The long-awaited regulatory framework in the crypto industry may begin with the final resolution of the SEC v. Ripple case

Original title: SEC vs Ripple: Inside the Case That Could Make or Break the Crypto Industry

Source: Decrypt

By Jeff John Roberts

Compiled and edited by Chen Zou

The outcome of an investigation into the U.S. Securities and Exchange Commission’s (SEC) case against Ripple suggests that no matter which way the scales tip, the loser will suffer significant losses as a result of the case.

Ripple's loss could mean it loses its XRP completely, while the SEC's loss comes at the cost of its credibility. Most lawyers currently believe that the SEC has the upper hand, but no one is fully confident that it can win completely.

Brad Garlinghouse and Chris Larsen's digital currency company Ripple was soaring in the first cryptocurrency bull market in many years in 2020. However, on December 22, Ripple faced its own nightmare - the SEC.

In a complaint letter, the SEC stated that Ripple Labs violated securities laws by selling unregistered securities. The news directly "burned" Ripple's XRP market value of nearly $14 billion. Many crypto trading platforms have removed XRP from their shelves, which is quite similar to the current situation of many platforms besieging Binance. Not only the market value, but also the market reputation of XRP has suffered a serious blow due to the lawsuit.

"It's certainly been a difficult holiday season," Garlinghouse said. "I've always thought I was doing the right thing, but the U.S. government has asserted in an inflammatory way that you're playing dirty."

For many years, XRP has occupied the third place in the cryptocurrency market, following Bitcoin and Ethereum. The company has established relationships with major banks and accumulated a group of loyal fans. But under the disclosure of the SEC, XRP does not seem to be as glamorous as it seems. Is the coin just a beautiful scam used by Brad Garlinghouse and Chris Larsen to harvest capital? The crypto market will soon find the answer as the case goes to trial.

Meanwhile, Ripple has taken an unusual tactic by confronting the SEC head-on, rather than quietly settling, as most companies would do, even hiring elite legal talent and promising to take the case to the Supreme Court.

For the SEC, the Ripple case is a test of strength. If the agency wins, the SEC will certainly bring new troubles to other cryptocurrency companies. If it loses, the result may mean a significant weakening of the SEC's credibility.

Born in the Bitcoin era

Ripple was originally called OpenCoin and was founded by a group of programmers, including Jed McCaleb. McCaleb is a pioneer in cryptocurrency, and also created the cryptocurrency Stellar and Mt.Gox, which later grew into the world's largest Bitcoin exchange, but was quickly crushed by the wheels of the times after a hacker attack. McCaleb's team founded the predecessor of Ripple in 2011, and Larsen soon joined the team.

In 2012, the team created a company called Ripple Labs and made a digital currency called XRP (originally called "Ripple") its native token. Unlike the slow minting of Bitcoin and Ethereum, XRP does not rely on miners to create and distribute its tokens. Instead, Ripple's founders chose to control the supply of XRP themselves - 100 billion XRP. This also posed a difficult problem for Ripple's founders: how to convince people of the real demand for the 100 billion XRP they created?

The two largest cryptocurrencies have already solved this problem. In the case of Bitcoin, it enjoys a special status as the original cryptocurrency, and its relative scarcity — there will only ever be 21 million bitcoins — makes it a store of value that its fans liken to “digital gold.” Meanwhile, on Ethereum, millions of users use its currency to pay gas fees to power smart contract transactions.

XRP’s purpose is decidedly less clear. Like other tokens, XRP is tracked on a blockchain ledger, with software nodes around the world verifying its transactions. The ledger is versatile, built by top cryptographers, and highly regarded in the industry. Even XRP skeptics, such as cryptocurrency analyst Ryan Selkis, who labeled XRP “toxic waste” in his annual report, praise the performance of the ledger system itself.

Ripple still owns most of those 100 billion XRP, and the challenge it faces is proving that all of those tokens can actually be useful.

Ripple has been trying to do this for years. Its efforts included convincing banks in 2015 to pay XRP transaction fees while transferring funds on the XRP ledger. But this proved impossible, as banks made it clear that they liked the ledger system, but not XRP. Ripple responded by creating a new distributed ledger product called xCurrent, which is similar to the original distributed ledger product and lets banks send messages and transfer funds, but without using XRP.

Ironically, xCurrent may be Ripple’s most successful product to date, bringing in over $23 million in revenue and positioning the company for success as a traditional SaaS (software as a service) company. But that doesn’t solve the market problem for the billions of XRP sitting on Ripple’s digital shelves.

After failing to convince banks to use XRP, a former employee recalled that Ripple began exploring various possible use cases for the currency, including XRP cards that customers could use at gas stations. Ripple denied the gas card anecdote, but it’s clear that the company was trying to find some logical outlet for all that XRP at this point.

When Garlinghouse was named CEO of Ripple in late 2016, he made the same diagnosis he had made at Yahoo. Ripple needed a killer use case, not dozens of experimental ones. The solution he found was to pitch XRP to banks and other institutions as a “bridge currency” to facilitate global money transfers between smaller national currencies.

According to Garlinghouse's "bridge" theory, banks will accept XRP for international transfers because it will eliminate the need to maintain reserves of small currencies like the Philippine peso, which obviously tie up banks' capital. To implement this plan, Ripple convinced a network of money transmitters to handle XRP, which means that the banks themselves only need to hold the currency temporarily. In theory, all this activity will increase liquidity and ultimately drive XRP's price up.

It was a complicated plan. To stimulate it, Brad Garlinghouse and Chris Larsen negotiated with large global banks such as Santander and remittance institutions such as MoneyGram. Ripple even bought a 10% stake in MoneyGram to encourage the company to use XRP in its business.

The bridge currency initiative involved another new product called xRapid, later renamed xVia, which behaved similarly to xCurrent but also facilitated some liquidity for XRP (the distinction between the various “x” products had been a source of confusion for many outside the company).

Meanwhile, Ripple has taken on the trappings of a major financial company. It has opened offices in global money centers, including London and Singapore. It has hired entertainers like Snoop Dogg to host a dinner in Toronto, where rock legend Steve Miller was invited to sing “Joker” and other songs.

All of this helped spur XRP to new heights. Whether due to Garlinghouse’s efforts or the broader cryptocurrency bubble of 2017 (or most likely both), XRP’s price surged from less than a cent in 2016 to $3 in January 2018.

At the time, XRP looked and acted like a big bank. Garlinghouse worked hard to promote that image, appearing at serious financial events and on television in an elegant gray suit. But in reality the company was still struggling to find a way forward for XRP.

Unfortunately for Ripple, the SEC doesn’t see the company that way at all. The agency sees only one giant scam, using fancy financial tricks to trick investors into buying XRP (in a security-like form). The SEC filed a lawsuit on December 22, bringing down the hammer on Ripple and taking the unusual step of naming Larsen and Garlinghouse as defendants. The agency alleges that the two men and their companies made billions of dollars by selling unlicensed securities to the public.

The SEC complaint caused XRP’s price to drop from around 58 cents to 21 cents in late December, though it has rebounded in a year that has been a big year for cryptocurrencies overall.

The Case Against Ripple. Executives Talk Up XRP While Quietly Selling Billions

Garlinghouse has said the lawsuit left him frustrated but also puzzled. The SEC filed the charges in the final days of the Trump administration, days after both Jay Clayton, the agency’s chairman, and Marc Berger, its top enforcement official, announced they were leaving their jobs early. Garlinghouse recalled asking himself, “Is this somehow personal?”

Larsen and Garlinghouse both expressed a sense of bewilderment and sadness about the SEC’s lawsuit, but that doesn’t change the point. The agency has been investigating Ripple since 2017, and its executives have been held up by lawsuits that forced them to preserve emails and other documents for years.

The company they run is ruthless in protecting its interests. When executives leave Ripple, they receive generous severance packages, but must sign terrible nondisclosure agreements in return. This strategy makes it difficult for journalists and others to understand what is really going on inside Ripple.

However, the SEC has made it clear that it understands what Ripple is up to. And some of its allegations are damning. In a 70-page complaint filed in federal court in Manhattan, the agency claims that Ripple’s corporate trappings are a cover for its true purpose: Ripple is simply trying to market the highly speculative XRP token, which the SEC believes should be classified as a security in the public interest.

The SEC said in its complaint that the only reason payment institutions use XRP as a "bridge currency" is because Ripple pays them. This applies to MoneyGram, the remittance giant in which Ripple holds a stake and was briefly a key collaborator in its "bridge strategy."

Garlinghouse told CNN that "when MoneyGram moved money from dollars to Mexican pesos, they bought [XRP] at market price, and there was no special private transaction behind it." But the SEC said that was not true, noting that Ripple gave MoneyGram more than 200 million XRP, most of which the company sold on the same day it received them. Ripple and MoneyGram severed their relationship in March.

The SEC also described Ripple’s bridge currency strategy as a failed plan, noting that only 15 payment institutions participated, no banks at all, and that in two years, the “bridge” program’s transaction volume never accounted for more than 1.6% of the total XRP volume.

The SEC also mentioned that during this period, Ripple forced XRP into the market through insider trading with large trading firms such as Jump Capital and Galaxy Capital. Under the terms of these deals, Ripple would sell its reserve XRP at a discount of 4% to 30%, allowing buyers to quickly sell their purchases on the open market for a guaranteed profit. In some cases, Ripple would even require trading firms to time their XRP purchase orders to coincide with company announcements.

Meanwhile, Ripple is also trying to use cash to get other companies to use XRP. In an email to the Winklevoss twins, who founded the exchange Gemini, a Ripple executive wrote, copying Garlinghouse, “Would $1 million in cash move the price in Q3?” (Ultimately Gemini rejected the offer).

The SEC believes that Ripple has pursued a sordid scheme to create demand for XRP out of thin air, on which the company’s revenue depends almost entirely.

For Larsen’s part, the SEC notes that he quietly sold $450 million worth of XRP, and in another swipe, noted that his previous company was embroiled in a lawsuit for selling unlicensed securities. “As he sold millions of XRP, Garlinghouse frequently told investors that he was invested in XRP and that he was bullish on the investment… He also encouraged investors to be patient and take a longer-term view of the price of XRP,” it also cites Garlinghouse, who pocketed $150 million from the sale of XRP, publicly saying that he was “only long XRP.”

But Garlinghouse and Larsen aren’t the only ones facing tough questions — the SEC is also in trouble

The SEC is arguably one of the most complex agencies in Washington, charged with overseeing a financial industry of staggering complexity. It has largely held its own despite the fact that many of the companies it regulates have wealth and technology far beyond what a single government agency could possibly accomplish.

The SEC relies on a team of securities lawyers, economists and, increasingly, software experts to help it track high-frequency traders, insider traders and all manner of financial scams. But when it comes to cryptocurrencies, the SEC has been a little slow.

The SEC stood by until mid-2017, when so-called initial coin offerings, or ICOs, fueled one of the biggest financial bubbles in history. ICOs let companies raise money, just as they would from an IPO, but instead of handing out shares, they distributed digital tokens to backers.

In theory, people who buy tokens distributed in an ICO can use them to participate in future blockchain projects. This is indeed what happened in some ICOs, including Ethereum’s ICO, which let users use its tokens as transaction fees to perform various tasks. But in the case of most other ICOs, most of them have faced technical difficulties or poor leadership, and some projects may not even have built a blockchain. Or they are outright scams from the beginning.

By 2017, scams or near-scam projects had siphoned billions of dollars from regular investors hoping to invest in the "next Bitcoin." In August of that year, the SEC finally took action, releasing a report that determined that a 2015 blockchain-based investment project called The DAO was a securities offering. While the report stated that the SEC would not take any action against the organizers of The DAO, the document was a warning to the entire cryptocurrency industry, essentially saying "Stop doing ICOs or we'll come after you."

And that’s exactly what the SEC did. In early 2018, the agency announced settlements against two small-scale cryptocurrency projects. Then, it began moving up the food chain. In 2019, the SEC forced two popular messaging platforms, Kik and Telegram, to hand over the money they earned from ICO projects, and laid out its reasons in a court-approved settlement.

According to Peter Fox, a securities attorney who specializes in cryptocurrency cases, the funds from the Kik and Telegram settlements provide ample ammunition for a larger target of the SEC: Ripple. It is no coincidence that the SEC chose the same court and legal team for all three cases.

Preston Byrne, a partner at cryptocurrency law firm Anderson Kill, agreed with the assessment that the Kik and Telegram cases were just a warm-up for the SEC. "This explains why the SEC waited to go after Ripple," the case was too big and they needed another ruling from the Southern District of New York to solidify their legal position.

By 2019, the SEC believed it had legal precedent to force Ripple to settle, but the company chose to reject the settlement. Ripple’s defenders saw it as a principled and courageous stance, while opponents said it was simply a stunt to continue selling XRP for a while longer.

Whatever Ripple’s motivations, the SEC finally filed a lawsuit on December 22. “When it takes this long to get a case out, you shouldn’t file a lawsuit. It’s not something I would do, so I’m leaving,” said former SEC Chair Mary Jo White.

Mary Jo White is a towering figure in American legal circles. In addition to her successful tenure at the SEC, she was previously the U.S. Attorney for the Southern District of New York—a job that entailed prosecuting high-profile cases involving terrorism and white-collar crime.

Today, White has become one of many gilded lawyers under Ripple. According to American Banker, Ripple has hired more than two dozen well-known lawyers for its defense, and its two executives have each hired at least six top lawyers, who can charge $2,000 per hour. As for the SEC, it only has seven lawyers responsible for Ripple's case.

It’s unclear how much all this legal muscle will help Ripple. Steven Palley, a cryptocurrency lawyer at Anderson Kill, is skeptical. “Hiring Mary Jo White makes no sense, it just means Ripple has a lot of money, you can hire a fancy law firm, you can get stuff leaked from the hearing… but the law is the law.”

White’s role as Ripple’s lawyer means it’s hard to be objective about the case, but her comments about the timing of the SEC’s lawsuit make sense. Unlike Kik or Telegram, which sold tokens in 2017 and 2018, Ripple conducted its first sale in 2012, long before the SEC’s DAO report warned of a crackdown and before Ethereum (which the agency says is not a security) even existed.

Josh Mitts, a securities law professor at Columbia University who has no ties to either party, questioned the SEC’s judgment in waiting so long to prosecute. “It’s a huge drag on innovation. If you try to invent something and seven years later it could lead to a lawsuit, it’s going to have a huge chilling effect.”

The SEC’s eight-year delay in prosecuting Ripple raises questions of fairness, but the agency justified the delay by characterizing the company’s actions as an ICO — part of an ongoing determination that its recent XRP sales violated securities laws.

The SEC's "Freewheeling" Legal Test

The agency has also raised eyebrows in its dealings with Ethereum. In 2018, a senior official at the agency gave a speech saying that Ethereum sales did not constitute securities violations because the project had become "sufficiently decentralized." But this also raised the question of why other projects, including Ripple, could not do the same. At the same time, the SEC has also failed to provide more effective guidance on how or when something crosses the "decentralized" standard.

The SEC’s Ethereum decision was cheered in cryptocurrency circles. But it puzzled many lawyers because the decision ignored a 1946 Supreme Court test known as the Howey test, which is the cornerstone of modern securities law and is applied to all business transactions.

“The ‘sufficient decentralization’ test is the worst piece of made-up law I’ve ever seen,” said Byrne, the Anderson Kill attorney. “The really simple test that everyone knows is the Howey test.”

Given that the SEC set up a fake ICO website called Howey Coins in 2018 (pictured below) to warn gullible investors about token issuance issues, the SEC’s use of the “decentralization” standard test is less convincing.

Meanwhile, Bill Hinman has a potential conflict of interest when discussing Ethereum. While he was the SEC’s director of corporate finance, Hinman received a $1.6 million pension from his former law firm, Simpson Thatcher. The firm’s client list included the Enterprise Ethereum Alliance, a consortium that promotes the use of the Ethereum blockchain in the corporate world. Hinman returned to Simpson Thatcher in 2020.

Mitts, the Columbia University law professor, said it was "really far-fetched" to imagine a regulator's judgment would be affected by receiving pensions from law firms.

However, Ripple has not been shy in calling attention to potential conflicts of interest, asking the federal judge overseeing the SEC lawsuit to let the company take depositions against Hinman. In July, the judge agreed to do so at the agency’s urging.

All of this is just the tip of the iceberg in its battle with the SEC in the court of public opinion, and given that most companies embroiled in regulatory troubles remain silent or issue terse, polite statements about how they are working with regulators, Ripple’s behavior is undoubtedly making enemies throughout the industry.

To further drum up sympathy from the public and politicians, Garlinghouse began suggesting that Ripple might move to Europe to escape stifling regulation. Meanwhile, the “XRP Army” — a Twitter group of Ripple loyalists (and XRP holders), including some bots, dutifully spread the news.

Ripple won’t say much, but its aggressive PR strategy appears to be driven in part by a hope that the SEC will back off from continuing the lawsuit because of a change in leadership and political pressure. The agency’s new chairman, Gary Gensler, teaches a blockchain course at MIT, leading many in the cryptocurrency industry, including Ripple, to predict that he will adopt more pro-crypto policies.

The strategy isn’t crazy. The SEC has come under scrutiny from lawmakers on Capitol Hill for its sluggish response to a series of technical crashes in the stock market and how it will address amateur investors’ frenzy in trading so-called “meme stocks” like GameStop. Under the circumstances, it might make more sense for the SEC to quietly capitulate in the Ripple case and use its resources to patrol other areas of the financial markets.

However, most lawyers are skeptical that Ripple can convince the SEC to change its course. "Acting like a jerk is generally not a good way to make the government like you," said Byrne, the cryptocurrency lawyer.

Still, Ripple’s PR campaign has won it some key allies. These include The Wall Street Journal, which in April published an editorial titled “SEC’s Crypto Confusion” lambasting the agency’s handling of the Ripple case.

But sympathetic media coverage and procedural victories in court only mean that Ripple is winning some local battles. This is a far cry from winning the overall war against the SEC.

Upcoming court clash

The final answer to whether XRP is a security may come this fall when the two sides go to trial in federal court in New York, barring an unlikely settlement. A judge in California is facing the same question, but that case involves a class-action lawsuit filed by investors, so the judge may wait until New York makes a judgment. Meanwhile, Ripple and the SEC continue to spar over procedural issues, including the SEC's request for proof of more than 1 million Slack messages from the company.

The final court hearing will determine Ripple's fate. If the company loses, Ripple, Garlinghouse and Larsen could be ordered to pay a huge fine. Worse, the court could order Ripple to register each XRP as a security or even destroy its XRP holdings, measures that would obviously cripple the company.

Decrypt surveyed a group of lawyers, most of whom believed that the SEC had the upper hand in the case, but some lawyers were less confident of the agency's victory. Among them was law professor and blockchain scholar Aaron Wright, who said that some lawyers criticizing XRP used the "everything is a security" argument to attract business.

Mittes, a securities law professor at Columbia University, is also cautious about predicting the outcome of the SEC v. Ripple case, noting that the set of facts involving Ripple and XRP is different from the facts in the earlier Kik and Telegram cases, but the SEC used those two cases as a precedent.

Mittes added that the legal issues aren’t simple when it comes to the fourth section of the Supreme Court’s Howey test for whether something is a security. That part of the test looks at whether there is an expectation that profits from one’s work will “arise from the efforts of others.” The difficulty is that in the beginning, the success of a cryptocurrency depends on a group of founders, but that can change over time if the currency begins to circulate widely. For that reason, he added, Hinman’s “sufficient decentralization” test still “has some compelling aspects,” even if that test appears to be made up by the SEC on the fly.

All of this means that Ripple has a chance of convincing a judge that XRP is not a security. But the company still faces an uphill battle, as the SEC, like other big agencies, has a lot of time on its hands and is not at all intimidated by a lengthy legal battle. The SEC also has a long history of successful battles in court.

Wright noted: “The SEC won’t bring a lawsuit unless they think they have a chance of winning.”

But if the SEC mishandles the legal issue, the consequences will be severe. A win for Ripple would not only humiliate the agency, but also embolden the cryptocurrency industry, which has long accused the SEC of failing to develop a coherent way to regulate blockchain technology. And according to Ripple's lawyer and former SEC Chairman White, a defeat in court would destroy the agency's credibility and could make it difficult for the industry to make a difference.

For Ripple, the lawsuit caused its flagship partner MoneyGram to sever ties with the company and stop using XRP. Its main investor Tetragon, which led a $200 funding round for Ripple in 2019, used the SEC's action as a basis for suing to get out of its funding commitment. The judge sided with Ripple in that dispute, but the lawsuit reflects the financial community's growing wariness of XRP, which remains core to the company's business strategy.

For the SEC, the Ripple case is critical to its new chairman's agenda. Gensler has said he will not take a more relaxed approach as many in the industry predict, and he has repeatedly emphasized the SEC's tough stance on cryptocurrencies. He also said this month that the SEC will investigate other areas of cryptocurrency, including stablecoins and decentralized finance (DeFi). However, the legal basis for such an agenda may be shaky, and Gensler's remarks have already triggered a counterattack from rival agency CFTC, and an SEC commissioner has also said that his approach is a bit radical. Bloomberg columnist Matt Levine made a similar point this week. Given this uncertainty, the SEC's victory over Ripple in court will firm up Gensler's agenda, while the loss of the case may cause him to abandon this goal altogether.

Many lawyers and policymakers believe the best outcome would be for Congress to enact a new system of rules to supplement the Howie test and take into account the unique attributes of cryptocurrencies. But Congress moves slowly, and cryptocurrencies are not high on its agenda. This means that the regulatory clarity long sought by the cryptocurrency industry is most likely to come in the form of a final decision in the SEC v. Ripple case.