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Ripple case seen as precedent for cryptocurrency regulation

SEC remained silent as the market for the digital coin developed

Garlinghouse, the Ripple CEO shown here speaking at TechCrunch Disrupt SF 2018, has been sued by the SEC for failing to register the digital coin offering as a security.
Garlinghouse, the Ripple CEO shown here speaking at TechCrunch Disrupt SF 2018, has been sued by the SEC for failing to register the digital coin offering as a security. (Steve Jennings/Getty Images for TechCrunch)

Cryptocurrency experts are closely watching a legal battle between Ripple Labs Inc. and the Securities and Exchange Commission, anticipating the case could establish precedent and clarify the regulatory landscape for digital coin offerings.

The SEC last year sued the company, CEO Brad Garlinghouse and Executive Chairman Chris Larsen in the U.S. District Court for the Southern District of New York, alleging they should have registered XRP under securities law. Ripple and its executives have asked the court to dismiss the case.

Ripple scored wins in preliminary rulings in the federal court, including gaining access to internal SEC documents and shielding its executives’ personal bank records from discovery. Holders of Ripple’s XRP cryptocurrency at issue in the litigation were also granted permission in April to intervene in the case.

Those wins don’t necessarily foreshadow a victory for Ripple, but the case is on track to establish legal precedent for the SEC’s authority over digital coin offerings, according to Drew Hinkes, a lawyer at Carlton Fields PA in Miami who works on cryptocurrency matters.

“This is a significant case,” Hinkes said in an interview with CQ Roll Call. “Ripple has tremendous financial resources, has assembled an incredible team of well-respected lawyers and has one of the most high-profile projects in the industry.”

Most securities enforcement actions end up resolved with a settlement, but the deep resources and firm positions on each side could take this case to the 2nd U.S. Circuit Court of Appeals, or eventually the Supreme Court, and provide the industry more reliable guidance than the current mix of district court decisions, settlements and nonbinding statements from agency officials, Hinkes said.

“The 2nd Circuit is incredibly sophisticated in this area, and it will be very interesting to see how they rule on these keystone issues,” said Hinkes, who teaches part time at New York University’s law and business schools. The 2nd Circuit is based in New York.

Suit over registration

San Francisco-based Ripple was founded in 2012 and offers a real-time payment settlement network based on blockchain technology. Since its formation, the fintech has raised $1.38 billion from the sale of more than 14 billion units of its digital coin called XRP, according to court documents.

XRP is the world’s fourth-largest cryptocurrency today, with a $70 billion market value.

The SEC says XRP meets the definition of a security because it’s an investment contract, the test articulated in 1946 by the Supreme Court in a case called SEC v. Howey. “Section 5 of the Securities Act is all embracing,” the agency wrote in the complaint.

The SEC wants to focus the dispute narrowly on whether XRP meets that long-standing definition, according to Thomas Gorman, a securities lawyer at Dorsey and Whitney LLP in Washington and former senior counsel in the agency’s enforcement division.

If money is pooled, and the investors are expecting to share profits, it’s probably a security subject to registration, Gorman told CQ Roll Call.

Ripple says XRP isn’t an investment contract but a medium of exchange, like cash or other cryptocurrencies. It cited a settlement in 2015 with the Justice Department and the Treasury Department’s Financial Crimes Enforcement Network that required the company to register as a money services business.

The cryptocurrencies bitcoin and ether were determined by the SEC to be commodities, not securities, in recent years, and the SEC doesn‘t have jurisdiction over them. Ripple wants to know more about that decision and was granted access in the court case to internal documents on how the agency concluded that XRP should be treated differently.

Ripple and the executives say the SEC failed to demonstrate that the company should have known XRP was subject to registration and because the agency remained silent for years while “a massive global trading market” built up around XRP, according to court filings.

Unfair delay can be a persuasive argument, Linda Jeng, an adjunct professor at Georgetown Law and former SEC lawyer, said in an interview.

“As a former regulator, I am disappointed to see the SEC wait so many years after the introduction of a product to launch an enforcement action,” said Jeng, who is also global head of policy at fintech startup Transparent.

Regulators should always apply their power thoughtfully and proportionally, and it should be predictable, Jeng said. When the agency waits this long to pursue an action, it makes them look arbitrary and chips away at their credibility, she said.

Hinkes also found Ripple’s arguments to be “very sympathetic” and said the agency’s delay and different classification of other coins undermines the government’s position that Ripple executives should have known XRP had to be registered as a security and recklessly disregarded the obligation.

Still, he cautioned that doesn’t mean the agency lacks authority to bring the case. The SEC has broad enforcement discretion, and it appears to be filed within the statute of limitations, Hinkes said.

Increasingly broad

Gorman predicted the court will focus its decision on the investment contract analysis and downplay delays in bringing the action.

The SEC has been increasingly broad in recent years as to what constitutes intent to pool an investment, so greater clarity on that issue would be beneficial, Gorman said. As for Ripple’s preliminary discovery wins, Gorman said the judge may be granting Ripple broad access because the case is likely to be scrutinized on appeal. 

Experts don’t anticipate any surprises when the SEC turns over internal memos, but industry insiders would be interested to take a peek behind the regulator’s veil.

“To my knowledge, these documents have not been publicly disclosed before,” Hinkes said. “Though it’s unclear whether they’ll be made public here, I imagine many in our industry would find those interesting.”

Leadership transition

The SEC filed suit against Ripple on Dec. 22, 2020, the day before former Chairman Jay Clayton’s resignation, and some noticed the timing.

“It made it seem more political,” Jeng said, also noting that Ripple is the largest cryptocurrency issuer the agency has gone after in recent years. Regulators should never appear political and must consistently apply the law to maintain credibility, she said.

The SEC didn’t respond to a request for comment.

Some think new SEC Chairman Gary Gensler, who has an interest in digital assets, is poised to launch a broader effort to clarify the regulatory landscape for cryptocurrencies. They don’t necessarily expect the agency to abandon the Ripple case or rush to settle under Gensler.

“I think the SEC has already headed down this path and they’re not turning back,” Jeng said.

Ripple isn’t backing down either, according to General Counsel Stuart Alderoty. 

“The SEC is out of step with the rest of the world,” Alderoty told CQ Roll Call. “This is much bigger than Ripple. It’s about the future of digital assets in the U.S.”

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