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:
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| 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. |
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| 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. |
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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:
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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 |
