XRP is not a security. Except when it is.
Ripple Labs is a cryptocurrency company most famous for creating and selling the XRP token. When the company was originally founded in 2012, the idea was they’d create a new cryptocurrency to facilitate currency exchange. The ticker for this token was XRP, and every token in existence was initially given to either the founders or the company itself — 80% to the company and 20% to the founders.
Over the following years, the founders, company, and employees sold significant volumes of the XRP token. These token sales both enriched the founders and employees, and helped raise money for development and expansion of the XRP ledger.
These sales caught the attention of the Securities and Exchange Commission, in charge of regulating the sale of securities like stocks and bonds. Ripple was selling off a proprietary currency they created to investors in order to raise money to further develop the ledger and encourage broader adoption — all goals which should theoretically result in higher demand for the token.
To the SEC, this sounded a lot like a security. So in December of 2020, they sued Ripple Labs and two of its executives for unregistered securities offerings.
This case has been slowly chugging away since then until July 13th, 2023, when the U.S. District Court for the Southern District of New York issued a summary judgment. The ruling had two main findings:
- Ripple’s sale of XRP on public exchanges to the general public with no disclosures DID NOT constitute a securities offering.
- Ripple’s sale of XRP to private investors, which included various disclosures, DID constitute a securities offering
In short — you can sell crypto tokens on the open market to investors who don’t really understand what they’re buying, but if you try to sell them to institutional investors with disclosures, you’ll get in trouble.
Huh?
XRP is a commodity. Sort of.
One way to think of XRP is as a commodity, which just so happened to be wholly owned by Ripple Labs and its founders.
This isn’t that far-fetched; China, for example, sits on a huge supply of rare earth elements that accounts for roughly 80% of the world’s production. Morocco sits on 75% of the world’s reserves of phosphate rock, a critically important mineral for fertilizer. So maybe XRP is kind of like the phosphate of finance — mostly owned by one entity, very important for a few financial applications, but independent of the company that created it.
This viewpoint is helped by the fact that the XRP ledger exists independently of Ripple Labs and its founders. Theoretically, even if Ripple Labs declared bankruptcy, the XRP ledger could continue to operate in its absence so long as at least one node was running.
But it’s also very clear that the price of XRP tokens is tied to the fate of the company that created it. When the recent ruling was issued, the price of XRP jumped by 75%, indicating that the markets think that whether or not Ripple Labs has to pay huge fines in a settlement with the SEC will have a large impact on future demand for the XRP token. Or something. It’s not always clear whether investors buying these tokens have a clear idea of how events and use cases should affect prices.
So in that sense, people are definitely treating XRP like a stock in Ripple Labs.
Why did the court rule as it did?
The traditional method for determining whether or not something is a stock or investment contract is the Howey Test, a standard established by a Supreme Court case in 1946. Roughly speaking, the Howey test defines an investment contract as follows:
- An investment of money
- In a common enterprise
- With the expectation of profit
- To be derived from the efforts of others
The court’s ruling that XRP sales did not constitute securities offerings hinged on its belief that the public sales on the blockchain fails the third prong of the Howey test. They write:
The Court next addresses Ripple’s Programmatic Sales, which occurred under different circumstances from the Institutional Sales. The SEC alleges that in the Programmatic Sales to public buyers (“Programmatic Buyers”) on digital asset exchanges, “Ripple understood that people were speculating on XRP as an investment,” “explicitly targeted speculators[,] and made increased speculative volume a ‘target goal.’” …
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. Indeed, Ripple’s Programmatic Sales were blind bid/ask transactions, and Programmatic Buyers could not have known if their payments of money went to Ripple, or any other seller of XRP. Since 2017, Ripple’s Programmatic Sales represented less than 1% of the global XRP trading volume. Therefore, the vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract, but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying its money.
Further, it is not enough for the SEC to argue that Ripple “explicitly targeted speculators” or that “Ripple understood that people were speculating on XRP as an investment.” … It may certainly be the case that many Programmatic Buyers purchased XRP with an expectation of profit, but they did not derive that expectation from Ripple’s efforts (as opposed to other factors, such as general cryptocurrency market trends)—particularly because none of the Programmatic Buyers were aware that they were buying XRP from Ripple.
So essentially, the fact that non-accredited investors couldn’t tell whether the XRP they bought through a crypto exchange came from Ripple Labs directly vs a third-party seller meant that these were not security offerings.
This is a little strange because that’s not at all how securities laws work in the stock market. Shares of Apple trading on the New York Stock Exchange don’t stop being a security just because the buyer can’t tell whether they were purchased from Apple directly versus a third party.
Foreseeable headaches from the court’s ruling
The SEC will almost certainly appeal the decision, but if the case is turned down by the court of appeals, this ruling could have very strange and potentially negative consequences for public markets.
When the SEC was created by the Securities Exchange Act of 1934, the intention was to stop shady companies with no earnings from duping people with lies and empty promises. There had been a substantial amount of such behavior in the 1920s.
Take Courtenay Chauncey “C.C.” Julian, for example. CC took out newspaper and radio ads to convince residents of Los Angeles to invest in his oil company. He raised two million dollars before being charged with mail fraud by a federal indictment. He fled to Shanghai before he could be arrested. Four years later, he committed suicide.
Or take Sheridan Lewis, another promoter of an investment scam who managed to rake in $150 million from film magnates, bankers, and many others in high society before being discovered. Lewis then bribed the three jurors and the district attorney to throw the case before eventually being discovered and thrown in prison.
These frauds were much easier to pull off in the 1920s because there were no laws in place requiring companies to disclose important financial and business information to investors.
If the federal ruling stating public sales of XRP is allowed to stand, the recent rise in fraud facilitated by cryptocurrencies could be here to stay.
This isn’t to say that the SEC necessarily needs to be the regulatory agency that rules over cryptocurrencies, or that existing securities laws in their entirety should be applied either. Regulating cryptocurrency as a commodity might provide adequate protection so long as a token’s prospects are sufficiently decoupled from the organization that issued it. One could perhaps argue that Ether is sufficiently decoupled from the Ethereum Foundation that a theoretical collapse of the Ethereum Foundation would be no more consequential than the bankruptcy of a large supplier.
But to have no financial disclosure requirements at all for tokens which the markets treat like a stock in a company would be a terrible outcome for cryptocurrency. The public perception of cryptocurrency being synonymous with “scam” has only been strengthened over the last year due to the collapse of many high-profile cryptocurrency companies such as FTX, Genesis, Celsius and many others. If the cryptocurrency landscape continues to be a lawless wasteland, its growth will be permanently stunted and the impact of innovations in blockchain technology on the wider economy will be severely limited.
