Over the past month, Ripple Labs Inc. has been beset by legal difficulties stemming from its sale of XRP—a digital asset or crypto token. In late December, the Securities and Exchange Commission filed an enforcement action alleging that XRP is a security and that Ripple and its principals had sold nearly $1.4 billion worth of XRP in unregistered securities sales since 2013.
Based on the SEC’s finding, one of Ripple’s investors—Tetragon Financial Group Ltd.—filed a suit in Delaware Chancery Court seeking to compel Ripple to redeem $175 million of Ripple stock that Tetragon purchased last year. Over Ripple’s objection, the Delaware Court issued a preliminary injunction requiring Ripple to maintain its current holdings of XRP and prohibiting Ripple from redeeming any other stock before Tetragon’s.
In the meantime, cryptocurrency exchanges have suspended trading of XRP, and class actions against Ripple and those exchanges have been filed in California and Florida. Though still in their infancy, these cases illustrate the challenges facing blockchain companies that sell digital tokens.
Blockchain companies wishing to sell tokens without registering them as securities and making the required disclosures need to candidly evaluate whether they can successfully sell their tokens without engaging in promotional conduct akin to Ripple’s, and must be aware of the challenges of creating so-called “utility tokens.”
The SEC’s allegations illustrate the factors likely to render a digital token a security.
SEC Says XRP Is a Security Under Howey
The primary dispute between the SEC and Ripple is whether the XRP token is a security under the U.S. Supreme Court’s “Howey test,” articulated in 1946 in SEC v. W.J. Howey Co. The SEC outlines in its 71-page complaint against Ripple what it believes rendered XRP a security. Among the salient allegations are:
- That Ripple understood that the primary reason anybody would buy XRP was to speculate as an investment.
- That Ripple understood and was advised by counsel that XRP could be considered a security.
- That Ripple promised and touted its ability to create demand and a public market for XRP and led investors to expect that Ripple’s efforts would drive the success or failure of XRP.
- That, because Ripple remained the single largest holder of XRP, investors were forced by “economic realities” to rely on Ripple’s efforts for the success or failure of their investments.
- That Ripple’s stated goals of increasing demand for XRP, protecting its trading markets, and ensuring XRP was freely tradeable were designed to assure investors to expect a profit based on Ripple’s efforts.
Practical Use But Still a Security
Some blockchain companies have sought to avoid the burden of complying with securities laws by creating tokens that have a practical use. Such “utility tokens,” it was thought, would be bought—not by investors looking for a profit—but by users desiring the good or service that the token enabled them to procure.
In its complaint, the SEC makes a point of alleging that XRP is not a utility token, despite Ripple’s efforts. Specifically, Ripple’s allegedly touted XRP’s “use” in facilitating cross-border payments. But adoption was minimal, and Ripple was forced to subsidize would-be users of XRP.
Moreover, the SEC observes, Ripple focused most of its marketing on investors rather than on those with a practical need for cross-border transactions. As a result, the SEC alleges, XRP has no significant non-investment “use” and was not sold for that purpose.
Ripple’s difficulties in gaining traction for “use” of XRP are far from unique. Utility tokens are often stymied by a chicken-and-egg problem: The token only becomes useful once it is widely adopted. Before then, the token has no “use,” and only investors would buy it, rendering the token a security—at least initially.
To address this problem, some have proposed a safe-harbor period during which an aspiring utility token would be subject to less than the full panoply of securities laws, on the condition that the token reach a certain level of decentralization and functionality by the end of safe harbor. But no such safe harbor has yet been adopted. Moreover, as Ripple’s experience indicates, achieving a practical “use” is difficult, even where the token is a popular as XRP and even for a company as well funded as Ripple.
Finally, the SEC’s action has had many knock-on effects for Ripple. Aside from adverse price impacts on XRP itself, the SEC’s determination has caused most cryptocurrency exchanges to halt trading of XRP; exposed those exchanges to lawsuits for their role in selling an unregistered security; invited Ripple shareholders, like Tetragon, to file suits; and of course, raised the possibility of multiple class-action lawsuits by purchasers of XRP across the county.
Blockchain companies would do well to monitor the fate of Ripple and XRP, and to tread very carefully until the U.S. regulatory landscape for crypto-tokens is reformed.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
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Ciaran Connelly is a partner and head of blockchain law at Ball Janik LLP.