29, 2021, Ripple – represented by a former chair of
the SEC – filed its answer with the SDNY.6 Ripple denied
the SEC’s allegations stating it had “never offered or
sold XRP as an investment.” Ripple noted how “XRP holders
do not acquire any claim to the assets of Ripple, hold any
ownership interest in Ripple, or have any entitlement to share in
Ripple’s future profits.” Further, Ripple argued that
“What limited contracts Ripple did enter into with
sophisticated, institutional counterparties were not investment
contracts, but standard purchase and sale agreements with no
promise of efforts by Ripple or future profits.” According to
the answer, Ripple therefore “has no relationship at all with
the vast majority of XRP holders today, nearly all of whom
purchased XRP from third parties on the open market.”
Ripple concluded that “the SEC’s theory in the
Complaint would read the word ‘contract’ out of
‘investment contract,’ and stretch beyond all sensible
recognition the Supreme Court’s test for determining investment
contracts in SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
Ripple never held an ICO, never offered future tokens to raise
money, and has no contracts with the vast majority of XRP
holders.”
Background on Ripple’s alleged unregistered securities
offerings
Ripple was founded in San Francisco in 2012 and describes itself
as a “privately-held payments technology company that uses
blockchain innovation (including XRP) to allow money to be sent
around the world instantly, reliably, and more cheaply than
traditional avenues of money transmission.”7 In
December 2012, the total supply of 100 billion XRP on the Ripple
protocol was created, and 80 billion XRP was transferred to Ripple,
with the remaining 20 billion XRP transferred to three early
employees.8
The complaint details how as far back as February 8, 2012, and
October 19, 2012, Ripple received two legal memos from an
international law firm which warned “there was some risk that
XRP would be considered” an “investment
contract.”9 Ripple contends this assertion arguing
in part “that any reasonable reader of the true and accurate
contents of the memorandum dated October 19, 2012 would understand
that counsel’s ultimate conclusion was that Ripple Credits (as
described) did not constitute ‘securities’ under the
federal securities laws.”10
According to the complaint, the unregistered securities
offerings began in August 2013 with the sales of XRP in exchange
for fiat currencies or digital assets. The SEC further alleged that
these unregistered sales continued until 2017 when they accelerated
as Ripple faced increasing operational costs and limited
alternative sources of revenue.
According to the SEC’s complaint, from 2014 through the end
of 2019, Ripple sold at an aggregate of 3.9 billion XRP to
purchasers in the open market for a total of approximately
$763 million. Ripple conducted the market sales by first
transferring the XRP to investors and later using traders to offer
and sell XRP to investors. The complaint alleges that Garlinghouse
and Larsen personally participated in these market sales and
profited by approximately $600 million.
According to the SEC’s complaint, from 2013 through the end
of the third quarter of 2020, Ripple sold at least 4.9 billion XRP
to investments funds, wealthy individuals or other sophisticated
investors for approximately $624 million. The complaint notes that
XRP II, LLC, a NY limited liability company and wholly owned
subsidiary of Ripple was the entity through which Ripple sold most
of the XRP in institutional sales at discounts ranging from 4% to
30% off market price. XRP II is registered as an MSB with FinCEN
and has a BitLicense from NYDFS.
Further, the complaint alleges that Ripple exchanged XRP for
non-cash consideration, such as labor or market-making services,
which had the goal of achieving widespread distribution of XRP.
Starting in 2013, Ripple began to distribute XRP through
“bounty programs” that paid programmer for reporting
problems with the Ripple protocol’s code.11
Observations
Looking backward, one of the notable aspects of the complaint is
its timing. According to the SEC, Ripple violated the Securities
Act through repeated unregistered offerings of securities dating
back to 2013, yet the SEC’s complaint was filed more than seven
years after. In its answer, Ripple noted that “The SEC filed
this Complaint 8 years after XRP was created, 5 years after the DOJ
and FinCEN characterized XRP as a virtual currency, and after more
than 2½ years of investigation during which the SEC allowed
Defendants to continue to distribute XRP, allowed the XRP open
market to grow, and allowed millions of market participants to rely
on the free and efficient functioning of that market.”
Notwithstanding any potential final outcome for the litigation,
the impacts of the SEC’s complaint have been immediate. As
Ripple noted in its answer, “the Complaint’s mere filing
has caused immense harm to XRP holders, cutting the value of their
holdings substantially and causing numerous exchanges, market
makers, and other market participants to cease activities in
XRP.” As of the publication of this alert, XRP continues to be
delisted by many crypto exchanges, leaving the people the SEC
purportedly protects without an avenue to liquidate their
positions.
Looking forward, the SEC’s case against Ripple, Garlinghouse
and Larsen has the potential to establish additional meaningful
precedent for the application of securities laws to the sale of
digital assets. One important aspect of the dispute that the SEC
under Gary Gensler’s possible new leadership and the SDNY will
need to grapple with is the potential remedy for the
defendants’ alleged violations. The SEC has previously pointed
to settlements that required the issuers of unregistered securities
to offer rescission to the purchasers of the digital assets as
frameworks to follow for remediation.12 However,
requiring Ripple to offer rescission for all of its sales of XRP
could have catastrophic consequences for Ripple the company and
XRP, as well as present an administrative nightmare. Demanding that
Ripple register XRP as a security could offer a path forward, but
would present immediate frictions that could be insurmountable. In
its answer, Ripple acknowledges the wide-ranging implications that
would flow from XRP being denominated a “security,”
arguing “that utility depends on XRP’s near-instantaneous
and seamless settlement in low-cost transactions. Treating XRP as a
security, by contrast, would subject thousands of exchanges,
market-makers, and other actors in the gigantic virtual currency
market to lengthy, complex and costly regulatory
requirements”13
Footnotes
1 The complaint is available here.
2 In its answer, Ripple “admits that on May
16, 2017, Ripple announced that it would place 55 billion XRP into
an escrow on the XRP Ledger, and thereafter implemented the escrow
of that XRP.”
3 In its answer, Ripple argued that “The Complaint
alleges information asymmetries as between Ripple and XRP holders
in vague, non-specific terms, but it fails to identify any material
information asymmetries and omits Ripple’s detailed quarterly
reports about Ripple’s activities in the XRP market. Nor could
any such purported information asymmetries, even if present,
transform the sale of a digital asset into a securities
offering.”
4 SEC v. Telegram Group Inc., No.
1:19-cv-09439-PKC (S.D.N.Y. March 24, 2020) (opinion and order
granting preliminary injunction).
5 SEC v. Kik Interactive Inc.,
19-cv-05244-AKH (S.D.N.Y. June 4, 2019) (opinion and
order granting motion for summary judgment in favor of the
SEC).
6 Answer
7 Answer
8 In its answer, Ripple “admits, upon information
and belief, that 20 billion XRP in total was retained by Mr.
Larsen, Co-Founder, and Ripple Agent-1 and never transferred to
Ripple.”
9 Complaint
10 Answer
11 In its answer, Ripple “admits that Ripple made
certain payments in XRP as a virtual currency substituting for fiat
currency through a bug bounty program in 2013 and
2014.”
12 In the matter of CarrierEQ, Inc., d/b/a AirFox, Order Instituting Cease-and-Desist Proceedings
Pursuant to Section 8A of the Securities Act of 1933 (Nov. 16,
2018); In the matter of Paragon Coin, Inc., Order Instituting Cease-and-Desist Proceedings
Pursuant to Section 8A of the Securities Act of 1933 (Nov. 16,
2018).
13 Answer9>
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