SEC vs. Ripple Lawsuit Everything You Need to Know

SEC vs. Ripple Lawsuit Key Information

After the 34-page court ruling by the SEC on Ripple this week, the price of XRP also soared. XRP rose nearly 80% to $0.81, reaching a new high in over a year. Other cryptocurrencies also joined in the frenzy.

The reason is that the “SEC’s characterization of XRP as a non-security token in the secondary market” is definitely something that the entire industry should be happy about. However, after carefully reading the 34-page lawsuit over the weekend, I feel that the market interpretation may be too optimistic. Of course, this is also because the SEC has never lost a token characterization lawsuit in the past, and this time in the Ripple case, it can be considered a tough battle.

Below, let’s review the key contents of the entire court ruling. (Related article: “Is the SEC suing Binance for jurisdiction or investor protection?”)

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Initially, Ripple’s defense claimed that XRP should be compared to gold, silver, or sugar, asserting that it is a commodity rather than a security. However, the court’s view on this matter is that even if XRP is similar to ordinary commodities in some aspects, if it is traded in an environment where profit is expected, it may be considered a security. For example: if you purchase a house solely for personal use, then the property is not considered a security. However, if you purchase the property for the purpose of renting it out and earning rental income from it, then the property may be considered a security in this case.

1. SEC attempts to accuse XRP of being a security from two perspectives

From the court ruling, we can understand that Ripple sold a significant amount of XRP in two ways, earning a considerable amount of money.

“Institutional Sales”

The court ruling shows that Ripple Labs, Inc. sold XRP to institutions through written contracts and earned $728 million. The Howey test was basically met in this case, as the following elements were satisfied, and the court ruled that the investment contracts of institutional sales belong to securities. The reasoning of the ruling is as follows:

1. Is it an investment activity?

The SEC believes that Ripple sold XRP to large institutions, and some of these institutions would buy XRP as brokers or market makers and then sell them to the public. Some institutions would also resell XRP as part of their trading strategies. Therefore, the SEC believes that this sales activity should be considered as an investment.

However, Ripple disagrees with this viewpoint. They believe that just because someone paid money for XRP does not mean they are investing. However, the court does not agree with Ripple’s view. They believe that, based on previous legal precedents, as long as institutional buyers pay money for XRP, regardless of whether their purpose is investment or just purchasing, it satisfies the requirement of “investment of funds” in the Howey test.

Aiying’s point of view: From the judgment, we can see that as long as the counterparty, whether it is an institutional entity or an individual, directly purchases the project through real-name agreements, according to previous legal cases, it meets the requirement of “investment funds” in the Howey test.

2. Is it a common enterprise?

The court began to discuss the second element of the Howey test, which is about the “common enterprise”. If it can be proven that the investors’ money is pooled together and each investor’s profit depends on the overall success of the enterprise, this can prove the existence of a “common enterprise”. This situation is called “horizontal commonality”.

In the Ripple case, the court found that Ripple deposited the money they obtained from selling XRP from large companies into bank accounts of their different subsidiaries. Even though Ripple has set up separate bank accounts for each subsidiary, all the accounts are controlled by Ripple, and Ripple uses the money in these accounts to support their business operations. Therefore, the court believes that Ripple’s actions meet the definition of a “common enterprise”.

In addition, the profits that each buyer receives depend on Ripple’s operations and the luck of other buyers, because all buyers are buying the same interchangeable XRP. Ripple uses the money obtained from the sale by large companies to develop the use of XRP and maintain the XRP trading market, thereby increasing the value of XRP. When the value of XRP rises, all buyers will receive corresponding profits based on the amount of XRP they hold.

In summary, the court conducted an in-depth study of Ripple’s sale of XRP to large companies and determined that these sales meet the requirements of the Howey test and should be regarded as investments and the existence of a common enterprise. This means that Ripple may need to be regulated by the SEC.

Aiying’s point of view: The centralization of Ripple’s deposits, that is, although they have distributed accounts, they have not decentralized independent management, but have pooled investors’ funds together for Ripple’s business operations and the distribution of common profits that every customer can buy. This is the key factor for determining the element of a “common enterprise”.

3. Does it provide institutional buyers with a reasonable expectation of profits from the efforts of others?

First, we need to understand what profits are. Here, profits refer to income or returns, such as dividends (profits distributed to shareholders by a company) or the increase in investment value. Institutional buyers purchase XRP with the expectation of earning profits from Ripple’s efforts, which does not mean that they are only purchasing for investment purposes. Some people may also consume or speculate at the same time.

So why did the court believe that institutional buyers would expect to earn profits from Ripple’s efforts?

This is because Ripple has always emphasized the close connection between the value of XRP and the success of the company in its promotion and marketing. For example, they have stated in their promotional materials that if the Ripple protocol (a technology that makes it easier to exchange digital currencies) is widely used, the demand for XRP will increase, thereby increasing the value of XRP. Senior leaders of Ripple have also made similar statements in public. They all expressed that Ripple will continue to strive to increase the value of XRP.

The Ripple company also emphasized that they are solving a trillion-dollar problem, which requires a large amount of funding. They stated that if the company continues to succeed, it will create a significant demand for XRP. In other words, if Ripple performs well, the value of XRP will increase.

In addition, some terms in the sales contracts between Ripple and institutional buyers also indicate that buyers are primarily purchasing XRP for investment rather than consumption. For example, some buyers agree to lock or resell their purchased XRP based on the trading volume of XRP. These restrictions mean that buyers cannot immediately use or resell the XRP they purchased. This is inconsistent with using XRP as a currency or other consumer goods.

Aiying’s viewpoint: Ripple’s official emphasis on the future appreciation of XRP’s value with the company’s efforts and the inclusion of investment demand conditions in the sales contract terms basically meets this criterion. This situation also occurs in the majority of token issuers, so the actual situation may not be too optimistic.

“Other Distributions”

The SEC also mentioned a situation called “Other Distributions,” which mainly involves Ripple distributing XRP to employees and third-party companies as compensation. These third-party companies include companies participating in Ripple’s Xpring project, which aims to develop more uses for XRP and the XRP ledger, involving an amount of $757 million. The SEC believes that by doing so, Ripple allows these third parties to transfer XRP to the public market and raise funds for themselves, which is also considered a securities act.

However, the court does not agree and believes that “Other Distributions” did not meet the first principle of the Howey test, which requires an “investment of money” action. In fact, the employees and third-party companies receiving XRP did not pay any form of money or tangible property to Ripple. On the contrary, Ripple paid XRP to them. Furthermore, there is no evidence that Ripple raised funds through this method because they did not obtain any profits from the distribution of these XRP.

Therefore, the SEC continues to argue that “Other Distributions” is actually an indirect public offering because the parties receiving XRP may transfer it to others.

However, the SEC did not further prove that the sales in these secondary markets constituted the provision or sale of investment contracts. They do not know the identity of the buyers, and the buyers do not know the identity of the sellers. Therefore, these transaction records cannot prove that they violated the provisions of the Howey test. As a result, the court ultimately ruled that Ripple’s “Other Distributions” did not constitute the provision and sale of investment contracts. Similarly, Larsen and Garlinghouse’s XRP transactions on digital asset exchanges do not constitute the provision and sale of investment contracts.

Aiying’s viewpoint: The interesting aspect of this ruling is whether it means that as long as sales activities are not conducted through investment contract agreements but through fee payments and sales on secondary markets, they can be classified as non-security tokens and not meet the Howey test criteria.

At least for now, congratulations to the tokens issued by exchanges and those that were not issued through investment agreements or ICO/IEO/LaunchLianGuaid, etc. You can temporarily escape the harassment of the SEC.

As a result, we can see that after the judgment was issued, exchanges such as Coinbase and Kraken confidently relisted XRP, which had been delisted before. Coinbase’s daily increase expanded to 21%.

2. The first round ruling is just the beginning, and the SEC is likely to continue to appeal

Speaking of which, Ripple also spent $200 million in legal fees, which is quite remarkable for exploring the industry. The U.S. court system also has a little secret. Due to resource constraints, the U.S. legal system cannot handle a larger number of cases, resulting in less than 10% of civil and criminal cases being ultimately tried. Judges who understand this situation usually put pressure on lawyers from both sides to reach a settlement.

Therefore, some people speculate that the U.S. Securities and Exchange Commission (SEC) may try to reach a settlement with Ripple. However, unexpectedly, both the SEC and Ripple have firm positions, as they both involve their own survival and jurisdiction in the field of cryptocurrencies. Currently, Ripple’s ruling is only “a partial summary judgment by a district court judge, although persuasive, it is not binding on other courts and is likely to be overturned on appeal by the SEC”.

Summary

“Institutional sales” lost the lawsuit, and “other sales methods” won a partial victory. However, there are ambiguous points in the judgment on “other sales methods”, such as buying a product in a large market and being told that this product may be considered illegal under certain circumstances, but completely legal under other circumstances, which is quite vague.

This mainly stems from the lack of clear and consistent legal definitions and applications for cryptocurrencies like XRP. It’s like not having clear regulations to determine what the product you bought should be considered. So in the end, the U.S. Congress may need to enact new regulations to clarify the legal status of cryptocurrencies, just like other countries (such as the European Union, Hong Kong, and Singapore) have done. (Related article: “Interpreting the Digital Asset Act that may be introduced before the U.S. presidential election in 24 years”).

This current debate will set the tone for the regulatory rules of the United States and the entire industry’s future, and will also affect the future direction of the cryptocurrency market. Therefore, the victory of either party may compress the power space of the other party, resulting in a stalemate between the two sides and not being willing to settle. So it is too early to go all in. It is understood that many tokens participating in the carnival have returned to their original prices, and the main players are looking at each other and smiling.

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