Analyzing XRP court documents: Why XRP has not escaped securities risks in the cryptocurrency market

Table of Contents

Too Long Didn't Read (TL;DR)

• The court determines whether the sales scenario of XRP meets the definition of an investment contract, regardless of whether XRP has the characteristics of a commodity or currency.
• The SEC sues Ripple Labs, Bradley Garlinghouse, and Christian A. Larsen for violating Section 5 of the Securities Act by conducting illegal securities sales. Some of the claims by both parties were approved, while others were rejected.
• Court documents from July 13, 2023, show that only institutional sales involve an investment contract, offering and selling unregistered securities illegally.
• Ripple Labs' planned sales through exchanges were not deemed to meet the criteria for an investment contract.
• Ripple did not emerge entirely victorious, as most issuers engage in similar institutional sales like XRP and marketing activities aimed at profit.

Why Did the SEC Sue Ripple? Selling and Offering Unregistered Securities

The SEC alleges that Ripple Labs, co-founder Christian A. Larsen, and Ripple Labs CEO Bradley Garlinghouse did not register any sales or offerings of XRP.

Ripple did not publicly submit any financial statements or other periodic reports to the SEC, nor did it submit any information related to Ripple or XRP to the EDGAR SEC electronic database, such as Form 10-Q quarterly reports, Form 10-K annual reports, or Form 8-K significant event filings.

The SEC accuses Ripple of conducting XRP transactions from 2013 to 2020 without registration, totaling over $2 billion. The lawsuit, initiated on December 22, 2020, is still ongoing.

Key Determinant of Securities: How Was XRP Sold?

In the court documents of July 13, 2023, the judge categorizes the defendant's actions as per the SEC's charges into four main types, with the only relevant one being "institutional sales," involving the offering and sale of unregistered securities.

The judge emphasizes that the focus is not on the nature of XRP but on the overall circumstances of its issuance and sale to determine if it qualifies as an investment contract.

This aligns with the Howey Test, a standard for assessing investment contracts in many cases, regardless of whether XRP possesses certain characteristics of a commodity or currency, it could still be offered or sold as an investment contract.

Here are the four scenarios of XRP issuance and sale as summarized by the court:

Institutional Sale

Ripple directly sells XRP to specific entities through its wholly-owned subsidiaries, primarily institutional buyers, hedge funds, and ODL clients.

The SEC alleges that Ripple sold approximately $7.289 billion worth of XRP in these institutional sales.

Programmatic Sale

Ripple systematically sells XRP on digital asset exchanges or through sales using trading algorithms. XRP sales on these exchanges occur in a "counterparty-agnostic" manner, where Ripple does not know who is buying XRP, and buyers do not know who is selling.

The SEC accuses Ripple of selling around $7.576 billion worth of XRP in these programmatic sales.

Other Sales: Service Payments, etc.

Ripple distributes XRP in the form of service payments. For example, Ripple provides XRP to employees as compensation and distributes XRP through its "Xpring Initiative" to fund third parties developing new applications related to XRP and the XRP Ledger.

The SEC accuses Ripple of generating $609 million in revenue by distributing XRP to individuals and entities providing services.

Executive Individual Sales

Ripple co-founder Christian A. Larsen and Ripple CEO Bradley Garlinghouse sell XRP through personal capacities.

The SEC alleges that Larsen made profits of at least $4.5 billion through planned sales on exchanges, while Garlinghouse similarly made profits of around $1.5 billion through sales on exchanges and received XRP as compensation.

Reasons for XRP Sales Behavior Being Classified as Securities

XRP Institutional Sale Meets Securities Criteria ◎

The judge deems XRP's institutional sales as providing capital since enterprises exchange legal tender or other currencies for XRP from Ripple, meeting the first element of the Howey Test. The judge also notes that Ripple controls and uses the proceeds from institutional sales, even though they are held in various subsidiary accounts. Ripple utilizes the funds from institutional sales to promote and enhance the value of XRP, develop XRP applications, and safeguard the XRP trading market, achieving "horizontal commonality," where investors' assets are pooled to share profits and risks. This aligns with the second element of the Howey Test, investing in a common enterprise. The third element, the expectation of profit, is seen through Ripple's communications, marketing activities, and the nature of institutional sales, where rational investors understand that Ripple will use the capital from institutional sales to enhance the XRP market and develop applications, thereby increasing XRP's value.

The judge cites many promises made by Ripple in past market reports and price impacts, such as: "Ripple CEO Garlinghouse once said, 'For Ripple to do well, we have to do very well in protecting the value of XRP and network value,' and urged potential investors to give Ripple 'time' to 'add the maximum value to the protocol.' Many statements by Ripple executives led the judge to believe that institutional buyers understood the speculative value of XRP.

Moreover, the judge points out that there are many contractual terms in institutional sales supporting their investment nature. For instance, some institutional buyers agree to lock or resell based on XRP's trading volume. The judge believes that if XRP were merely a currency for payment purposes, rational economic actors would not agree to freeze millions of dollars. Thus, institutional sales entirely comply with Section 5 of the US Securities Act, conducting illegal securities sales.

XRP Programmatic Sale Does Not Meet Securities Criteria ×

In the context of programmatic sales, the court finds that Ripple knew people viewed XRP as speculative, targeting speculators and aiming to increase speculative trading volume. Selling XRP on exchanges occurs in a "counterparty-agnostic" manner.

While many buyers on exchanges under programmatic sales expect profits from Ripple, they cannot attribute this expectation to Ripple's efforts since these buyers do not know they are purchasing XRP from Ripple. Therefore, it does not meet the third element of the Howey Test, "expectation of profit based on Ripple's efforts."

Additionally, programmatic sales differ from institutional sales as they lack restrictions like lockups or resale common in institutional sales, and Ripple's promotional materials are not widely disseminated to the general public. The judge also believes that buyers in programmatic sales are less sophisticated than institutional buyers in their understanding of information and expectations.

Other XRP Sales by Ripple Do Not Meet Securities Criteria ×

In the SEC's allegations against Ripple for other types of sales, the court ruled against it. The SEC accused Ripple of transferring XRP to third parties, who then sold XRP on the public market to fund their projects. However, the court found no specific evidence indicating that these third parties, after receiving XRP from Ripple, paid money back to Ripple or engaged in any concrete exchange.

Therefore, it does not meet the first element of the Howey Test, "providing capital."

XRP Executive Individual Sales Do Not Meet Securities Criteria ×

Although Section 4a1 of the Securities Act exempts transactions conducted by persons other than issuers, underwriters, or dealers from securities registration, the SEC argues that co-founder Christian A. Larsen and Ripple Labs CEO Bradley Garlinghouse are "affiliates" of Ripple and are not exempt.

The judge believes this issue does not warrant discussion, similar to the reasons for programmatic sales. Since both executives engaged in planned sales on exchanges, where buyers and sellers do not know each other's identities, it does not meet the third element of the Howey Test.

Ripple Not Completely Victorious, Crypto Community Also Affected

Ripple Labs did not prevail entirely, as the court only determined that institutional sales involved unregistered securities, while other behaviors were not classified as unregistered securities due to their secondary market transactions or lack of direct investment benefits. However, Ripple Labs still faces penalties related to institutional sales.

Most Cryptocurrencies Involve Institutional Investment Agreements

The court finds that institutional sales in the SEC's allegations, in terms of contract formation and information provision, fully meet the definition of the Howey Test, providing unregistered securities. In many of today's cryptocurrency startups, most involve early institutional participation, with contract conditions and issuer statements similar to Ripple Labs. If these startups' institutional sales involve US citizens, then the SEC's enforcement actions have already been preliminarily validated by the court.

In this document, the judge also uses the Telegram fundraising case as an example to explain similar sales behaviors. The case ultimately settled with the SEC, with Telegram being fined $18.5 million and required to notify before issuing any tokens within three years.

Good News! Exchange Dumping Tokens Not an Issue?

The court believes that Ripple Labs' programmatic sales, conducted in a manner where buyers and sellers do not know each other, do not constitute the definition of expecting profit in the Howey Test. This reduces risks for cryptocurrency issuing companies when liquidating tokens in the secondary market.

Bad News! Ripple's Attempt to Narrow the Definition of Howey Test Fails

In addition to the broad interpretive space of the four conditions of the Howey Test, Ripple Labs also attempted to propose some necessary conditions for an investment contract to make the criteria for determining investment contracts more stringent, known as the "Essential Ingredients Test." Unfortunately, it was not adopted by the court.

The "Essential Ingredients Test" consists of three conditions:

1. An agreement established between promoters and investors, determining investors' rights to the investment
2. The agreement gives promoters the responsibility to take concrete action for investors' benefit after the sale
3. Empowers investors and promoters to share profits generated from investor funds

Conclusion: The Crypto Community Cannot Evade SEC's Scrutiny

Reviewing the lawsuit filed by the SEC against Binance, detailed accounts of securities allegations for various tokens reveal that the SEC lists marketing activities, expectations of profit, and establishing investment relationships for different token issuers. Several involve providing or selling tokens to institutions. If institutional sales, like those in the XRP case, establish unregistered securities, these tokens may also find it challenging to escape scrutiny.

Explanation of XRP Case Terminology

ODL

On-demand liquidity, one of the functions of RippleNet, uses XRP as a medium to exchange different fiat currencies, facilitating cross-border remittances. ODL is one of the services utilizing Ripple's distributed ledger and XRP.

Howey Test

Whether a financial product constitutes an "investment contract," a type of security, is determined by the "Howey Test," established in 1946 when the SEC sued Howey Company. It includes:

• Capital investment
• Investing in a common enterprise
• Expectation of profit
• No direct participation in operations, relying solely on promoters or third parties for returns

Section 5 of the US Securities Act of 1933

Under the Securities Act Section 5, all issuers must register non-exempt securities with the Securities and Exchange Commission (SEC).