39 - Ripple making waves
The contents of this post are based on research and conversations with industry experts. I am not a lawyer and I am definitely not your lawyer. Opinions expressed are solely my own.
Shout out to my friend and colleague John Schneider and my parents for some great edits.
Since the dawn of the crypto industry, there have been teams both publicly and anonymously attempting to create “the next bitcoin” (BTC). Few projects and teams aiming to dethrone BTC are better known and more controversial than Ripple Labs ( RL) and the digital asset XRP. In 2020, the Securities and Exchange Commission (SEC) charged Ripple Labs and two executives with overseeing the issuance of over $1 billion in unregistered securities. From the beginning the SEC v. Ripple case has been one of the most followed cases in the industry. In July of this year, the judge overseeing the case came down with summary judgment both affirming and denying the SEC’s claims of Ripple and its executives' wrongdoing. The ruling has been touted largely by the industry as a “win” for crypto, but further scrutiny of the case has some experts scratching their heads. The story of Ripple and XRP as well as the recent ruling make for one of the most intriguing and legally contentious stories in an industry known for them.
Ripple (The company)
Ripple Labs was founded in 2012 by Chris Larsen and Jeb McCaleb, two technology vets. Larsen sold an online mortgage company called E-Loan and McCaleb had founded the now infamous Mt. Gox digital asset exchange a few years prior. The two seemed like a match made in heaven with Larsen and McCaleb taking the titles of CEO and CTO respectively. They were able to raise money from Jesse Powell, the founder and former CEO of Kraken, as well as some other well known venture capital firms in the Bay area. Ripple was touted as the next step in modernizing payments: Bitcoin with an allstar team. Unfortunately, within the first two years of starting the company, the relationship between Larsen and McCaleb turned sour.
There is much speculation as to what caused the rift but many familiar with the matter cite the divisive action of McCaleb's then-girlfriend, Joyce Kim. Kim was brought on after her travel company failed and almost immediately started clashing with the small RL team, first by giving herself the title of Chief Engagement Officer (CEO), and then by repeatedly saying that McCaleb was actually the Bitcoin founder, Satoshi Nakamoto. Two months in to her tenure, Kim had been forced out; and McCaleb, disenchanted with the venture, looked for some way to make some changes. His first approach was to arrange a deal with Stripe’s founder, Patrick Collison.
At the time, Stripe was the golden child of the startup space. After a few months of negotiations, Collision and the Stripe team agreed to purchase RL for a reported $13M. The picture below is of a dinner between the Stripe and RL teams to celebrate the pending acquisition of the latter by the former. The photo shows Stripe’s head of business development, McCaleb, Collison, Larsen,and the CFO of Stripe. Despite being essentially closed, the deal fell through in the 11th hour for reasons that are still not entirely clear. Ever more frustrated, McCaleb began to wage war on his cofounder. The battle between the two hit a crescendo when McCaleb forced the RL board to vote on removing Larsen as CEO – a vote that McCaleb lost 5-1. In the middle of 2014, McCaleb decided to leave RL and launch a blockchain powered competitor called Stellar. Even after McCaleb's departure, RL continued to pursue its vision and grow.
Ripple (The product)
When RL was founded, McCaleb and Larsen had a lofty objective of revolutionizing the cross border payment industry. They saw bitcoin as the first phase of a technology that could help replace the current cross border payment juggernaut SWIFT. Founded in 1973, SWIFT was built with outdated technology. By 2012 it was seen as inefficient, expensive, and ripe for a technology makeover. Core to the RL strategy for solving these problems was a blockchain called XRPL which was launched in 2012 by McCaleb, Larsen, and some other RL employees.
Similar to Bitcoin and BTC, XRPL relied on a native token called XRP to track value and process transactions. Outside of the word “blockchain,” the similarities between Bitcoin and XRPL stop there. Unlike Bitcoin which creates BTC over a given period of time and has a capped supply of 21 million, the XPRL network created 100 billion XRP the day the first block was created. When BTC is created, it is used to reward miners for processing a transaction. When XRP was created, 20% of its total supply was allocated to the founders of XRPL, and the remaining 80% was given to RL to do with it as it pleased. RL planned to use these tokens to raise money to fund product developement. Their original products consisted of xCurrent, xRapid, and xVia.
xCurrent was built specifically for banks and gives banks the ability to process cross-border payments at a much lower cost than SWIFT. xRapid helps ease bank’s liquidity issues. Using xRapid allowed banks to use the digital asset XRP in addition to government issued currency to facilitate payments, something SWIFT does not allow. xVia ties the first two products together through a suite of APIs. In 2019, RL consolidated these products into a single suite known as “RippleNet.” Since the consolidation RL has added more functionality to RippleNet and launched other product lines, which provide, among other things, broader crypto liquidity services and central bank digital currency services. It's important to note that XRP is not required to leverage the RippleNet system. In fact, it's been reported that almost no RL customer holds XRP.
SEC vs Ripple Labs Inc., Bradley Garlinghouse, and Christian A. Larsen
Since its launch, the digital asset community has given XRP the side-eye.The fact that a single group led the development of the XRPL blockchain, the XRP created was allocated to a small group of individuals, and that it was being sold in some cases to fund RL made many suspect that the SEC would come after RL for illegal securities issuance. That suspicion was confirmed on December 22, 2020 when the SEC charged RL, Chris Larsen, and RL’s CEO Bradley Garlinghouse with securities fraud. The complaint alleged….
“…that Ripple raised funds, beginning in 2013, through the sale of digital assets known as XRP in an unregistered securities offering to investors in the U.S. and worldwide. Ripple also allegedly distributed billions of XRP in exchange for non-cash consideration, such as labor and market-making services . . .In addition to structuring and promoting the XRP sales used to finance the company's business, Larsen and Garlinghouse also affected personal unregistered sales of XRP totaling approximately $600 million.”
In the past, most digital asset companies the SEC has taken action against have folded either because they were in fact breaking the law or because they didn’t have the financial resources to fight the commission. RL took the stance that they were not breaking the law and were going to fight the case. Over the past two and half years, the battle between RL and the SEC has been a closely watched but slow moving duel. That changed when on July 13, 2023, the United States District Court of the Southern District of New York ruled on a motion for summary judgment which affirmed in part and denied in part the SEC’s claims. The decision could be broken down into four areas of finding.
Sale of XRP by RL to institutional investors
Sale of XRP by RL on anonymous exchanges
Use of XRP for employee compensation and community grants
Sale of XRP by Larsen and Garlinghouse
Sale of XRP by RL to institutional investors
The court affirmed that the sale of XRP to institutions for the purposes of raising money was in fact an illegal sale of a security. At the heart of the ruling was the flow of information. Judge Analisa Torres held that the active sale and associated statements about the success of XRP to institutions constituted the sale of a security (Pg. 16 - 22). The marketing of XRP by RL gave the impression that based on the efforts of RL the investor could expect the value of XRP to increase. She applied the Howey Test, stating,
“Based on the totality of circumstances, the Court finds that reasonable investors, situated in the position of the Institutional Buyers, would have purchased XRP with the expectation that they would derive profits from Ripple’s efforts.”
Sale of XRP by RL on anonymous exchanges
When it came to RL’s “Programmatic sale” of XRP (Pg. 22- 25), Judge Torres made a contrary finding, holding that anonymous sales of XRP on exchanges were in fact not securities. The key difference between the two sales was the information available to the investor and the source of that information. With institutional investors, RL made statements that Torres believed constituted the promotion of a security. RL said something akin to “If you give Ripple Labs money we will give you XRP and work hard to make the token more valuable.” When a regular investor buys XRP on an exchange, they don’t know who they are buying from. The lack of information about sellers means that the person buying cannot expect the price of a token to increase based on the efforts of others (Howey test’s third prong). In her ruling, the judgment Judge Torres states….
“Having considered the economic reality of the Programmatic Sales, the Court concludes that the undisputed record does not establish the third Howey prong. Whereas the Institutional Buyers reasonably expected that Ripple would use the capital it received from its sales to improve the XRP ecosystem and thereby increase the price of XRP, Programmatic Buyers could not reasonably expect the same…..”
Other distributions and personal sales
The additional charges the SEC brought against the defendants were related to other distributions and sales of XRP by the company's officers (Pg. 26 - 28). These other distributions were instances where RL used XRP to compensate employees and issue grants to third parties working in the XRPL ecosystem. In all cases, Torres determined that these distributions and sales were not in violation of securities laws. In the cases in which the company gave XRP to employees and third parties, the transactions did not involve an “investment of capital” and therefore failed the first prong of the Howey test. The sale by company officers was done via a “Programmatic sale” and therefore fell under the earlier ruling.
What does it all mean?
Torre’s ruling has in many ways created more questions than answers. The great debate within the crypto industry has been whether or not a digital asset should be considered a security as defined by the Howey test. The SEC has repeatedly stated that most digital assets are securities but not given any guidance as to the details of their claim. Instead, they have used the broad stance that “everything is a security because we said so” to justify taking legal action against companies like RL. Proponents of digital assets’ not being a security have made counter arguments that crypto is more like a digital good or product than a financial instrument. The comparison that often gets made is that of some kind of physical product like a concert ticket.
If Taylor Swift sells tickets to her Era Tour for $50 and then they go on resale for $1,000, you can’t charge Taylor for securities violations. She simply sold a product which others then turned around and sold for a higher price. The RL case was the first time the SEC has gone after someone big enough to adequately defend itself. The court’s decision didn’t address the question of “Can certain digital assets be products?” but what it did do is question how Howey has historically been interpreted.
At the heart of Torre’s ruling is the idea that an item can be a security in some instances and not in others. When RL was selling XRP directly to institutions, it was a security; but when they were compensating people and selling it anonymously, it was not. The logic and judicial precedent applied by Torres flies in the face of traditional securities laws. For example, replace XRP with a share of Apple stock. When Apple sells the stock directly to investment firms, that is a securities sale. When that same share is then sold on NASDAQ anonymously, that sale is also the sale of a security. Apple stock doesn’t change its form when it is sold to different audiences. Yet that is essentially what Judge Torres ruled.
Crypto bulls view the ruling as a big win. It opens the door to the argument that over time something can go from being a security to not being a security. The “asset can transition over time” argument is one that even the SEC has said could have merit under the right circumstance. In 2018 Director William Hinman said that “If the network on which the token or coin is to function is sufficiently decentralized…. the assets may not represent an investment contract.” At the time, Hinnman made the statement when talking about the creation of Ethereum and the issuance of ETH.
Unfortunately, current laws don’t give a clear picture as to how that transition could happen, and the SEC seems hell bent on pursuing legal action unless the court tells them otherwise. Torres did not rely on the decentralization argument presumably because XRP is extremely centralized but instead questioned how and to whom the asset was marketed. That stance only further muddies the waters and puts years of established securities laws under the microscope. Regardless of how you interpret the ruling it is almost certain that the SEC is going to appeal. When they do, it will likely be only the next chapter in the story instead of the end.