A purported class action lawsuit was filed in a California court against Ripple Labs, Inc. and other defendants for offering and selling unlicensed securities, namely the Ripple digital token – XRP. The named plaintiff, Ryan Coffey, seeks rescission and punitive damages against all the defendants, who also include XRP II, LLC and Bradley Garlinghouse, the chief executive officer of Ripple.
According to the complaint filed in this action, all 100 billion XRP tokens currently in existence were created by Ripple Labs in 2013. Twenty percent of these were allegedly given to individual Ripple Lab founders, while 80 percent were retained by Ripple Labs. The complaint alleges that the defendants have steadily sold off their XRP over time “in what is essentially a never-ending initial coin offering” and XRP tokens offered and sold by defendants “have all the traditional hallmarks of a security.” This is because purchases of XRP tokens represent investments in a common enterprise with profits expected through the efforts of Ripple Labs. Because of the restrictive governance of Ripple Labs, the XRP distributed ledger is also a centralized ledger controlled by a few persons, as opposed to a decentralized ledger like Bitcoin or Ethereum, claims the lawsuit
Ripple Labs and XRP II were collectively fined US $700,000 by the Financial Crimes Enforcement Network of the US Department of Treasury in May 2015 for facilitating transfers of virtual currency and providing virtual currency exchange transactions services in connection with XRP without registering as a money service business and not complying with anti-money laundering requirements. FinCEN noted that XRP II became registered as an MSB in September 2013, but claimed it did not have an effective, written AML program until early 2014. (Click here for background on the FinCEN legal action against Ripple in the article “Money Service Businesses for Second Largest Virtual Currency Fined for AML Deficiencies; Bitcoin Exchange Gets First NY License as Trust Company” in the May 10, 2015 edition of Bridging the Week.)
Ripple represents itself as a “digital asset for payments,” claiming it is “the fastest and most scalable digital asset, enabling real-time global payments anywhere in the world.” (Click here to access the Ripple website.) The defendants have not yet filed an answer to the complaint and this lawsuit has not been approved by the court for class action status.
My View: According to published reports, the Commodity Futures Trading Commission and the Securities and Exchange Commission may meet this week to discuss whether Ether, the digital token associated with the Ethereum blockchain, and XRP are securities potentially subject to regulation by the SEC. (Click here, for example, to access a recent article in The Wall Street Journal.) The CFTC has previously suggested that both Ether and XRP are virtual currencies. (Click here to access the October 17, 2015 LabCFTC primer on Virtual Currencies; see footnote, page 5.) FinCEN in its lawsuit against Ripple Labs and XRP 2 also referenced XRP as a virtual currency and, in fact, grounded its lawsuit on the defendants’ exchange activities involving their virtual currency.
Recently there have been suggestions – most notably by former CFTC Chairman Gary Gensler – that digital tokens issued as part of initial coin offerings or subject to limited governance might be regarded as securities as investors purchase them with the expectation of profits through the activities of others, in one case those of the Ethereum Foundation and in the other case, Ripple Labs. (Click here for access to a purported transcript of a speech by Mr. Gensler at MIT on April 24 as provided by Coindesk.)
The SEC and CFTC have long dealt with products that have characteristics of futures and securities – instruments known as security futures – and have worked out rules for the exercise of their jurisdiction over such products. (Click here for a general background.)
To me, a discussion over when a digital token might be a security as opposed to a virtual currency would be very helpful, particularly if it is followed by the issuance of clear guidance and an opportunity to cure for cryptocurrencies that might be forced to change their existing, popular characterization. However, no guidance should be issued without public input. CFTC Commissioner Brian Quintenz indicated that a subcommittee of the Technology Advisory Committee might be formed to consider this issue (Click here for Mr. Quintenz’s opening remarks before the February 14, 2018 Technology Advisory Committee.) This would be a great forum to initiate such conversations.
Notwithstanding the class action lawsuit filed in California, the more common view is that Ether and Ripple are virtual currencies. Ether clearly is the payment mechanism for transactions on the Ethereum blockchain requiring “gas” and is used in some real-world transactions. Ripple likewise was designed and is used as a payment vehicle. Moreover, Ripple was not issued as part of an ICO, and while 60 million Ether tokens were issued as part of the Ether ICO in July 2014 (valued at approximately US $18.4 million), today Ether tokens are exclusively created through mining – just like Bitcoin. Ripple was previously criticized by some for having too few validators to approve blockchain transactions. However, the amount of so-called "validator nodes" was increased to 55 last year.
Today, when I analyze whether a particular digital token is likely a security or a virtual currency, I consider a number of factors:
- What was the initial stated purpose for the digital token?
- How is the digital token promoted today?
- Is the digital token generally regarded as a currency, currency substitute or payment substitute, serving as a medium of exchange, store of value or unit of account?
- Do merchants or any third parties accept the digital token for payment? If yes, how widespread? Is the digital token used for payment on a blockchain? If yes, how?
- Was the digital token initially issued as part of an ICO or a type of continuous offering? If not, how are new digital tokens currently issued and what is the percentage of ICO and non-ICO derived digital tokens? Was there a pre-sale associated with the ICO (e.g., SAFT)?
- What is the governance regarding the blockchain associated with the digital token? Is there a different governance for the token itself? If yes, what is it?
- Is the blockchain associated with the digital token centralized or decentralized?
- How are transactions involving the digital token validated and recorded on the associated blockchain?
- Do holders of digital tokens directly or indirectly have any rights to income? Are there any other rights associated with ownership of the digital token? If yes, what are they?
No one or two answers are definitive for me. But when thinking about all the answers it more often than not becomes clearer to me how the digital token should likely be classified. To me collectible cars and private-minted gold coins are not securities even if they behave somewhat like investment contracts. Likewise, a virtual currency is not a security even if it has some characteristics of an investment contract. Moreover, the nature of a digital asset may morph over time. As divisions of the SEC have seemingly acknowledged on multiple occasions, just because something has some qualities of an investment contract – like a baseball stadium's seat leases – and trade on secondary markets – like eBay – doesn’t mean they should be regulated as securities. (Click here, e.g., for a request for no action by the San Francisco Baseball Associates L.P related to seat leases and here for the grant of no-action relief by the Office of Chief Counsel of the Division of Corporate Finance on February 24, 2006.)