A predictable lawsuit that could have many unintended effects

SEC vs. Ripple: a predictable lawsuit that could have many unintended effects

In 2020, the US Securities and Exchange Commission has not been friendly towards cryptos. In March 2020, in the SEC vs. Telegram case, the Commission won Bitcoin Trend App globally valid injunction against Telegram’s proposed issuance of Grams, wiping out years of work despite no allegations of fraud. Then, on the last day of September 2020, Judge Alvin K. Hellerstein dashed Kik Interactive’s hopes by ruling in favour of the Commission’s motion to block the sale of the Kin tokens.

Both lawsuits were filed in the Southern District of New York. On December 22, 2020, the SEC decided it was time for another high-profile lawsuit, filing a subpoena in the same district against Ripple Labs and two of its executives, Christian Larsen and Bradly Garlinghouse, for raising over $1.38 billion through the sale of XRP since 2013.

The initial fallout from this action was swift and severe: 24 hours after the lawsuit was filed, the price of XRP dropped by almost 25%. Despite this, Ripple still ranks fourth in CoinMarketCap’s rankings, with a total market cap of around $9.8 billion.

The complaint

In its complaint, the Commission alleges that XRP sales were never registered with the SEC and could not be exempt from registration. In the Commission’s view, this constitutes an unlawful sale of unregistered and non-exempt securities under Section 5 of the Securities Act of 1933.

To readers unfamiliar with the legal process, it may seem unusual for the case to be brought in a New York federal court, especially since Ripple is based in California and both defendant executives reside in the same state. However, Ripple has an office in the Southern District of Ney York, some of Garlinghouse’s statements were made while he was in New York, and significant sales of XRP were made to residents of that state. In legal parlance, this would make it „proper“ to bring an action in the Southern District of New York.

In addition, it may seem unusual to some that both Larsen and Garlinghouse are personal defendants in a lawsuit that is primarily aimed at recovering XRP sold illegally (according to the SEC) by Ripple, through its wholly owned subsidiary, XRP II LLC. The two executives are being sued both because they individually sold significant amounts of XRP, 1.7 billion by Larsen and 321 million by Garlinghouse, and because the SEC alleges that they „aided and abetted“ Ripple in its sales.

Aiding and abetting is an indictment that depends on a primary violation by a third party, in which the person voluntarily and knowingly participates with the objective of contributing to the success of the enterprise. In this case, Ripple would be the primary infringer, and both Larsen and Garlinghouse are accused of substantially participating in Ripple’s XRP sales model with the goal of enabling the company to raise funds without registering the cryptocurrency under the federal securities laws or pursuant to any exemption.

Much of the subpoena is actually an overview of digital assets: it sets out the SEC’s version of Ripple’s history and marketing campaigns with respect to XRP and explains how, in the Commission’s view, the so-called „Howey Test“ under the federal securities laws is fully applicable to XRP. Finally, the lawsuit seeks to show how Larsen and Garlinghouse participated in the sales, which are still ongoing.

In addition to restitution of all „ill-gotten gains,“ the injunction sought by the SEC would permanently prohibit the defendants from selling unregistered XRPs or participating in any way in the sale of unregistered, non-exempt securities. It would also prohibit them from offering any digital assets, as well as require unspecified civil monetary penalties.

A brief history of Ripple and XRP

The idea behind the current XRP dates back to late 2011 or early 2012, before the company changed its name to Ripple. The XRP Ledger works as a peer-to-peer database, spread across a network of computers that records data on transactions, among other things. Each server in the network evaluates transactions submitted by a subset of nodes it trusts, and these trusted nodes are known as Unique Node Lists (UNL). Although each server defines its own trusted nodes, XRP Ledger requires a high degree of overlap between the trusted nodes chosen by each server. To facilitate this overlap, Ripple publishes a proposed UNL.

Once the XRP Ledger was completed, in December 2012, when its code was distributed to the servers that would run it, a fixed supply of 100 billion XRP was set up and created. Of this XRP, 80 billion was transferred to Ripple and the remaining 20 billion XRP went to a group of founders, including Larsen. At this point, Ripple and its founders controlled 100% of the XRP.