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Ripple SEC Lawsuit Win

Ripple Wins SEC Lawsuit

A simplified overview of Ripple’s landmark win in SEC lawsuit

As the crypto industry grew from a quirky Bitcoin project to a market cap in the trillions of dollars, the industry’s relationship with the SEC became increasingly acrimonious. Most noteworthy is the SEC’s position that cryptocurrency is not a currency but a security, and they should regulate it as such.

The crypto industry disagreed and repeatedly requested more explicit guidance for crypto use cases. The SEC, under Chairman Gary Gensler, has primarily seen this as a stalling tactic. He says the rules are already unmistakable. In 2022 – 23 the SEC embarked on a series of lawsuits that seem to point to a strategy of suing first and letting the courts sort it out.

On July 13, 2023, Judge Analisa Torres of the US District Court for the Southern District of New York issued a split ruling in the SEC’s lawsuit against Ripple Labs. The ruling found that Ripple’s XRP cryptocurrency was a token, not a security in and of itself. As such, Ripple has not broken security law in offering XRP on exchanges and other situations we’ll touch on in this post.

The ruling sparked cheers from crypto Twitter, raised eyebrows from institutional investors, and NFT drops in honor of Judge Torres.

Ripple Wins SEC Lawsuit
Source: OpenSea

What was not as widely celebrated was Judge Torres’s additional ruling that Ripple had violated securities law by offering the XRP token for sale as a speculative investment to institutional investors.

Even so, the Ripple ruling clarifying XRP’s token status is the first crypto industry win against the SEC. It’s significant because it sets a precedent for other crypto assets, tokens, and securities regulations in the United States. Let’s take a closer look.

The SEC vs. Ripple Labs Lawsuit

After about four years of contentious wrangling, the question before the Court got to the heart of the matter for the crypto industry – whether XRP, a crypto token, is an investment contract, or a security, under the law. To sell securities in the US, you must register with the SEC.

The Court ruled that XRP, as a digital token, is not in and of itself a security. The critical distinction is this: the Court distinguished between the token and the context for its sale. This distinction is huge for the crypto industry because it implies that the SEC is wrong and sets a favorable case law precedent for crypto in future and pending lawsuits.

While the case is important, it is also very complex. This post highlights what happened while attempting to stay out of the weeds. First of all, it’s helpful to know what Ripple does. So let’s start there.

What Does Ripple Do?

In an era where banks keep track of money electronically, international transactions with physical money rarely happen. Despite what international spy movies show, no one is sending briefcases of cash dollars to European banks, for example.

Yet it still takes several days for global deposits to clear. Why is that?

It’s because many banks in different countries still use the SWIFT system from the 1970s to transfer money to each other. The problem is that transactions are anything but swift.

The friction arises because the SWIFT system doesn’t execute the funds transfer; it simply facilitates one-way messaging about the transaction. The transfer occurs via a complex framework of bank relationships, intermediaries, and KYC regulations.

Each player takes a fee in the process, and the funds are tied up in limbo for days, unavailable to either the sender or the receiver until the transaction is complete. There is also almost no transparency in the system about the transaction status.

Ripple’s Innovation for International Bank Transfers

Using blockchain and crypto technology, Ripple developed tools and services like RippleNet, Ripple Protocol, XRP Ledger, and InterLedger protocol. These tools provide clarity, better communication, and almost instantaneous transactions, saving banks an estimated 33% on operational costs.

Stakeholders use the XRP token as a bridge currency to enable seamless transfers across different fiat currencies. You can check out this video from Whiteboard Crypto for a deeper dive into how Ripple works.

Ripple has seen significant early success, attracting over 100 international banks and corporate clients like American Express. Ripple is a private company at the heart of millions of dollars of global transactions. That kind of traction tends to get the attention of federal regulators. Additionally, Ripple (XRP) ranks among the most valuable blockchain-based tokens by market capitalization.

Key Elements for Understanding the SEC Ripple Labs Lawsuit

Ripple designed its payment system primarily for bank use, but individual investors can speculate on the price of XRP. Ripple listed XRP as a cryptocurrency on digital asset exchanges and distributed it to employees and others. Ripple’s founders also sold XRP on various platforms.

The XRP activity, apart from the Ripple banking platform, is the reason the SEC took issue with XRP and Ripple. In December 2022, after several years of legal wrangling, the SEC filed a lawsuit alleging that Ripple and its founders had raised over $1.3 billion through an unregistered, ongoing digital asset securities offering.

The Howey Test

Knowing the basics of the Howey test is key to understanding the Court’s ruling. Courts have used the Howey test since 1946 to determine if an investment offering is a security subject to SEC regulation.

The Howey Test has four simple questions:

  1. Is it an investment of money, where people buy it hoping to make more money in the future?
  2. Is there an expectation of profit? Do people buying it expect to make money from it?
  3. Is the investment in a common enterprise? Are many people putting their money together into one project or business?
  4. Does the profit come from the efforts of others? – Will the people who invest make money mostly because someone else (like the person who created it or the company selling it) is doing a lot of work to make it successful?

If the answer to all these questions is “yes,” it could be considered an investment contract.

The Heart of the Lawsuit

The SEC argued that XRP meets the criteria of a security under US securities laws and should have registered it as such before selling it to the public. This legal challenge posed significant threats to Ripple’s operations and the broader cryptocurrency market.

Ripple staunchly denied the SEC’s allegations. The company contended that XRP is not a security but a fully functional digital asset that serves a practical purpose within its payment network. Ripple argued that XRP’s primary use case as a bridge currency for cross-border transactions exempted it from being classified as a security.

At the heart of this complex case were the following four types of XRP distribution transactions:

  1. Sales of XRP directly to institutional investors (Institutional Sales)
  2. Algorithmic sales of XRP on digital asset trading platforms (Programmatic Sales)
  3. XRP distributions to Ripple employees and third parties (Other Distributions)
  4. Sales of XRP by Ripple founders Garlinghouse and Larsen on various digital asset trading platforms

Once the Court established that XRP was not, by default, a security, the context for the transaction became important. In other words, whether XRP is a security depends on the sale’s context.

The Heart of the Lawsuit

Concerning institutional sales, the Court held that Ripple violated securities law because, in the context of sales to institutional buyers and hedge funds, XRP met the definition of a security according to the Howey test.

Programmatic Sales Win the Day, For Now

The big win for the crypto industry was around the programmatic sales. Programmatic sales refer to open-market, automated exchange sales of cryptocurrency tokens. In the context of programmatic sales, the Court ruled that those sales did not meet the definition of a securities offering.

Because XRP was sold utilizing trading algorithms on digital asset exchanges via blind bid/ask transactions, the Court found insufficient evidence to define these sales as investment contracts/securities.

For similar reasons, the XRP distribution to employees and sales by Ripple’s founders did not constitute an investment contract. For a well-written deep dive into the ruling’s legal technicalities of the ruling, check out this post from the law firm Holland and Knight.

Moving Ahead

While the outcome of the Ripple SEC lawsuit has far-reaching implications for the entire cryptocurrency industry, it is by no means the last word. Ripple may appeal the ruling regarding institutional investor sales. Also, the SEC will likely not stand down anytime soon. Swan Bitcoin CEO Cory Klippsten believes that we will continue to see a continuation of regulation by enforcement, leading to court rulings that will eventually clarify the marketplace.

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This material has been prepared for informational purposes only and should not be interpreted as professional or legal advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.

Kala Philo