- Why Ripple is so annoying to the SEC
- What makes Ripple unique?
- How XRP was distributed
- Witch hunt
- Courts assess economic reality
- Conclusions
On December 22, 2020, the Securities and Exchange Commission (SEC) accused Ripple of selling $1.3 billion in unregistered securities under the guise of XRP tokens. This SEC lawsuit against Ripple has been dragging on ever since. Ripple CEO Brad Garlinghouse told attendees at the DC Fintech Week conference that the SEC lawsuit against Ripple will be resolved in the first half of 2023. According to Garlinghouse, there is a chance that the lawsuit could be settled in the next three to four months. However, he does not rule out that it could take longer.
Why Ripple is so annoying to the SEC
The company and its associated protocol are among the longest-running and most significant cryptocurrency projects in the world. XRP is practically a household name. Apparently, that is what is causing the regulators’ attacks. The reason for the lawsuit was the initial coin offering (ICO), which is now considered an offering of securities. But there is a time paradox in this story.
In fact, in 2012, when Ripple was founded, the term “initial coin offering” did not exist. Nor was there enforcement action against the then tiny crypto industry. In fact, the US Securities and Exchange Commission (SEC) would not announce its first settlement for alleged registration violations until November 2018 with the Airfox and Paragon ICOs. It is worth noting that the Ripple network was launched on January 1, 2013 – nearly six years earlier.
What makes Ripple unique
In addition to the fact that XRP has been among the top 10 coins by market capitalization for nearly a decade, the Ripple project also represented a unique consensus approach at a time when alternative approaches to coordination of any kind in blockchain have only been around for a few years.
Ripple uses a new consensus mechanism in which a list of nodes, the so-called “UNL” or “Unique Node List,” votes cyclically until 80% of them agree on which transactions should be added to the end of the chain. This is similar to the model better known today as delegated share proof (only without the share).
Proponents of Ripple argued that the advantages of this cyclic approach are that the network can process many more transactions at a much lower cost. The disadvantages, detractors said, are that it requires a higher degree of trust and is not truly decentralized.
How XRP was distributed
Ripple’s legal problems in the SEC v. Ripple case are not about the protocol, but about the tokens. Ripple Labs and its predecessor OpenCoin entity minted 100 billion XRP tokens, which were subsequently distributed to the company and early employees and then sold to the broader crypto markets to fund Ripple Labs operations.
There was much lively debate at the time about whether the tokens sold in this way were securities. On the one hand, there were cryptopreneurs who argued that token sales could serve as a lightly regulated governance mechanism and a crowdfunding tool. On the other hand, there were many lawyers who believed that the SEC would eventually dismantle the practice.
Witch hunt
The first ICO that failed miserably was Kik Interactive. Kik is still a little-used messaging app that went crypto in the midst of the first big ICO boom in 2017. Kik was selling tokens directly to the public without a valid registration statement. The SEC sued, and 16 months later, Kik lost a motion for summary judgment.
Telegram became the SEC’s next target. Telegram is a popular, supposedly encrypted messaging app founded by Russian billionaire Pavel Durov. Despite being one of the most popular messaging apps on the planet, Telegram is not generating revenue. To remedy this, Telegram issued and sold $1.7 billion in cryptocurrency tokens in various private fundraising transactions through private placement during 2018.
Telegram differed from Kik Interactive primarily in that Telegram first sold tokens through a private placement to wealthy and offshore investors, who presumably later offloaded those tokens to US markets and, therefore, to retail buyers in the United States. Just days before the tokens were issued, the SEC sued Telegram and obtained an emergency restraining order stopping the conversion of the tokens. The SEC quickly won a motion for a preliminary injunction. The official Telegram token project immediately came to an end (though it did continue to exist in various and unrelated forms).
LBRY was the next project that became a victim of the SEC. Created in 2018, LBRY was a reinvented version of YouTube with decentralized monetization tools designed to address politically motivated censorship at companies like Google and Facebook. The token performed a real function in a real application. However, the sale of this token was considered an offer of investment contracts.
Like Kik Interactive and Telegram, LBRY also lost a motion for summary judgment, this time in New Hampshire. In 2022, after losing the trial, LBRY stated that “LBRY Inc. is likely be dead in the near future.”
Courts assess economic reality
The SEC claims Ripple raised $1.3 billion between 2013 and 2020 by selling XRP, which constituted an “investment contract.” The company’s legal counsel, Stuart Alderoty, argues that there is no investment contract because there is no formal contract between Ripple and XRP buyers, and that the tokens were sold for consumer use.
The SEC, for its part, refers to the “economic reality” of Ripple sales no less than 15 times, asking the court to look “beyond boilerplate disclaimers” at the facts as they stand, including who bought the tokens and how they were used. This economic reality allegedly “forecloses any argument that Ripple offered and sold XRP primarily for consumptive use.”
On analyzing the precedent lawsuits, it becomes abundantly clear which argument has been more successful in the federal courts.
1. 1. In Kik, Judge Alvin Hellerstein wrote that “form should be disregarded for substance and the emphasis should be on economic reality.”
2. In Telegram, Judge P. Kevin Castel pointed out that “Congress intended the application of [the securities laws] to turn on the economic realities underlying a transaction, and not on the name appended thereto.”
3. In LBRY, Judge Paul Barbadoro wrote that “the focus of the inquiry is on the objective economic realities of the transaction rather than the form the transaction takes.”
Conclusions
At this point, the crypto industry has more or less come to terms with the fact that an ICO likely meets all the criteria of the Howey test, the foundational set of standards for defining what a security is.
But the “economic reality of the crypto market” is clear: there are a growing number of cryptocurrency holders in the world. And trying to bring crypto projects into line with SEC requirements is like scooping water with a sieve.
The basic mode of operation of the crypto economy is independent and direct peer-to-peer transactions over the Internet, not paper forms signed in ink. There are no national securities exchanges that support crypto-asset trading. The SEC stubbornly fails to approve a regulated exchange-traded fund (ETF), despite many proposals and great market demand.
It is clear that a huge class of investors do not want what the SEC is trying to bring to the industry. Millions of users use secure smart contracts every day to obtain loans and other financing or lend and buy assets such as partial cash flows from royalties. They do it in an instant, from anywhere in the world, with anyone, on handheld supercomputers. All attempts by the SEC to corral the new realities within the framework of classical economics are knowingly failing. There is no tool to stop or control this process. Only centralized exchanges are available to the Commission, and true crypto is decentralization. The state, stopping the development of the new sector, only drives it offshore. And this means that the more loyal countries will be the leaders in the new economy.
