Between Reddit’s populist uprising (and eventual win) against Wall Street execs, Spike Lee’s starring role in a Coin Cloud commercial, and Dogecoin co-founder’s announcement that crypto is a scam, cryptocurrency is a hot topic. Among the many crypto-related headlines splashed across the web, there’s one that continues to generate even more coverage that Elon Musk’s newest dog: “SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering.”
When Elon Musk posted a picture of his new pup, Floki, it caused Floki Inu, “[a]n obscure, meme-inspired cryptocurrency” to surge to an all-time high.
In a December 2020 complaint, the Securities and Exchange Commission alleged that Ripple Labs Inc. and its co-founders, Brad Garlinghouse and Christian Larsen, violated federal securities laws by selling XRP, what it claimed was an unregistered security.
Note: According to Ripple, “XRP is a digital asset that trades on digital asset exchanges around the world, which RippleNet customers can use to source on-demand liquidity for cross-border payments.” Stated plainly, Ripple’s network “is a blockchain-based digital payment network and protocol with its own cryptocurrency, XRP.”
The complaint caused Ripple’s market value to decrease, and the effects continue to reverberate: “Ripple’s XRP, which used to be #3 [in the top 10 cryptos by market capitalization] … now ranks #7 with a $52 billion market as investors across the United States remain unable to buy or sell the digital asset.” The complaint also triggered wild speculation and flamewars, a My Cousin Vinny spoof directed at the SEC, and predictions that this case may go all the way up to the Second Circuit.
Is XRP a digital asset subject to securities laws or an exempt currency?
The Securities and Exchange Commission’s complaint classifies XRP as a digital asset subject to federal securities laws
The SEC’s complaint alleged that Ripple raised $1.3 billion through an unregistered, ongoing digital asset securities offering. The complaint also alleged that the co-founders, Brad Garlinghouse and Christian Larsen effected unregistered sales of XRP totaling around $600 million. The thrust of the SEC’s complaint was that Ripple’s failure to register offers and sales of XRP deprived investors with information necessary to make informed investment decisions. In other words, Ripple created an “information vacuum” that allowed Ripple to release information that benefited Ripple and its founders.
One explosive allegation was that Ripple sought – and ultimately, rejected – legal advice in 2012. The advice, allegedly memorialized in two legal memos, warned Ripple that there was “some risk” that XRP would be considered an investment contract and therefore, a security. According to the SEC, these legal memos also warned that XRP would not be considered a currency because it wasn’t backed by a central government and wasn’t a legal tender. Yet, “Ripple and Larsen ignored this advice and instead elected to assume the risk of initiating a large-scale distribution of XRP without registration.”
At its core, the tension between the SEC and Ripple is the definition and classification of securities. The complaint states that “[t]he definition of a ‘security’ under the Securities Act includes a wide range of investment vehicles, including ‘investment contracts.’ Investment contracts are instruments through which a person invests money in a common enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of others.”
The SEC’s definition for “investment contract” and “security” is rooted in the Supreme Court’s decision in SEC v. W.J. Howey Co. There, the Court held that “an offering of units of a citrus grove development, coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor” was an investment contract under § 2(1) of the Securities Act of 1933. The Court then explained that an investment contract is a security because, under the Act, security is defined “to include the commonly known documents traded for speculation or investment.” Further, “[t]his definition … includes ‘securities’ of a more variable character, … such … as ‘certificate of interest or participation in any profit-sharing agreement,’ ‘investment contract,’ and, ‘general[ly], any interest or instrument commonly known as a security.’”
Relying on Howey, the SEC concluded that XRP is an investment contract because people bought XRP expecting to obtain profits, and these profits depended on Ripple’s success (i.e., “from the entrepreneurial or managerial efforts of others”).
Ripple’s response raises tough questions about the SEC’s hidden motivations to file a complaint on the then-SEC chair’s last day
In response to these inflammatory claims, Ripple came out swinging with a bursting trove of allegations against the SEC. Highlights include:
1. The SEC mischaracterized the legal memos’ contents
Ripple addressed the legal memos in their answer, writing, “Ripple denies the allegations … which selectively quote and mischaracterize portions of a legal memorandum dated February 8, 2012 … addressed to Co-Founder and another individual, and a second legal memorandum dated October 19, 2012 … addressed to Mr. Larsen, Co-Founder, and OpenCoin.” According to Ripple, the “memoranda only purported to compare XRP to fiat currency backed by the full faith and credit of national governments…” Further, the SEC’s complaint “ignores that XRP has since been determined by DOJ and FinCEN to be a ‘convertible virtual currency’ which can serve as a substitute to fiat currency.”
The legal memos have been a source of controversy since the beginning: in a joint February 2021 report, the SEC asked for additional “discovery on the memos, including communications between Ripple executives and the lawyers who advised the company in advance of the first distributions of XRP in 2013.” Ripple argued against the request on attorney-client privilege grounds. In June 2021, U.S. Magistrate Judge Sarah Netburn, pictured, determined “that Ripple did not waive attorney-client privilege when it argued… in an answer to the SEC’s complaint accusing the company of selling unregistered securities, that the SEC failed to provide clear notice of whether XRP was subject to federal securities laws.” Thus, Ripple did “not have to turn over hundreds of privileged documents to the SEC.”
2. XRP is a digital currency and is not a security
Citing a 2015 and 2020 settlement between Ripple, the Financial Crimes Enforcement Network, and the U.S. Attorney’s Office for the Northern District of California, Ripple argued that XRP is a digital currency and not a security. The Department of Justice’s 2015 announcement stated that Ripple “resolve allegations that Ripple and its subsidiary failed to follow the law while engaging in the exchange of virtual currency and that the entities failed to establish and maintain an appropriate anti-money laundering program.” The 2015 settlement involved allegations that Ripple, “[f]rom at least March 6, 2013, through April 29, 2013… sold convertible virtual currency known as ‘XRP,’ while “not registered with FinCEN as an MSB [Money Services Businesses] while engaging in these sales.”
Ripple’s invocation of both settlements is meant to show the court and the SEC that “XRP performs a number of functions that are distinct from the functions of ‘securities …’” Ripple continued, noting that, “[f]or example, XRP functions as a medium of exchange — a virtual currency used today in international and domestic transactions — moving value between jurisdictions and facilitating transactions.”
3. The SEC’s potential conflict of interest and the curious timing of the complaint
As reported in the New York Times, “The day before [then-SEC Chairman Jay] Clayton resigned from the S.E.C., the agency filed a lawsuit against Ripple Labs, which competes with Bitcoin, alleging that the company had improperly raised $1.3 billion from investors through what the agency claimed was effectively an illegal stock offering.” A few months later, Mr. Clayton joined “One River Digital Asset Management, which invests hundreds of millions in Bitcoin and Ether, two cryptocurrencies, for its clients.” In August 2019, One River “filed a carbon-neutral Bitcoin ETF application with the SEC.” That same month, Mr. Clayton also joined “Fireblocks, a $2 billion Israeli-based crypto custodian focused on institutions as an advisor.”
Forbes observed that “[t]he timing of the lawsuit on Clayton’s last day and his subsequent hiring by a crypto-focused hedge fund are very curious coincidences” which raise conflict of interest concerns. Yet Mr. Clayton is not the only SEC official facing scrutiny; “[F]ormer SEC Corporation Finance Division head William Hinman” has endured similar accusations. Mr. Hinman left the SEC to join his former firm Simpson Thacher, “which paid him a $1.6 million annual pension while he worked at the SEC.” Notably,
Hinman’s influence to the determination that ether is not a security keeps the SEC’s regulatory paws off Ethereum, the blockchain platform which Simpson Thacher supports as a member of the Ethereum Enterprise Alliance. Simpson Thatcher also handled the $100 million IPO of Canaan, the Chinese maker of machines used to mine cryptocurrency.
Ripple and its supporters have seized on these relationships as evidence that Ripple was unfairly targeted to promote the officials’ own financial interests. These potential conflict of interests have led to major discovery wins for Ripple. Perhaps the most notable was the court’s order granting Ripple’s request to
depose William H. Hinman, the former director of the SEC’s Division of Corporation Finance, seeking testimony on the process the agency uses to arrive at policy decisions. The aim was partly to determine whether a June 2018 speech Hinman gave saying that Bitcoin and Ether aren’t securities can be used to show the commission’s adopted position, and to develop evidence on whether market participants viewed XRP as a security.
According to some sources, the resulting deposition “provided a general feel that regulatory clarity is something lacking in the SEC’s communications.” Why is this important? Because Ripple is pursuing a fair notice defense. In other words, because the SEC did not “inform a third party that it consider[ed] XRP to be a security,” Ripple was not on notice that they were violating any rules or regulations. Thus, according to Ripple, the SEC’s subsequent complaint was improper.
Similarly, in an August 31 hearing, the court rejected the SEC’s argument that the internal documents requested by Ripple were covered by the deliberative process privilege. The court found that the requested documents, focused on “the regulator’s intra-agency documents that express its views on XRP, Bitcoin, and Ether,” should be reviewed in camera. There is no update at this time regarding the court’s decision on this issue.
Of course, that’s not to say that Ripple has won every hearing. For example, in early September, the court granted the SEC’s request to obtain Ripple’s Slack messages. Three weeks later, the SEC scored another win when the court denied Ripple’s request
to compel the SEC to produce documents relating to the SEC’s trading policies governing digital assets. Specifically, Defendants seek production of (1) either anonymized or aggregated documents reflecting the SEC’s trading preclearance decisions with respect to its employees’ transactions in bitcoin, ether, or XRP, and (2) either redacted or aggregated annual certifications concerning SEC employees’ XRP holdings.
Legal experts and financial analysts are skeptical of the SEC’s claims
Bloggers, Twitter personalities, and YouTube creators have heralded the case as a victory over traditional market forces and institutions. Legal experts and former SEC officials have also joined the voices crying victory and simultaneously, deriding the SEC. One issue that’s spurned these predictions is the SEC’s inconsistent and contradictory position on crypto. In fact, despite industry pleas, including from Ripple, the SEC refused to clarify if XRP was a security. In one instance,
[t]he Commission … was … approached by a crypto exchange in 2019 demanding clarity for XRP. The unnamed cryptocurrency exchange wanted to make sure that the token was not a security before listing it for trade on its platform. However, the SEC did not provide a clear response, probing the exchange to conduct research of its own on XRP. The unnamed exchange then concluded that XRP was not a security.
Further, “Clayton told CNBC that bitcoin is not a security, and Hinman gave a widely covered speech which laid out how ether was not a security, despite debuting in an initial coin offering (ICO) in 2014.” In fact, observers recently learned that Mr. Hinman had meetings with Ripple execs in 2020. The meetings’ purpose? To “find… a way for XRP to be regulatorily compliant. It was during these meetings he [Mr. Hinman] first suggested XRP was operating as an illegal asset.” This revelation reinforces Ripple’s argument that the SEC did not provide reasonable notice of the SEC’s concerns that XRP was an illegal asset or that Ripple needed to act in compliance with security regulations. In mid-September, the SEC conceded this point when they admitted that they informed no one outside the agency that XRP was considered a security and therefore, subject to security regulations.
On top of this credibility issue, another factor that makes the SEC’s battle even tougher is Ripple’s seemingly endless resources. Unlike most companies – who settle with the SEC – Ripple has the deep pockets to continue to fight. That said, Ripple CEO Brad Garlinghouse is willing to settle under one condition: “there is absolute certainty about what is XRP on a go-forward basis.” Unless this condition is met, this fight could potentially end up at the Second Circuit.
SEC v. Ripple’s impact on the law’s understanding of cryptocurrency
Practitioners, corporations, and amateur investors alike hope that Ripple will clarify the law surrounding digital asset regulations. The current meaning of these rules and regulations are unreliable because they are a “mix of district court decisions, settlements, and non-binding statements from agency officials.” If the case makes it to the Second Circuit, the resulting holding could give investors, companies, and lawyers a modern test for evaluating the crypto space, including digital assets, Initial Coin Offerings, and securities. Such clarity is much needed, which is one of the many reasons that the world is watching the ongoing litigation closely.
If Ripple loses, will federal criminal charges follow?
In 2019, the SEC filed “fifteen enforcement actions against blockchain organizations.” Of those fifteen, “the SEC cited the sale of an unregistered security in eight.” But “none of the SEC’s enforcement actions for unregistered sales of securities [in 2019] have resulted in parallel criminal prosecution.” Similarly, as of this writing, the SEC has filed sixteen enforcement actions against blockchain organizations, eleven of which have involved the sale of an unregistered security, and this number is expected to continue to rise. Even so, Ripple’s lawyers are surely on the lookout for criminal charges related to the SEC’s complaint because of the federal government increased interest in crypto’s role in securities fraud, wire fraud, and money laundering offenses.
Will President Biden’s pick to lead the Office of the Comptroller cripple crypto?
In late September, President Biden announced his nominee to lead the Office of the Comptroller. If confirmed by the Senate, the nominee, Saule Omarova, would be responsible for “setting policy around the businesses that banks engage in — from traditional ones like mergers and lending to newer efforts like cryptocurrency.” Because of Ms. Omarova’s past “critiques of digital tokens,” there is a palpable concern that “U.S. financial regulators will be void of any crypto allies for at least the next three years.” Why? Because
the OCC would likely go even further in pursuing stricter oversight of digital tokens and tougher rules. That would conform with the trend in Washington. Gensler wants crypto to be regulated much like securities are, and a group of financial agencies are considering implementing guardrails around stablecoins such as Tether. The Fed is weighing establishing its own digital currency, which could compete with stablecoins that traders use to buy Bitcoin and other virtual currencies.
SEC v. Ripple is an important and historic case that will change the way laws, enforcement agencies, and corporations understand, treat, and use cryptocurrency. The lawsuit, regardless of outcome, is expected to cause ripple effects in related industries and fields, including the Internal Revenue Service, the Department of Justice, and Wall Street.
 The Securities and Exchange Commission later filed an amended complaint. In the amended complaint, the Commission added details intended to show that Ripple and its executives knew that they were illegally selling a security. For example, paragraph 110 was added to say, “Larsen and Garlinghouse both played significant roles in negotiating and approving Ripple’s Institutional Sales and other offers and sales of XRP to institutional investors, including while Garlinghouse was COO.”