On Thursday last week, a New York federal judge made a curious ruling on a case brought by the SEC against Ripple Labs, the company behind blockchain payments settlement platform Ripple. Ripple issues the XRP cryptocurrency, or token, as it prefers to call it.
The SEC alleged Ripple had sold $1.3 billion worth of XRP tokens to a combination of institutional investors, retail investors and employees it was rewarding in-kind. The SEC further alleged that another $600 million worth of XRP had been sold by two high ranking Ripple executives.
The outcome of the case rested on the SEC’s assessment that XRP should be considered a financial security. If it was, Ripple would have been obliged to file registration statements and various disclosures in relation to the sales and giveaways. It didn’t because Ripple insists XRP is not a security.
The judgement of US District Judge Analisa Torres brought the three year case to a conclusion last week. However, the outcome was probably not what either side had expected.
Judge Torres ruled that the XRP tokens sold by Ripple Labs to retail investors over cryptocurrency exchanges should not be considered securities. She also ruled that the sales of XRP made by the two executives were not of securities. Nor were XRP distributions to staff, contractors and charities.
However, the judge also concluded that the XRP Ripple Labs sold to institutional investors a few years ago did qualify as securities. The ruling seems to go against the general grain of securities laws, which typically give more protection to retail investors and members of the general public than those considered ‘sophisticated investors’. The latter group would be always be expected to include institutional investors.
This ruling instead focused on the fact that the sophisticated institutional investors, over a period up until 2020, would have seen their purchase of XRP as directly funding Ripple Labs, who sold it to them directly. The expectation, in the eyes of the judge, is that capital would have been invested in the XRP ecosystem, improving it and, by extension, increasing the value of the crypto tokens acquired.
This part of the ruling was informed by the ”third Howey prong”, which refers to the US Supreme Court test for a security that asks whether buyers are expecting profits resulting directly from the “entrepreneurial or managerial efforts of others”.
Those being paid in-kind in XRP tokens would not have had the same expectation, seeing their allocation as an expense to the company, not a capital injection. Retail investors that bought XRP put up for sale by Ripple via cryptocurrency exchanges would not have associated the tokens with the issuer at all and presumed they were buying from a secondary owner.
The judge’s ruling read:
Having considered the economic reality of the Programmatic Sales, the Court concludes that the undisputed record does not establish the third Howey prong. Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, see Kik, 492 F. Supp. 3d at 180; cf. supra § II.B.1, Programmatic Buyers could not reasonably expect the same.
Indeed, Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. Since 2017, Ripple’s Programmatic Sales represented less than 1% of the global XRP trading volume.
Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.
The key sentence from the judgement was:
“XRP, as a digital token, is not in and of itself a ‘contract, transaction or scheme’ that embodies the Howey requirements of an investment contract.”
Did Ripple Labs and the wider crypto sector or the SEC win the case?
Ultimately, the ruling has done little to clarify the grey area of what does and doesn’t count as a security in the context of cryptocurrency. The judge based her decision on the interpretation that the secondary buyers of XRP were not made any promises by Ripple Labs itself.
That’s something that can be said of most exchange-traded instruments bought and sold on the secondary market. And it’s something that the crypto exchanges Binance and Coinbase, will certainly add to their own defence dossiers when taking on SEC cases made against them, which also hinge on whether or not they facilitate the unregulated trade of securities.
The XRP price leapt by over 72% from $0.47 to $0.81 in the immediate aftermath of Judge Torres’s ruling. It has since eased back to $0.74.
The Coinbase share price also gained around 25%, suggesting markets also view the ruling as relevant in a positive way to the exchange’s case with the SEC. Binance, the other major exchange the SEC has opened cases against, is still privately held.
Ripple Labs is predictably calling a win in the case, despite it being only a partial victory. The San Francisco-based company is confident that the conclusion of its case with the SEC will now also mean American banks start to use its XRP-powered “On-demand Liquidity (ODL)” product for money transfers and inter-bank messaging – it can be described as a blockchain-based alternative to the SWIFT system.
When asked if he believed the ruling would encourage banks to start to use the blockchain platform as an alternative to SWIFT, Stu Alderoty, Ripple’s general counsel was unequivocal:
“I think the answer to that is yes.”
The blockchain company, often regarded as the closest to traditional financial markets and institutions due to its positioning as a solution for the banking sector, has undoubtedly suffered negative consequences as a result of the SEC’s case against it.
In 2021, MoneyGram, the American market leader in non-bank money transfers, dropped its partnership with Ripple. The company was concerned it would be caught up in the fallout were the SEC to win its case. Ripple’s UK-based investor Tetragon also tried to sue the company for the money it spent on XRP after the SEC case was initiated. In the end a deal was agreed for Ripple to rebuy the tokens at a loss for Tetragon.
On Friday, Alderoty told the U.S. media CNBC:
“I think we’re hopeful that this decision would give financial institution customers or potential customers comfort to at least come in and start having the conversation about what problems they are experiencing in their business, real-world problems in terms of moving value across borders without incurring obscene fees.”
“Hopefully this quarter will generate a lot of conversations in the United States with customers, and hopefully some of those conversations will actually turn into real business.”
Over the past few years, Ripple has had to work almost exclusively with companies and banks from outside of the USA, limiting its revenue generating potential. The company appears confident last week’s ruling will change that, with the first new U.S. business expected in the third quarter.
Does the ruling mark the end for IPOs and blockchain projects raising finance by selling tokens?
The element of the SEC’s case against Ripple Labs that the latter did cede, that earlier sales of XRP tokens to investors did count as the unregistered sale of securities, also has implications.
If the sale of crypto tokens to VCs and other institutional investors do count as selling securities, because there is an implicit suggestion that the cash will be used to increase the value of those tokens through entrepreneurial efforts, IPOs could be numbered. If other judges go with Judge Torres’s interpretation, which is more likely than not now the precedent has been set, VCs and investors would be forced to buy tokens on the open market – and deal with its notorious volatility.
IPOs that market or sell tokens directly to U.S. citizens that would be categorised as retail investors would almost certainly face heavy-handed action from the SEC.
The ruling could speed up the process of Congress creating new legislation fit for the digital world
The biggest beneficiaries of last week’s ruling appear to be Ripple Labs itself, any other blockchain project only selling tokens via secondary markets, or over exchanges where buyers are unaware of who the seller is. And cryptocurrency exchanges themselves, which facilitate secondary markets.
Any new blockchain project that may have intended to raise capital through the direct sale of its tokens at a set price, either to institutional or retail investors, probably need a new plan.
Otherwise, there are still grey areas. Judge Torres’s ruling may have set a precedent other judges may be inclined to follow when faced with comparable cases brought by the SEC. However, with the role of judges to interpret and not create laws, that is not guaranteed. A future court ruling could feasibly come down the other way, in favour of the SEC, throwing the crypto sector into even more confusion than it currently contends with.
There is still a general consensus that the current legal framework judges must interpret is not properly equipped to deal with cryptocurrencies – it was created for a pre-crypto world.
Congress has been slow to move on updating laws with many observers attributing that to a reliance on SEC Chair Gary Gensler’s avowed declaration that “crypto markets suffer from a lack of regulatory compliance, not a lack of regulatory clarity.”
The Ripple ruling demonstrates that is, in fact, not the case and there is a clear lack of clarity that can only be elucidated by an update to laws. When asked by Forbes if he thought the Ripple decision would provide the nudge Congress needed to get something done, Tomicah Tillemann, the chief policy officer of Haun Ventures, responded:
“I’ll put it this way. The odds lawmakers will move on crypto legislation are much greater now than they were a week ago.”
If Congress is to move on updating legislation to better fit the opportunities and risks that the crypto sector represents, it will have to happen relatively quickly. With a new presidential election campaign quickly coming up on the horizon, voting will take place in November next year, there will be an effective freeze on new legislation from next spring.
If there is movement from Congress to curtail the potential for conflicting rulings from different judges leading to mass confusion around the crypto sector, that will be the most significant result of last week’s ruling. In the meanwhile, markets will be looking for announcements from Ripple over new agreements with American banks and payments companies.