The U.S. Securities & Exchange Commission (“SEC”) filed a complaint against Ripple Labs, Inc. (“Ripple”) and two of its executives, Brad Garlinghouse and Chris Larsen, on December 22, 2020 in the U.S. District Court for the Southern District of New York [1], alleging that sales of $1.3 billion of XRP by Ripple and the executives during a period ranging from 2013 through 2020 constitute an ongoing unregistered offering of securities in violation of Section 5 of the Securities Act of 1933, as amended. In a significant departure from prior actions by the SEC, the complaint names Ripple executives as individual defendants, both for their alleged direct offers and sales of Ripple’s XRP in violation of Section 5, as well as their role in allegedly aiding and abetting Ripple’s violation of securities laws. As new leadership prepares to take the helm at the SEC, likely under the leadership of former CFTC Chair Gary Gensler who was recently announced as President Biden’s nominee to chair the SEC, the industry must wait and see whether Gensler’s deep knowledge and familiarity with blockchain and digital assets will lead to a continuation of enforcement in the blockchain space under new leadership or if new rules and guidance will be on the horizon. And, if long-awaited guidance does emerge as a priority for the new Chair, will it be helpful or harmful to the industry?
The SEC’s Allegations against Ripple
The SEC filed its complaint in the Southern District of New York, a court where it has had recent successes against Kik and Telegram. [2] The complaint cites the issuance, sales and distributions of XRP by Ripple and its executives dating back to 2013. The SEC argues that Ripple, by failing to file a registration statement, “created an information vacuum such that Ripple and the two insiders with the most control over it — Larsen and Garlinghouse — could sell XRP into a market that possessed only the information Defendants chose to share about Ripple and XRP.” By controlling the flow of information, and using major announcements and messaging about XRP, the SEC alleges that Ripple and its executives were deemed to create the conditions of hype around XRP to “continue to monetize their XRP while using the information asymmetry they created in the market for their own gain, creating substantial risk to investors.” The complaint alleges that Ripple was dependent upon the sales of XRP to fund its operations, and was dependent upon its own efforts to develop a “use” and increase apparent demand for XRP. The SEC argues such efforts were designed to ensure an increase in price for Ripple’s own benefit since it must sell more XRP to fund ongoing operations, and for the benefit of purchasers of XRP, thus satisfying the expectation of profits from the efforts of others prongs of the Howey test continuously from the initial launch and sale to the most recent sales of XRP in the months prior to the filing of the complaint.
As it relates to the named executives specifically, the SEC cites to myriad interviews and selected quotes deemed by the agency to constitute ongoing promises of future value and undertakings by Ripple and its executives to underwrite and ensure that future value. More specific to the alleged wrongdoing by the defendants were statements by the executives indicating that they were “very long” on XRP, while at the same time selling their individual XRP holdings for significant profits, in some cases, the complaint alleges, even taking advantage of market responses to the information that they “selectively” shared with the market. These allegations concerning directly contrasting public statements and private sales may be why the SEC included the executives as named defendants in the complaint, a step not previously taken in Kik or Telegram or many other crypto-related settlement actions brought by the SEC that did not name any individual associated with the alleged issuer.
The complaint divides the alleged distributions of XRP among four categories: (1) market sales consisting of direct public sales via digital asset exchanges, at times using market makers; (2) public distributions through discounted sales of XRP to institutional investors the complaint alleges Ripple knew and expected would immediately resell the XRP into public secondary markets for guaranteed profits; (3) a catch-all category of “other distribution” including executive compensation plans, listing partnerships with digital asset exchanges and grant programs run by a Ripple affiliate in which grants were made to entities the SEC argues were expected to immediately resell XRP into public markets; and (4) direct sales by the named executives.
The complaint charges all defendants with allegedly offering and selling XRP in violation of Section 5, and charges the executives individually in connection with their role in allegedly aiding and abetting Ripple’s violation of securities laws. The SEC seeks injunctive relief, disgorgement with prejudgment interest, and civil penalties.
Familiar Themes
The SEC’s case against Ripple and its executives touches upon a number of common themes similar to those asserted in cases previously brought by the SEC in connection with distributions of digital assets. In particular, the complaint focuses on certain actions taken by the company and its executives as amounting to ongoing efforts of others that allegedly led purchasers to expect profits from such efforts. These familiar themes provide some insights on the SEC staff’s evolving views regarding digital assets and possible ways to avoid SEC scrutiny. These include the following.
- Token issuers should not tout, promote, promise or take action to secure future liquidity to purchasers, including exchange listings. The SEC complaint alleges that Ripple’s strategy to establish a use and acceptance of XRP as a “universal [digital] asset” relied upon Ripple first creating an active, liquid XRP secondary trading market. It alleges that Ripple took many steps to ensure development of a fulsome secondary market, such as utilizing market makers, identifying as many means as possible to increase the number of XRP in circulation and creating and supporting secondary market trading opportunities for the speculative investors the SEC argues were the target of Ripple’s sales and distributions. In particular, the SEC complaint focuses on Ripple’s specific agreements with digital asset exchanges and volume-linked incentive payments designed to encourage and demonstrate high volume, used by Ripple and its executives as evidence of increasing use and demand for XRP.
- The SEC complaint alleges that Ripple’s plan and strategy was to sell XRP to as many speculative investors as possible, that Ripple touted the potential future use of XRP and that Ripple and its executives sold XRP widely into the market to individuals who had no “use” for XRP. The SEC goes further to allege that XRP had no “use” at all at the time of such sales, or even at the time the complaint was filed. A factual dispute as to whether XRP has a bona fide “use” now and/or at the time of each offer and sale by Ripple and its executives will likely be an area of focus as the case proceeds. It is worth noting that the existence of speculation does not, in and of itself, cause something to be deemed a security. The SEC continues to overly associate the existence of some speculation as a hallmark of a security while even their own case makes clear that it is the absence of other/real uses that was problematic here. If the SEC’s argument is true, speculation was both the means and the ends. If the goals, strategy, and the driving force of XRP distributions are found to be solely speculation, that may prove to be problematic in the eyes of the court, but where speculation accompanies something that has a use or utility, the independent development of a speculative market does not transform that thing into a security. This is obvious as we look to designer purses, baseball cards, coveted sneakers or even non-fungible tokens, which all have a speculative secondary market and each of which are often purchased for investment rather than to wear or use, but the SEC has not yet deemed them to be securities.
- As in prior complaints and settlements from the SEC, the complaint cites basic economic principles of supply and demand as a sword against the issuer. The SEC supports its position that XRP sales were designed to encourage speculation and that Ripple would engage in ongoing efforts to ensure profits for purchasers of XRP with statements such as the one cited in paragraph 64 of the complaint that Ripple believed that the value and liquidity of XRP “will happen if the Ripple network is widely adopted as a payment system ... One would expect increased demand to increase price.” With a limited supply asset, Economics 101 (not even Cryptoeconomics 101) taught us all the increased demand of a limited supply asset will cause the price to increase. Characterizing statements to this effect as promises of profits — rather than statements of basic economic principles — seems to indicate the SEC’s preference for fixed price, unlimited supply token networks, which is consistent with the Division of Corporation Finance’s IMVU and Pocketful of Quarters No-Action Letters. [3] But limited supply and fungibility are the founding principles of crypto and essential to the realization of the potential of this technology. Satoshi’s launch of Bitcoin was in part a direct response to and an attempt to solve governments’ unlimited ability to print money. It is foundational to blockchain-based networks designed to be decentralized and autonomous that no founder, issuer or participant be positioned to unilaterally dilute the other participants, which allows for a hard-coded mechanism that incentivizes and rewards early adopters, contributors, developers and others that help to bootstrap a technology and collectively drive demand and is essential to ensure network effects of early adoption. The SEC’s reliance on such statements reflecting the market realities of supply and demand is at odds with these underlying principles.
Unexpected Focus — Executives Named as Defendants
In prior enforcement actions targeting digital asset distributions as illegal unregistered securities offerings, the SEC has typically only pursued action against the issuer of the digital asset. While often noting specific statements or actions by the respective CEOs or other sponsors of the digital asset issuer, the SEC has rarely named individuals associated with the issuer or the distribution as defendants.
It is therefore highly unusual that the SEC named two executives as defendants, but even more unusual is that they are charged not only with a primary violation of Section 5 in offering and selling securities themselves, but also with aiding and abetting Ripple’s violation of Section 5. The complaint characterizes the executives as key decision makers and participants in Ripple’s ongoing offering: as CEO Garlinghouse initiated the timing of market sales and approved the timing and amounts of the sales of XRP, and as chairman of the Board Larsen was consulted on such offers and sales; both were described as continuing to communicate with investors and others to encourage them to participate in certain projects Ripple is pursuing. Additionally, the SEC claims that Garlinghouse sold over 321 million XRP generating approximately $150 million from the sales, and that Larsen and his wife sold over 1.7 billion XRP via public markets, netting at least $450 million from the sales. One difference may be that in both Kik and Telegram, it was not alleged that any of the executive officers had sold any of the related digital assets, which may explain why those individuals were not named individually, despite allegations of statements along the same lines as those noted in the complaint to have been made by the executives. Recently, in a settlement involving sales of a SAFT that alleged material misstatements and omissions made by executive officers in connection with the SAFT offering, only the issuer of the SAFTs, and not the related individual officers, were named in the SEC’s action and ultimate settlement. [4] Here, where the complaint does not allege fraud or misrepresentations, but rather relies only on general claims of information asymmetry caused by selective releases of information by Ripple and its executives, it is difficult to discern why the SEC has brought claims against the individual defendants.
It is possible that the SEC took particular issue with what the SEC’s complaint characterizes as statements by the executives signaling long term alignment with the market while the executives were, at the same time, selling large amounts of XRP for significant profits without disclosure, given the complaint’s focus on information asymmetry. If the XRP distributions had been registered, a number of different investor protection and disclosure obligations covering executive buying and selling activity such as Section 16, restricted trading windows following material announcements and general prohibitions on insider trading would have applied, and trades might have been prohibited or required disclosures would have remedied the alleged bad actions of Larsen and Garlinghouse.
Signals Ahead
The complaint against Ripple was filed just a day before Chair Jay Clayton resigned, and the industry will be watching for signals of whether more enforcement actions loom under new leadership at the SEC and other financial regulators. The Biden administration announced on January 17, 2021 that President Biden intends to nominate Gary Gensler to chair the SEC. Gensler led the CFTC during the Obama administration from 2009 to 2014. During Gensler’s tenure, he is credited with bringing many big banks to account in the aftermath of the 2008 financial crisis and helping to draft portions of the Dodd-Frank Act. More recently Gensler has been a regular at crypto conferences and on Capitol Hill [5] discussing cryptocurrencies and blockchain technologies. He took an active interest in the technology following his tenure at the CFTC, and he has closely studied the space, often expressing his views on the technology and its regulatory intersects. While there is no doubt that Gensler is well-versed in the technology, it remains to be seen whether crypto-savvy will translate into crypto-friendly if he is at the helm of the SEC.
Equally important, if approved to lead the SEC, Gensler will need to immediately fill director roles in both the Division of Enforcement and the Division of Corporation Finance (among other high level staff positions), both of which have been active in shaping the policies that have influenced the industry. The new directors, and the new Chair, will be important in determining whether the Division of Enforcement will have both appetite within the agency and support among the commissioners to continue to bring actions such as that brought against Ripple and its executives. Will new technologies be a focus for the Commission or will Gensler renew his focus on Wall Street and “big banks” as a priority? A new director of the Division of Corporation Finance will likely help set the rulemaking agenda and establish priorities for guidance for the financial industry, including emerging technology’s role within the financial industry. The rulemaking agenda was left somewhat cleared by virtue of Chair Clayton’s push to complete many Dodd-Frank mandated rulemakings during his tenure, so the agenda may have room to tackle a regime for digital assets. Under Gensler’s leadership, however, any proposed regime may be unlikely to resemble the flexible framework previously suggested by Commissioner Pierce, which leaves open the risk that the industry’s long-awaited and eagerly-sought guidance may be more of an impediment to adoption and innovation than the gray area that currently governs.
[1] Complaint, SEC v. Ripple Labs, Inc., No. 20-cv-10832 (S.D.N.Y. Dec. 22, 2020)
[2] SEC v. Kik Interactive Inc. No: 1:19-cv-5244-AKH, 2020 WL 5819770 (S.D.N.Y., Sept. 30, 2020) (opinion and order granting motion for summary judgment). SEC v. Telegram Group Inc., 448 F. Supp. 3d 352 (S.D.N.Y 2020) (opinion and order granting preliminary injunction)
[3] IMVU, Inc., SEC Staff No-Action Letter (November 19, 2020); Pocketful of Quarters, Inc., SEC Staff No-Action Letter (July 25, 2019).
[4] In the Matter of Wireline, Inc. Release No. 10920 (January 15, 2021).
[5] Mr. Gensler testified before the House Committee on Agriculture during the July 18, 2018 hearing “Cryptocurrencies: Overview of New Assets in the Digital Age”. Written testimony available at https://docs.house.gov/meetings/AG/AG00/20180718/108562/HHRG-115-AG00-Wstate-GenslerG-20180718.pdf.