XRP case, and how does it affect markets

Over the past years, the SEC’s case against Ripple has become one of the most important proceedings in the crypto industry. The end result of the Ripple case could have serious legal implications for cryptocurrencies both in the U.S. and around the world. In this article, we are going to analyze the history of the relationship between the SEC and Ripple, the recent court decision, whether XRP is a security or not, and possible consequences.

The court in New York has partially sided with Ripple Labs in a lawsuit against the U.S. Securities and Exchange Commission (SEC). The court stated that neither sales nor other forms of distribution of XRP tokens issued by the company, as well as sales of these tokens to private investors, are transactions with investment contracts, i.e., tokens are not actually recognized as securities. However, the court recognizes as an investment contract transaction the sale of tokens to institutional investors under a preliminary contract.

How to qualify a transaction as an investment contract?

For this purpose, there is the Howey test, created by the U.S. Supreme Court in 1946. Under the Howey Test, an investment contract exists if there are:

1. an investment of money
2. an investment in a common enterprise
3. an investment with the expectation of profit
4. an investment, where profit is generated from the efforts of others

How to define security?

Securities are fungible and tradable financial instruments used to raise capital in public and private markets, and should have the following criteria:

1. The existence of an investment contract
2. The formation of a common enterprise
3. A promise of profits by the issuer
4. The use of a third party to promote the offering

So, what has really happened?

Ripple Labs only partially won the trial. The judge stated that the XRP token was not a security, but that only applies if it was sold on cryptocurrency exchanges to the public or through algorithms. At the same time, the court stated that Ripple Labs violated the securities law when XRP was sold to institutional investors. This means that selling the token to hedge funds or venture capital firms was considered a violation of US securities laws.

The XRP distribution from 2013 to 2020:

1. $730 millions — to institutions via various contracts;
2. $760 millions — to retailers via exchanges and trading algorithms;
3. $610 millions — to employees in the form of payment for services;
4. $600 millions — personally from CEO and COO to retailers via exchanges

In 2020, the SEC accused the executives of Ripple with illegal (i.e., in violation of securities laws) offering and selling $1.3 billion worth of unregistered securities. Namely, Ripple was obliged to register and file reports.

The court has stated that:

• Transactions with institutions meet the criteria of the Howey test, which means such transactions are investment contracts/securities.
• Retail transactions do not meet the criteria of the Howey test because:

– the sales were blind bid-ask transactions, which means that the buyers could not know who their payments would go to;

– even if XRP token was bought for speculative purposes, it does not mean it is an investment contract/security because profit expectations are not related to Ripple’s efforts;

– there is no evidence that marketing materials were distributed to retail buyers;

• Fee-for-service transactions do not meet the criteria of the Howey test because there is no investment of money here.

Why does the case still matter?

The SEC’s lawsuit against Ripple Labs is significant because its results can later be used as a precedent for similar cases. At the moment, the SEC solely decides on the status of a particular cryptocurrency based on the Howey test. Theoretically, a victory in court will actually untie the commission’s hands and serve as a basis for even more similar claims and lawsuits.

Apparently, other projects will try to get as far away as possible from the first point of the Howey test (investment of money), and token distribution schemes will become more complicated. Those who conclude from the Ripple case that from now on sales to institutional investors will be investment contracts and distribution through exchanges/airdrops will not be, are wrong. On a case-by-case basis, the court (and the SEC) will look at the complexity of the circumstances, the marketing slogans of the project, and other things.

To summarize:

• The question whether XRP and other tokens are securities remains open. This has not been explored by the court at all;
• Transactions involving the same asset will qualify as investment contracts/securities in some cases and not in others.
• The intentions of the parties are important to define whether a cryptocurrency is security or not: the seller (whether or not he promoted his product as an investment opportunity) and the buyer (whether or not he perceived the offer as an investment opportunity with potential profits from the seller’s or third parties’ actions);
• The more marketing with promises of profit, the better the chance of investment contract/security status.