SEC Digital Asset Guidance a Boon For Investors Claiming XRP is Unregistered Security

September 26

A group of investors in Ripple’s cryptocurrency XRP filed an amended complaint exploiting recent guidance published by the Strategic Hub for Innovation and Financial Technology (FinHub) of the U.S. Securities and Exchange Commission (SEC).  The SEC’s “Framework for ‘Investment Contract’ Analysis of Digital Assets” provides guidance for evaluating whether a particular cryptocurrency has the characteristics of an “investment contract” and therefore subject to registration under federal securities laws.  The SEC’s “Framework” identifies each of the elements of the Howey test, the four factors that the SEC and the U.S. courts apply to determine if an offering constitutes an investment contract that must be registered with the SEC (or otherwise meet an established exemption from registration). In the SEC’s “Framework,” the staff identifies a number of elements for each of the factors in the Howey test that would tend toward or against a finding of an investment contract.  Each factor analyzed in the “Framework” is addressed in the amended filing, where the investors offer examples to illustrate their position that the application of the analysis in the “Framework” must result in a finding that the offering of XRP was an investment contract and, given that classification, that XRP was illegally sold as an unregistered security.

“All the traditional hallmarks of a security”

The U.S. Supreme Court’s Howey decision and subsequent case law have found that an “investment contract” exists when the following factors are present:

1) Investment of money

2) in a common enterprise

3) with a reasonable expectation of profits

4) to be derived from the efforts of others (e.g., a promoter or other third party).

Since the lawsuit’s inception in May 2018, the investors have made claims that XRP has “all the traditional hallmarks of a security.” The updated filing sets out each substantive allegation against Ripple that its sales of XRP tokens constituted illegal sales of unregistered securities and matches each allegation of fact, statement or circumstance to the relevant section of the “Framework” to lead to the conclusion that XRP should be classified as a security.  The chart below provides an overview of the allegations made against Ripple as matched with the relevant portion of the “Framework” as set forth in the amended complaint.

Howey  |  SEC Guidance Claims in Amended Complaint
The Investment of Money
Satisfied in an offer and sale of a digital asset in exchange for value (e.g., fiat, another digital asset, other consideration). Members of the class invested fiat and other digital currencies to purchase XRP, both of which satisfy this first prong under Howey.
In a Common Enterprise
Typically exists with digital assets because the “fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.” Ripple’s CEO has conceded that, “Our self-interest is aligned with building and maintaining a healthy XRP market.”
Reasonable Expectation of Profits
Digital asset holder has rights to share in the enterprise’s income or profits or to realize gain from capital appreciation of the digital asset (e.g., resulting from appreciation in the value of the digital asset derived from improvements/positive developments in the network). Defendants pooled XRP investments to fund projects that would promote “the XRP Ledger and Interledger Protocol,” thereby increasing the value of the XRP Ledger and XRP.
The digital asset is offered broadly to potential purchasers as compared to being targeted to expected users of the goods or services or those who have a need for the functionality of the network (including being offered and purchased in quantities indicative of investment intent rather than use of the network). Money raised through the sales of XRP substantially exceeds the amount of money needed to establish a functional network or digital asset; little apparent correlation between the purchase price of XRP and the market price of any goods or services that can be acquired in exchange for XRP (which to date has not been functionally adopted nor used in any meaningful way).
An Active Participant (“AP”) is able to benefit from its efforts as a result of holding the same class of digital assets as those being distributed to the public. Defendants, including Ripple CEO, have publicly touted their own investment in XRP.
AP continues to expend funds from proceeds or operations to enhance the functionality or value of the network or digital asset. Ripple concedes that it “sells XRP to fund its operations and promote the network.  This allows Ripple to have a spectacularly skilled team to develop and promote the Ripple protocol and network.”
Digital asset is marketed in certain ways, including but not limited to:

  • expertise of an AP or its ability to build or grow the value of the network or digital asset;
  • in terms that indicate it is an investment or that the solicited holders are investors;
  • intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset;
  • the future (and not present) functionality of the network or digital asset, and the prospect that an AP will deliver that functionality;
  • the promise to build a business or operation as opposed to delivering currently available goods or services for use on an existing network.
  • Ripple has made public statements (including over Twitter) lauding the expertise of its team to develop the network and has held a number of events for the purpose of same.
  • The Ripple CEO, among others, have stated their own investment activity in XRP.
  • Ripple has stated funds have been invested to promote the development of XRP (including to support additional use cases and improvements).
  • XRP is not currently functional and Ripple leadership has continued to promote future functionality.
Derived from Efforts of Others
An AP is responsible for the development, improvement (or enhancement), operation or promotion of the network, particularly if purchasers of the digital asset expect an AP to be performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality.e.g., when the network or digital asset is still in development and an AP is and/or promises further development efforts in order for the digital asset to attain or grow in value. Unlike other cryptocurrencies that are mined by validating transactions on their networks (e.g., Bitcoin and Ethereum), all 100 billion of the XRP in existence were “created out of thin air” prior to any distribution and without any functionality.  Ripple stated that “Ripple Labs sells XRP to fund its operations and promote the network.  This allows Ripple to have a spectacularly skilled team to develop and promote the Ripple protocol and network.”
Essential tasks or responsibilities performed by an AP rather than an unaffiliated community of network users (i.e., “decentralized” network). Unlike cryptocurrencies such as Bitcoin and Ethereum, which use a Proof of Work (“PoW”) consensus protocol to verify the legitimacy of transactions on the network, the XRP Ledger relies on nodes operated by Ripple to verify the legitimacy of transactions and maintain agreement on the network (i.e., centralized vs. decentralized).
AP creates or supports a market for, or the price of, the digital asset. This can include an AP that: (1) controls the creation and issuance of the digital asset; or (2) takes other actions to support a market price of the digital asset, such as limiting supply or ensuring scarcity.
  1. All 100 billion XRP were created by Ripple at its inception, rather than resulting from mining or other validation efforts.
  2. Ripple publicly announced that it would limit distribution of the remaining 61.68 billion XRP owned by the company, placing 55 billion XRP in a cryptographically secured escrow account and offering and selling only limited amounts of XRP at defined intervals.
AP has a lead or central role in the direction of the ongoing development of the network or the digital asset (e.g., deciding governance issues, code updates or how third parties participate in the validation of transactions). Ripple publishes a quarterly report detailing its efforts to grow the “XRP ecosystem”, including plans to accelerate “the pace of our investment in the XRP Ledger to build on its speed, uptime, and scalability, to ensure XRP is the most trusted enterprise-grade digital asset.”
AP has a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents, e.g., (i) determining whether and how to compensate persons providing services to the network, (ii) determining whether and where the digital asset will trade, (iii) determining who will receive additional digital assets and under what conditions, (iv) playing a leading role in the validation or confirmation of transactions on the network.
  1. Ripple founded an advocacy group called “Securing America’s Internet of Value Coalition” and retained the Klein/Johnson group, a D.C. based lobbying firm, which, in exchange for its services to the coalition, will receive monthly payments of $25,000 and 10,000 XRP tokens.
  2. Ripple attempted to pay two U.S. cryptocurrency exchanges to list XRP to drive demand and make XRP more easily available to a larger audience.
  3. Ripple’s CEO admitted, “To build CRP liquidity, we have been mindful over the years about how we distribute XRP … We engage in distribution strategies that we expect will result in a strengthening XRP exchange rate against other currencies.”
  4. “Ripple is essentially in complete control of moving the ledger forward, so one could say the system is centralized”.
Purchasers would reasonably expect the AP to undertake efforts to promote its own interests and enhance the value of the network or digital asset, such as where:

  • AP has the ability to realize capital appreciation from the value of the digital asset (e.g., if the AP retains a stake or interest in the digital asset);
  • AP distributes the digital asset as compensation to management or AP’s compensation is tied to the price of the digital asset in the secondary market;
  • AP owns or controls ownership of IP rights of the network or digital asset;
  • AP monetizes the value of the digital asset, especially where the digital asset has limited functionality.
  • Twenty billion XRP, or 20% of the total XRP supply, were given to the individual founders of Ripple, with the remaining 80 billion XRP retained by Ripple.
  • Ripple CEO has been a vocal advocate for investing in XRP, stating that he has long-term personal investments in XRP.

In addition, the amended complaint also addresses the “economic reality of the transaction” analysis of the Framework.  While none are dispositive, the more these elements are true for a given digital asset, the less likely it is to satisfy the Howey test (i.e., less likely to fall under the SEC definition of an “investment contract.”).

Economic reality of the transaction Ripple Complaint
The distributed ledger network and digital asset are fully developed and operational. No
Holders of the digital asset are immediately able to use it for its intended functionality on the network. No
The digital assets’ creation and structure is designed and implemented to meet the needs of its users, rather than to feed speculation as to its value or development of its network. No
Prospects for appreciation in the value of the digital asset are limited. No
With respect to a digital asset referred to as a virtual currency, it can immediately be used to make payments in a wide variety of contexts or acts as a substitute for real (or fiat) currency. No
Any economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality. No
The digital asset is marketed in a manner that emphasizes the functionality of the digital asset, and not the potential for the increase in market value of the digital asset. No

 

Sam Kramer focuses his practice on multi-jurisdictional outsourcing, complex technology licensing, commercial contracting, and supply chain agreements and integration. He is frequently involved in outsourcing transactions and large scale IT services projects. Mr. Kramer also focuses on emerging technology services, including mobile virtual network operator (MVNO) transactions. He is the North American coordinator of the Firm’s MVNO practice.

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