An Analysis of the SEC vs Ripple Labs Inc Complaint
We have reviewed the 71 page SEC complaint against Ripple Labs Inc. and two of its executives. The charges that are outlined in Case 1:20-cv-10832, outline allegations of the plaintiffs selling $1.3 billion through an unregistered, ongoing digital asset securities offering.
We outline the major points in the SEC charges along with comments as to what this complaint means.
Summary: From at least 2013 through the present, Defendants sold over 14.6 billion units of a digital asset security called “XRP,” in return for cash or other consideration worth over $1.38 billion U.S. Dollars (“USD”), to fund Ripple’s operations and enrich Larsen and Garlinghouse. Defendants undertook this distribution without registering their offers and sales of XRP with the SEC as required by the federal securities laws, and no exemption from this requirement applied.”
This clearly outlines the entire premise behind the charges. Ripple Labs Inc raised $1.38 billion USD in capital by selling XRP. XRP were deemed securities by the SEC, but Ripple Labs Inc failed to notify the SEC that they were distributing securities. Ripple Labs also failed to provide any type of financial and managerial information typically provided in registration statements.
8. 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 allegations behind this statement are quite strong and are an indicator of the position the SEC is taking. By failing to register or file statements, the executives at Ripple Labs had access to data and insider information that was not available to regular investors who purchased XRP during the distribution event, or who continue to hold XRP. This essentially is alleging (without directly stating) that this lack of information distribution has the potential to enable insider trading, as not all investors had equal access to company finances or the information required to properly make investment decisions.
Executives were then able to act on material information before regular XRP token holders.
27. Section 5 of the Securities Act is all embracing; it prohibits any unregistered securities offering. Through exemption provisions like Section 4 of the Securities Act [15 U.S.C. §77d], however, Congress distinguished between (1) sales by issuers of their securities into public markets, which require registration, and (2) ordinary trading transactions in the market by investors, once the securities have come to rest with them, which typically are exempted from registration.
This explains Section 5 of the Securities Act, and further outlines the failure on behalf of Ripple Labs Inc to properly register the securities offering of the XRP token distribution event(s). Under the Securities Act of 1933, the offer and sale of securities must be registered unless an exemption from registration is available. It is not clear if an attempt at exemption was made.
41. Approximately 40% of the nodes validating transactions on the XRP Ledger are operated by organizations or entities based in the United States, including Ripple itself.
This statement is clearly outlining that Ripple Labs Inc, its business, and its investors have a significant US presence, and are therefore liable to follow US regulations.
This liability is the reason so many ICOs have in the past denied access to investment opportunities to US investors. An example of this include Block.one requiring all ERC-20 Token purchasers in the EOS ICO to agree to the Token Purchase Agreement, which included provisions that U.S. persons were prohibited from purchasing ERC-20 Tokens, and that any purchase by a U.S. person was unlawful.
44. In September 2012, Co-Founder, Larsen, and Ripple Agent-1 founded Ripple.
45. Upon the completion of the XRP Ledger in December 2012, and as its code was being deployed to the servers that would run it, Co-Founder, Ripple Agent-1, and Cryptographer-1 created—at little cost—the final version of what today is a fixed supply of 100 billion XRP.
46. Co-Founder, Larsen, and Ripple Agent-1 then transferred 80 billion XRP to Ripple and the remaining 20 billion XRP to themselves—9 billion XRP each to Co-Founder and Larsen and 2 billion XRP to Ripple Agent-1—as compensation for Ripple’s founders. After this transfer, Ripple and its founders controlled 100% of XRP.
By the above statements the SEC is pre-emptively removing the argument by Ripple Labs that the XRP tokens are decentralized. With these broad statements the SEC has a strong case that unlike other cryptocurrencies which have so far been deemed not to be securities such as Bitcoin and Ethereum, XRP tokens are controlled by a small minority of shareholders that benefit greatly from price movement.
With regular investors unable to gain access to material company information, it is therefore possible that while Ripple Labs Inc did not necessarily manipulate prices, they did have the opportunity to do so.
47. As Cryptographer-1—a well-respected and known Ripple spokesperson—stated in a recent tweet (on Twitter): “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.”
While this Twitter statement might have been taken out of context, it does make allegations that the only purpose behind Ripple Labs Inc was to distribute XRP tokens.
B. Ripple’s Lawyers Warned Ripple and Larsen that XRP Could Be a Security
51. Ripple sought the advice of an international law firm regarding certain state and federal legal risks associated with the distribution and monetization of XRP. Case 1:20-cv-10832 Document 4 Filed 12/22/20 Page 9 of 71
52. The law firm provided two memos—one on February 8, 2012 and another on October 19, 2012 (the “Legal Memos”)—that analyzed these risks. The first memo was addressed to the Co-Founder and another individual, and the second to Larsen, the Co-Founder, and Ripple.
53. The Legal Memos warned that there was some risk that XRP would be considered an “investment contract” (and thus a security) under the federal securities laws depending on various factors. These included, among other things, how Ripple promoted and marketed XRP to potential purchasers, the motivation of such purchasers, and Ripple’s other activities with respect to XRP. If individuals purchased XRP “to engage in speculative investment trading” or if Ripple employees promoted XRP as potentially increasing in price, the Legal Memos warned that Ripple would face an increased risk that XRP units would be considered investment contracts (and thus securities).
The SEC is clearly laying out the framework that the executives at Ripple Labs Inc were understanding the potential liabilities of XRP tokens being classified as securities. The memos provided by these law firms clearly outlined the high probability that should the SEC investigate the matter that they would consider XRP securities under either the Securities Act of 1933 (“Securities Act”) or the Securities Exchange Act of 1934 (“Exchange Act”).
57. On May 26, 2014, Larsen explained in an email to an individual formerly associated with Ripple that the international law firm that wrote the Legal Memos advised “that investors and employees could not receive XRP” because that “could risk SEC designation [as] a security.” Larsen also explained that the XRP he received upon Ripple’s founding was “comp[ensation] for . . . personally assuming th[e] risk” of being deemed the issuers of securities—namely, XRP.
This email is a nail in the coffin for Ripple Labs Inc executives potentially claiming a lack of understanding that XRP tokens are classified as securities under the Securities Act of 1933. It is also damning that this information was withheld from investors.
59. Despite this knowledge and Larsen’s familiarity with Section 5 from the SEC enforcement action that his previous company had settled in 2008 while Larsen was its CEO, Ripple and Larsen failed to heed some of the legal advice and warnings in the Legal Memos. Neither contacted the SEC to obtain clarity about the legal status of XRP before engaging in a large-scale distribution. Moreover, as described in more detail below, Ripple and Larsen (and later Garlinghouse) offered, sold and promoted XRP as an investment—precisely the type of conduct the Legal Memos had warned could lead to a determination that XRP was a security.
The SEC is clearly laying out a timeline for when Ripple Labs Inc executives discovered that legally speaking XRP would be classified as securities, but ownership failed to act on this information with the intent of enriching themselves. It will be very difficult for defense attorneys to argue against this.
60. In addition, Ripple and Larsen (and later Garlinghouse) never filed a registration statement with the SEC prior to offering or selling XRP. Nor did they limit their sales of XRP to transactions that fit within legal exemptions to the registration requirements of the Securities Act. In other words, Ripple and Larsen embarked on a large-scale unregistered public distribution of XRP and—with the goal of immense profits—simply assumed the risk that they were violating the federal securities laws.
The lack of a registration statement is clearly in violation of the Securities Act of 1933, the SEC is making sure that this lack of registration is clear. There is no room for confusion on the intent behind the token distribution or the lack of registration.
62. At the same time (Editor note: 2013 & 2014), Ripple began to make public statements with respect to XRP (then Ripple Credits) that began to create in investors an expectation of profit based on Ripple’s efforts.
If the buyers of XRP tokens purchased XRP with the sole intention of earning a profit and becoming investors, it removes the argument that XRP tokens are simply utility tokens. The expectation of profit is the problem.
The U.S. Supreme Court's Howey case and subsequent case law have found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others. The so-called “Howey test” applies to any contract, scheme, or transaction, regardless of whether it has any of the characteristics of typical securities.
With investors purchasing XRP tokens with the expectation of earning a profit, the distribution of XRP tokens has therefore failed the Howey test.
63. For example, in a promotional document Ripple circulated to potential investors around May 2013, Ripple explained that its “business model is based on the success of its native currency,” that it would “keep between 25% to 30%” of XRP, and noted the “record highs” of prices other digital assets had achieved as something Ripple hoped to emulate for XRP.
This is another indicator of how investors were purchasing XRP with the sole intention of benefiting financially by the appreciation of the underlying asset (XRP).
69. In other words, Ripple’s stated business plan made Ripple’s conduct alleged here a foregone conclusion—Ripple made it part of its “strategy” to sell XRP to as many speculative investors as possible. While Ripple touted the potential future use of XRP by certain specialized institutions, a potential use it would deploy investor funds to try to create, Ripple sold XRP widely into the market, specifically to individuals who had no “use” for XRP as Ripple has described such potential “uses” and for the most part when no such uses even existed.
In other words when investors purchase XRP there was zero use case for XRP tokens. Ownership chose to pursue banks and other financial institutions to artificially create a demand for the tokens, this was performed with the intention of increasing the value of the XRP asset class.
III. Defendants Created and Control the XRP Trading Markets While Selectively Disclosing Information about Their Activities.
166. Defendants’ offers and sales of XRP in the Offering occurred into a market that they had largely created and which—consistent with their dual purposes of raising funds from their XRP sales and managing the liquidity of the XRP market—they played a significant role overseeing.
167. Defendants’ efforts in this regard principally involved monitoring the timing and amount of their XRP sales and purchases, sometimes to coincide with strategic announcements about Ripple or XRP, and establishing an escrow for Ripple’s own XRP holdings.
The above are some of the most serious allegations for the potential of insider trading in the complaint. Ownership was selectively withholding information from investors of material changes to the business. Ownership then sold XRP to investors who were buying or selling XRP tokens based on press releases, or other news distribution. The timing of the news coincided with the sale of tokens.
The SEC defines insider trading as:
“Insider trading” refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.
A. Ripple Managed the Price and Liquidity in the XRP Market
169. Throughout the Offering, Ripple—as Garlinghouse and Larsen directed at various times—undertook significant efforts to monitor, manage, and impact the XRP trading markets, including the trading price and volume of XRP.
170. As described in Section II, these efforts included: (1) using algorithms to time the amount and priceof Defendants’ XRP sales into the market; (2) paying incentives to certain market makers—some of which Ripple engaged to effect the Market Sales—if the sales reached certain trading volume levels on XRP; and (3) paying digital asset trading platforms to permit XRP trading.
171.These efforts also included timing the prices and amounts of XRP sales to achieve what Ripple viewed as desirable trading volume or price levels and fluctuations with respect to XRP. Ripple sought to maximize the amount it could earn from the XRP Market Sales while minimizing volatility and any downward pressure on XRP’s market price caused by Ripple’s constant injections of new XRP into the market to raise operating funds.
The allegations here are quite serious. It outlines the ways Ripple Labs Inc executives manipulated information flow with the intention of profiting from the sale of unregistered XRP securities tokens. By manipulating prices both upwards and downwards, they used insider information to directly benefit from price movements.
173. Starting in late 2015, Ripple directed the Market Maker to buy or sell XRP (on occasion strategically timed around Ripple announcements), to account for the volume impact of XRP trading, as a Ripple executive told the Market Maker by email on September 20, 2016.
With this statement it is impossible to deny the strategic manipulation of prices based on the timing of news distribution or press releases.
174. To accomplish this, Ripple had an internal “XRP Markets Team” that monitored XRP’s price and volume daily and regularly communicated with Ripple’s XRP market makers about Ripple’s XRP sales strategy, which relied on selling XRP in amounts no greater than a certain percentage of XRP’s daily volume, generally between 10 and 25 basis points.
This advanced type of price monitoring proves that the SEC believes that there was alleged intent to manipulate prices. These are very serious allegations.
185. On October 15, 2016, the VP of Finance informed the Market Maker that, after an upcoming announcement, Ripple “would like to go to sales at 1%” of trading volume and asked the Market Maker to “be thoughtful / opportunistic around the timing of implementing 1%” because Ripple did not “want to depress the rally but rather capitalize on the additional volume.” He further instructed the Marker Maker “to take more money off the table,” if there was a chance to do.
This is one of many smoking guns in the complaint that alleges Ripple Labs Inc executives made strategic decisions to manipulate the price movements of XRP tokens, in order to financially benefit from these price movements.
IV. XRP Was a Security Throughout the Offering.
205. As noted, the Supreme Court made clear in its Howey decision of 1946 that the definition of whether an instrument is an investment contract and therefore a security is a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”
206. 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.
This is where the SEC hammers in the point that XRP should be classified as a securities based on the Howey Test.
210. Similarly, in its official application to the NYDFS for XRP II in 2016, Ripple acknowledged that buyers were “purchasing XRP for speculative purposes.”
This essentially confirms without any doubt that Ripple Labs Inc ownership understood that the entire purpose behind buyers purchasing XRP is to speculate on potential asset appreciation. This alone classifies XRP as a securities.
After this there are dozens of pages in the complaint that allege Ripple Labs Inc executives used social media, emails, and the Ripple website to control the type of information that is accessible to investors with the intention of increasing the price of the underlying XRP asset.
C. Ripple Led Investors to Reasonably Expect a Profit from Their Investment Derived from Defendants’ Efforts
289. Ripple also led investors to reasonably expect that they could reap a profit from their investment into XRP, derived from Ripple’s and its agents’ efforts into their common enterprise. Ripple did so by, among other things, stating that Ripple’s efforts sought to increase “demand” for XRP; assuring investors that Ripple would take steps to protect the market for XRP, including by fostering a readily available XRP trading market; highlighting XRP price increases and at times tying them to Ripple’s efforts; and selling XRP to certain institutional investors at discounted prices.
The problem with all of these efforts is that Ripple Labs never attempted to increase market adoption of XRP for actual real world usage, instead the intention was to increase the value of XRP. This would be similar to a regular company ignoring its fundamental core business, to instead rely on cheap tricks to manipulate stock prices, by selectively announcing partnerships or by manipulating when shares are purchased and/or sold.
293. Ripple executives confirmed in internal emails that one of Ripple’s goals in announcing the XRP Escrow was to encourage the price of XRP to go up. In a May 7, 2017 “XRP Markets Update” to certain Ripple executives, Ripple Agent-2noted that “XRP activity in the last few days has been impressive, to say the least,” and that this activity “seems to be driven by speculation around the lockup”; and highlighted the 50% “rall[y]”in XRP’s price after Ripple Agent-2 publicly mentioned the possibility of the XRP Escrow for the first time.
This confirms the earlier allegations. In their own words executives have admitted that the actions of the company were first and foremost designed to manipulate/increase the value of XRP tokens.
V. In the Offering, Ripple Did Not Sell XRP for “Use” or as “Currency”
A. No Significant Non-Investment “Use” for XRP Exists, and Ripple Did Not Sell XRP in the Offering for “Use”
332. The first potential use that Defendants touted for XRP—to serve as a “universal digital asset” and/or for banks to transfer money—never materialized
333. Not until approximately mid-2018 did Ripple first begin earnestly testing ODL—to date its only product that permits XRP use for any purpose. The potential “users” of ODL that Ripple is targeting are money transmitters.
It will be extremely difficult to argue that XRP was designed as a utility token when Ripple Labs Inc executives waited until 2018 to approach banks and other financial institutions to integrate XRP as a payment gateway.
339. Much of the onboarding onto ODL was not organic or market-driven. Rather, it was subsidized by Ripple. 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.
340. Between early 2019 and July 2020, the “Money Transmitter” conducted the overwhelming majority of XRP trading volume in connection with ODL. Ripple had to pay the 58 Money Transmitter significant financial compensation—often paid in XRP—in exchange for the Money Transmitter’s agreement to help Ripple increase volume. 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.
Herein lies the strongest problem behind the XRP token distribution. On one hand Ripple Labs is announcing in press releases partnerships about market adoption by financial institutions, to give investors the impression that progress is being made. Investors are fooled to believe that these banks and institutions are testing sending funds by using XRP, and in some cases will soon be adopting this payment method.
On the other hand these same institutions are finding the XRP option too expensive and too much of a pain point, and are therefore only “onboarded” in order to profit from selling XRPs that are issued to them.
This causes the market to pump with investors purchasing XRP at an inflated rate. To unload the XRP investors then need to wait around until the next news announcement, afterwards the cycle repeats itself.
At no time does there seem to be intention for actual market adoption of this payment solution.
343. 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.
As stated above, it is alleged that investors and the general public were unaware that behind the scenes payments were being made to financial institutions for them to partner with Ripple Labs Inc. It appears that the intention behind these announcements was exclusively to sell XRP back into the marketplace.
The remainder of the complaint illustrates how XRP was never properly registered as a securities, and that the plaintiffs were fully aware of this, and that many of the actions of the executives and the company they controlled was exclusively designed with alleged price manipulation in mind.
Disclaimer: I am not a registered broker, financial advisor, or a legal professional, this information is provided for educational purposes only, and does not constitute investment or legal advice.