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Ripple Effect: SEC Lawsuit Against Cryptocurrency Company May Provide Guidance for Crypto Industry Nikhil A. Mehta and Eric M. Fogel SmithAmundsen
On December 22, 2020, the Securities and Exchange Commission (SEC) filed a high-profile enforcement action against a major cryptocurrency company. The SEC complaint alleges violations of federal securities laws by defendant Ripple Labs, Inc. (“Ripple”). Founded in San Francisco in 2012, Ripple is a well-established company, and its founders are regarded as pioneers in the crypto industry. The SEC complaint alleges that Ripple sold its cryptocurrency, named XRP, as an unregistered security. The SEC argues that XRP is a security, and not a commodity or other type of asset, because it was generated, distributed, and sold by Ripple in a “centralized fashion.” IS XRP AN “INVESTMENT CONTRACT” (AND THUS A SECURITY) UNDER U.S. SECURITIES LAWS? The outcome of the Ripple case will largely depend on whether XRP is an “investment contract” under U.S. securities laws, thus making it subject to registration
requirements under the Securities Act of 1933. The U.S. Supreme Court’s decision in SEC v. W.J. Howey Co. provides that an investment contract exists when there is “an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” SEC v. W.J. Howey Co., 328 U.S. 293 (1946). In the Ripple case, the SEC has focused heavily on the final prong of the Howey test – a “reasonable expectation of profits derived from the efforts of others.” In particular, the SEC has alleged that purchasers of XRP reasonably expected their profits to be derived directly from the efforts of Ripple, including Ripple’s alleged efforts to develop, control, and manage secondary markets for XRP, develop use cases for XRP, and to facilitate the implementation of XRP with banks or other financial intermediaries.1 The SEC has already indicated that bitcoin and Ethereum are not securities due to their decentralized nature, which is a hallmark of blockchain applications. The
bitcoin blockchain is a distributed ledger that maintains a permanent and immutable record of all transactions. There is no central entity that mints or distributes bitcoin. Instead, transactions are verified, and bitcoin is mined by a series of “nodes,” which is a widely distributed network consisting of hundreds of thousands of individuals across the world. Since there is no central entity whose efforts are a key factor in developing or distributing bitcoin, it is not considered to be a “common enterprise with profits derived from the efforts of others.” Therefore, it is not deemed to be a security under the Howey test.2 Ripple, on the other hand, is viewed differently by the SEC, which has taken the position that the development and distribution of XRP was conducted by Ripple in a centralized way. One of the examples given by the SEC is that Ripple, by itself, minted the entire supply of XRP when it was first launched.3 Ripple has asserted seven affirmative defenses, which include its two main de-
