The U.S. Securities and Exchange Commission (SEC) believes Ripple Labs violated federal securities laws in selling the XRP cryptocurrency to retail consumers.

According to a lawsuit filed Tuesday, Ripple raised $1.3 billion over a seven-year period to retail investors through its sale of XRP on an ongoing basis. Ripple CEO Brad Garlinghouse announced Monday that the SEC had told his company of the impending lawsuit, and published the payment firm’s Wells Response, a document that seeks to tell the SEC why certain activity did not violate U.S. securities laws.

The San Francisco-based fintech firm has long maintained that XRP the cryptocurrency is separate from Ripple the company. The cryptocurrency was often referred to as “ripple” through early 2018 and shared a logo with the company until later that year. 

The impact could be wide-ranging: several exchanges list XRP in the U.S., with only one deciding to delist the cryptocurrency ahead of the Tuesday lawsuit. If the SEC prevails, platforms that continued to list the crypto may have to register as securities exchanges.

According to the complaint, which names CEO Brad Garlinghouse and Chairman Chris Larsen in addition to Ripple Labs as defendants, Ripple violated Sections 5(a) and 5(c) of the Securities Act of 1933 by failing to register XRP as a security or seeking an exemption. 

“Over a years-long unregistered offering of securities (the ‘Offering’), Ripple was able to raise at least $1.38 billion by selling XRP without providing the type of financial and managerial information typically provided in registration statements and subsequent periodic and current filings,” the filing said. “Ripple used this money to fund its operations without disclosing how it was doing so, or the full extent of its payments to others to assist in its efforts to develop a ‘use’ for XRP and maintain XRP secondary trading markets.”

Ongoing debate

XRP’s status under U.S. securities law has been a subject of debate for several years. 

The Crypto Rating Council, a joint venture spearheaded by Coinbase and supported by cryptocurrency exchanges like Bittrex, Kraken and OKCoin, among other entities, assessed that XRP looked more like a security than a non-security. 

The group has specified that its ratings should not be taken as legal advice, but rather its members’ assessment of how different cryptocurrencies might fall within the U.S. regulatory umbrella. CrossTower, one of its members, delisted XRP earlier Tuesday after news of the lawsuit first came out, though other trading platforms have yet to weigh in on whether they’ll consider doing so. 

XRP allegedly being centralized through control by a single entity was even seen as an attractive aspect by some. Wall Street veteran Brian Kelly told CNBC in 2018 that, “I happen to like the fact that they have several banks using it and they have a company … that is out there trying to make the value of the currency go higher.”

On the other hand, former Commodity Futures Trading Commission (CFTC) Chairman Christopher Giancarlo has said that in his view, XRP should be “considered a currency or a medium of exchange,” not a security.

Giancarlo cited the Howey Test – a Supreme Court case that has been used as a chief standard for assessing whether or not something is a security – in his reasoning.

In short, Howey states that something is a security if it 1) is an investment of money in b) a common enterprise with c) a reasonable expectation of profits derived from the efforts of others. According to Giancarlo, XRP investors were not promised returns or a share of Ripple’s profits.

The SEC sees it differently.

“At all relevant times during the Offering, XRP was an investment contract and therefore a security subject to the registration requirements of the federal securities laws,” the lawsuit said. 

According to the SEC, the defendants allegedly said that the main reason someone might buy XRP is to speculate on its price, with the complaint quoting Ripple employees from as far back as 2013. 

“Similarly, in its official application to the NYDFS for XRP II in 2016, Ripple acknowledged that buyers were ‘purchasing XRP for speculative purposes,’” the complaint said.

Information asymmetry

Much of the SEC’s complaint contends that there was asymmetric information about XRP. The defendants allegedly “created an information vacuum” that let Ripple, Larsen and Garlinghouse sell XRP to a market that didn’t have a lot of information about the cryptocurrency. 

“Defendants continue to hold substantial amounts of XRP and – with no registration statement in effect – can 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 said.

David Schwartz, Ripple’s CTO, is cited in the complaint as saying that Ripple’s “publicly announced strategy” was to “do everything we can to maximize the price of XRP over at least the time it takes us to sell the XRP we have.”

“The people who created XRP are pretty much the same as the people who created Ripple and they created Ripple originally to, among other things, distribute XRP,” he said in a tweet (though he’s identified as “Cryptographer-1” in the complaint).

Ripple even knew that XRP may fulfill the requirements of being a security, the SEC claimed, saying the company received a pair of memos in 2012 from “an international law firm” which stated that there was some risk of this assessment. 

Many of the comments in the SEC complaint seem to match or are similar to statements used in a two-year-old investor lawsuit against the company.

The SEC also heavily cites internal emails and communications between Ripple employees and board members in its complaint. 

Part of this information vacuum is the fact that On-Demand Liquidity, a Ripple product which uses XRP, did not have organic or market-driven volume, the SEC alleged.

“Though Ripple touts ODL as a cheaper alternative to traditional payment rails, at least one money transmitter (the ‘Money Transmitter’) found it to be much more expensive and therefore not a product it wished to use without significant compensation from Ripple,” the complaint said.

It appears to be referring to MoneyGram; it said the majority of XRP trading on ODL between “early 2019 and July 2020” was conducted by the unnamed transmitter. Ripple took a stake in MoneyGram in June 2019 and as has been publicly disclosed, the payments firm has compensated MoneyGram for using XRP.

“Specifically, from 2019 through June 2020, Ripple paid the Money Transmitter 200 million XRP, which the Money Transmitter immediately monetized by selling XRP into the public market, typically on the very days it received XRP from Ripple. The Money Transmitter publicly disclosed earning over $52 million in fees and incentives from Ripple through September 2020,” the lawsuit said.

The amount matches details in MoneyGram’s public filings.

“Ripple and Garlinghouse did not disclose to XRP investors or the public the full extent of incentives that Ripple provided to the Money Transmitter in return for its assistance in increasing XRP trading volume,” the complaint said.

Political upheaval

The SEC’s lawsuit comes as the agency’s chief prepares to step down and the federal government undergoes a change in leadership. Chairman Jay Clayton previously announced he would leave his role at the end of the year, though a specific date has not been provided. 

SEC Enforcement Director Stephanie Avakian, who created the commission’s cyber unit, likewise plans to leave her role by year-end. Avakian is quoted in a press release saying, “We allege that Ripple, Larsen, and Garlinghouse failed to register their ongoing offer and sale of billions of XRP to retail investors, which deprived potential purchasers of adequate disclosures about XRP and Ripple’s business and other important long-standing protections that are fundamental to our robust public market system.”

This means incoming President Joe Biden may appoint an acting chair to oversee the commission while his nominee to run the agency for a full term makes their way through Congress. 

Garlinghouse has previously donated to the Biden for President campaign, as well as to the former presidential campaign of Vice President-elect Kamala Harris. In public statements, he’s indicated that he is waiting to see how the new administration might handle matters of crypto regulation. 

“I am optimistic that will actually improve where things sit for the XRP community broadly,” he told CNN’s Julia Chatterley earlier this month, when asked whether Ripple had made a decision on whether it was relocating its headquarters outside of the U.S.

Prior to the presidential election, Garlinghouse raised the possibility that Ripple could leave for greener pastures due to the lack of clarity from the SEC about XRP’s legal status. 

Read our ongoing coverage of the SEC’s case against Ripple and its impact on the industry.

UPDATE (Dec. 22, 2020, 22:05 UTC): Updated with additional context and details from the complaint.

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