Over the past month, Ripple Labs Inc. Legal difficulties arising from its sale of XRP – a digital asset or crypto token. In late December, the Securities and Exchange Commission filed an enforcement suit alleging that XRP is a security and that Ripple and its managers have sold nearly $1.4 billion of XRP in unregistered securities sales since 2013.
Based on the results of the Securities and Exchange Commission, one of the Ripple investors – Tetragon Financial Group Ltd. A lawsuit in Delaware’s Chancery court seeks to force Ripple to recover the $175 million of Ripple shares purchased by Tetragon last year. During Ripple’s objection, a Delaware court issued a preliminary injunction requiring Ripple to maintain its existing holdings of XRP and to prevent Ripple from redeeming any further stock before Tetragon.
Meanwhile, cryptocurrency exchanges have suspended XRP trading, and class-action lawsuits have been filed against Ripple and these exchanges in California and Florida. Although these cases are still in their infancy, they illustrate the challenges facing blockchain companies selling digital tokens.
Blockchain companies wishing to sell tokens without registering them as securities and making the required disclosures need to assess whether they can successfully sell their tokens without engaging in promotional behavior similar to Ripple, and they need to be aware of the challenges of creating so-called “benefit” tokens. .
The SEC allegations illustrate the factors that likely make a digital token secure.
SEC says XRP is a security under Howey
The primary dispute between the SEC and Ripple is whether the XRP token is a security underHowey Test ”, expressed in 1946 in SEC vs. WJ Howey Co. The Securities and Exchange Commission, in its 71-page complaint against Ripple, outlines what it believes made XRP a security. Among the notable claims:
- Ripple realized that the main reason anyone would buy XRP was to speculate as an investment.
- Ripple understood and was informed by the lawyer that XRP could be considered collateral.
- This Ripple company has promised and touted its ability to create demand and a public market for XRP and lead investors to anticipate that Ripple’s efforts will drive the success or failure of XRP.
- That is, since Ripple remained the largest single owner of XRP, investors were forced by “economic realities” to rely on Ripple’s efforts for the success or failure of their investments.
- Ripple’s stated goals to increase demand for XRP, protect its trading markets, and ensure XRP can trade freely, are designed to ensure investors can expect a profit based on Ripple’s efforts.
Practical but still safe use
Some blockchain companies have sought to avoid the burden of complying with securities laws by creating tokens of practical use. It was believed that such “utility tokens” would be purchased – not by profit-seeking investors – but by users desiring the good or service that the token enabled them to acquire.
In its complaint, the Securities and Exchange Commission (SEC) made the point of claiming that XRP is not a useful token, despite Ripple’s efforts. Specifically, Ripple allegedly promoted the “use” of XRP to facilitate cross-border payments. But the adoption was minimal, and Ripple had to support those who would be users from XRP.
Moreover, the Securities and Exchange Commission noted, Ripple has focused most of its marketing on investors rather than those with a practical need for cross-border transactions. As a result, the Securities and Exchange Commission claims, XRP has no significant non-investment “use” and was not sold for that purpose.
Ripple’s difficulties in gaining traction to “use” XRP are far from unique. Utility tokens are often hampered by the chicken and egg problem: tokens become useful only once they are widely adopted. Before that, the token had no “use,” and only investors would buy it, making the token a security — at least at first.
To address this issue, some have suggested a safe haven period during which an aspiring utility token is subject to less than the full set of securities laws, provided the token reaches a certain level of decentralization and functionality by the end of the safe haven. But no such safe haven has yet been adopted. Moreover, as Ripple’s experience indicates, achieving a practical “use” is difficult, even when the token is as popular as XRP and even for a well-funded company like Ripple.
Finally, the work of the Securities and Exchange Commission has had several spillover effects on Ripple. Apart from the negative price effects on XRP itself, the SEC’s decision has caused most crypto exchanges to stop trading XRP; Subject those exchanges to lawsuits for their role in the sale of an unregistered security; invited Ripple shareholders, such as Tetragon, to sue; And, of course, it sparked the possibility of multiple class actions being brought by XRP buyers across the province.
Blockchain companies will do well to monitor the fate of Ripple and XRP, and proceed with extreme caution until the US regulatory landscape for crypto tokens is overhauled.
This column does not necessarily reflect the opinion of the Office of National Affairs or its owners.
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Ciaran Connelly He is Partner and Head of Blockchain Law at Ball Janik LLP.