Ripple’s XRP Still at Risk of Securities Classification
Ripple can win this battle and still lose the war.
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Even if the court rules in favor of Ripple’s motion to dismiss, XRP’s fate as a “currency” remains uncertain.
Motion to Dismiss
Ripple, the company behind the third-largest digital asset on the crypto market XRP, is battling an open-ended class-action lawsuit.
The case dates back to early 2018 when XRP investors first began filing lawsuits against the company. The first to file a class-action lawsuit against Ripple was Ryan Coffey (who later voluntarily dropped the case). Ripple is currently facing only one, consolidated class-action lawsuit combining previous class-action lawsuits filed by plaintiffs Vladi Zakinov, Avner Greenwald, and David Oconer.
The plaintiffs argue that XRP is a security and that Ripple, its subsidiary XRP II, Ripple’s CEO Brad Garlinghouse, and others broke the law by “issuing and selling XRP as an unregistered security.” Moreover, the plaintiffs claim that every class member — meaning everyone who’s purchased XRP — is entitled to a refund, plus compensatory damages.
In Feb. 2019, the federal court denied the plaintiffs’ motions to return the case to the state court of California. This marked a small victory for Ripple because California has broader blue sky laws and employs the “risk capital test” in addition to the (federal) Howey Test, both of which would have worked in favor of the plaintiffs.
The developments unfolding today are a result of the motion to dismiss (MTD) that Ripple filed on Sept. 19th of last year. Importantly, the specific route Ripple has taken in terms of their defense strategy is to “seek dismissal of the Complaint with prejudice” without addressing the real question of whether XRP is a security.
Ripple is clearly attempting to win the case on technicalities rather than substance.
Ripple asked the court to dismiss the complaint on the grounds that the plaintiffs (i) didn’t file the case on time, (ii) didn’t purchase XRP directly from Ripple or any of the individual defendants, (iii) failed to allege an offer or a sale of XRP in California, and (iv) failed to identify any statements made by the defendants “in connection with” the plaintiffs’ purchase of XRP.
If the court accepts Ripple’s motion to dismiss (keep in mind that the court could take months to decide on the motion), then the debate is over. They can then consider the case closed and will be forever done litigating the “XRP is a security” issue with any future private plaintiffs.
If, on the other hand, the MTD is denied, Ripple could either settle or deal with a long and costly discovery procedure.
There is a catch, however: “done litigating with all private plaintiffs” doesn’t include the SEC. Even if Ripple wins this particular class-action lawsuit before the Northern District Court of California, the SEC could still file a suit before the District Court for the Southern District of New York.
What’s more, if Ripple settles or wins on procedural grounds, the potential case the SEC could make before another court won’t be weakened since Ripple hasn’t actually proven that XRP is not a security.
Does the SEC Have a Case?
XRP proponents say that if the SEC could actually make a case, they would have already moved against Ripple. After all, there’s nothing legally stopping them.
Even though there is some truth to this claim (and CFTC’s chairman Heath Tarbert would agree), it would be wrong to interpret the SEC’s prior actions (or rather “inaction”) that way.
There may be many reasons why the SEC hasn’t yet made a move against Ripple, but not having a good enough case isn’t one of them.
Putting Ripple’s official position aside, the leading arguments XRP bag holders (and Saudi Arabian XRP bots) endlessly regurgitate on Twitter are (i) Ripple didn’t create XRP, (ii) FinCen’s 2015 ruling suggests that XRP is a currency, and (iii) regulators in other countries (e.g. UK’s FCA) treat XRP as a currency/commodity.
First, there is a great deal of evidence, including on-the-record admissions by Ripple themselves, suggesting that Ripple did, in fact, create XRP.
Second, FinCen’s ruling (as it’s already been made clear in their guideline) has nothing to do with this particular issue. According to U.S. law, unless a court rules otherwise, a particular digital asset can be treated both as a “convertible virtual currency” for AML purposes and as a “security” for securities fraud purposes.
Third, the legal treatment of XRP in other countries has nothing to do with the legal treatment of XRP in the US.
Ripple’s official position, although a bit more nuanced, follows the same lines.
In a recent interview, Ripple CEO Brad Garlinghouse stated his belief that XRP isn’t a security because: (i) XRP the currency exists independently of Ripple the company, (ii) ownership of XRP doesn’t give purchasers ownership of Ripple equity, and (iii) XRP has a clear utility — which isn’t a characteristic of securities.
In addition to Mr. Glaringhouse’s statements, Ripple and its employees have repeatedly denied any possibility that XRP could be a security and place great effort into making the clear distinction between the company as separate from the currency.
The bottom line is, however, that token issuers’ statements and opinions don’t really matter. All that the judges care about is how the particular digital asset measures up against the Howey Test.
XRP vs the Howey Test
The Howey Test is the American gold standard for determining whether a particular asset, digital or otherwise, is a security.
To qualify as a security, a transaction in XRP must meet all four requirements under the Howey Test:
- It is an investment of money.
XRP can be purchased directly with fiat or other cryptocurrencies and therefore meets the first requirement.
- There is an expectation of profits from the investment.
Ripple has certainly taken a step back recently and has refrained from making comments on the potential appreciation of the price of XRP as a direct result of their efforts. Looking back at the pre-lawsuit, a no-holds-barred era of Ripple’s XRP shilling, one can find plenty of evidence to suggest that XRP meets this criterion too.
David Schwartz, CTO at Ripple, has been caught saying “anyone who holds XRP, particularly those who are contractually prohibited from dumping it, shares our interest in seeing the price appreciate over the long term.”
In 2014, Ripple issued a paper crediting Ripple as the creator of XRP, and boldly implied expectations of profit by stating:
“[…] there is a finite number of XRP, as demand for XRP grows, the value of XRP should appreciate. In this manner, Ripple Labs believe that its incentives are aligned with those of [the] protocol’s users – both want the protocol to reach its full potential and scale.”
In addition, the class-action lawsuit discussed earlier cites roughly 50 tweets and statements where Ripple’s CEO not-so-vaguely implies expectations of profit.
- It’s an investment of money in a common enterprise.
This requirement is tricky because the federal circuit courts of appeal don’t agree on the definition of a “common enterprise.”
However, the SEC states in their framework that, when looking into digital assets, they find “a ‘common enterprise’ typically exists” and based on their experiences:
“Investments in digital assets have constituted investments in a common enterprise because the fortunes of digital asset purchasers have been linked to each other or to the success of the promoter’s efforts.”
Furthermore, evidence brought up in the class-action lawsuit suggests that the purchase of XRP is either (i) an investment of money in a common enterprise, or (ii) investors were led by Ripple to believe it is.
When asked what could cause the price of XRP to drop to $0, Ripple’s CTO, David Schwartz said the following:
- Any profits come from the effort of a promoter or third party.
Even though Ripple claims that the XRP protocol is an independent, open-source protocol and that its survival and well-being aren’t contingent on the efforts of the company, the evidence below strongly suggests otherwise.
An official statement on the Ripple website from 2014 states the following:
Another statement made by Ripple CTO David Schwartz in 2013:
“As a corporation, we are legally obligated to maximize shareholder value. With our current business model, that means acting to increase the value and liquidity of XRP.”
XRP Is Not a Security Because “It Has Utility”
Now that there’s enough evidence to suggest that XRP meets all four requirements of the Howey Test, one should back up and address Mr. Garlingouse’s interview — especially the sections where he states that XRP doesn’t give purchasers ownership of Ripple equity and that XRP has a clear utility which makes it clear it’s not a security.
First, a transaction does not have to provide rights to equity to be classified as a security. Second, whether XRP has “clear utility” is debatable. One of the main arguments the plaintiffs make in the class-action lawsuit is that XRP has no utility outside of being a speculative investment.
Even though Ripple says in its defense that XRP is a “bridge currency” used for international payments, in reality, those claims don’t hold water. More than 60% of XRP is held by Ripple and, aside from serving as a source of liquidity, none of it is being used for much of anything.
Moreover, the vast majority of the remaining XRP sold to investors is not utilized to help “bridge international payments” as Ripple would have us believe, but rather it serves as a vehicle for speculative investment purposes.
Observers are unlikely to see any legal clarification on the XRP security issue anytime soon.
Ripple has assembled an all-star team of securities lawyers, with Andrew Ceresney, former director of the SEC’s Division of Enforcement being one of them.
Suffice to say, they know what they’re doing and, unless they win the motion to dismiss, they will drag out the case indefinitely, or until they eventually settle and leave the crypto community back where it started — in the dark.
Taking everything into consideration, however, the SEC does not have to wait for the conclusion of a class-action lawsuit to demolish XRP.
A hypothetical “XRP = security” court ruling will not go unnoticed. The ripple effect of such a decision could lead to a wipeout of many adamant altcoin investors.