Amidst the staggering market all-time highs reached by Bitcoin (BTC) and other altcoins in recent weeks, Ripple Credits (XRP) — one of the industry’s top cryptocurrencies by market cap — stalled in growth and found itself in precarious territory by drawing the scrutiny of the U.S. Securities and Exchange Commission.
To be more precise, the US S.E.C. charged Ripple Labs Inc. (Ripple) and two of its top executives for unregistered sale of securities in violation of the U.S. Securities Act.
The Origins of XRP
As opposed to cryptocurrency market leaders BTC and Ethereum (ETH) which aim to achieve Decentralized Finance (DeFi) — that is, a global financial system without intermediaries and borders — the creators of the Ripple Protocol or XRP Ledger envisioned its native digital asset XRP to be a universal token for banks and other financial institutions to effect instantaneous and cost-effective global money transfers. Ripple’s gambit of inclusivity of traditional financial institutions and intermediaries was seen as a compromise into what could have been viewed as an anarchic system espoused by the likes of BTC and ETH. This also appealed to a niche demographic of the investing public that fears the high volatility of most untethered cryptocurrencies lacking the acceptance of traditional financial institutions.
With a fixed supply of 100 Billion XRP, Ripple and its founders allegedly had initial 100% control of XRP. The U.S. SEC claimed that through a series of primary and secondary offerings in the U.S. and abroad structured through various entities and projects, “Ripple determined to create a market for and sell XRP to the public to monetize its holdings and finance its operations.”
U.S. SEC v. Ripple
Filed in the Southern District of New York, U.S. District Court, the U.S. SEC alleged that XRP is an investment contract — a type of security — that had been offered for sale and distributed without the requisite registration or qualification for exemption in violation of the U.S. Securities Act.
In alleging that XRP is an investment contract, the U.S. SEC referred to the test in SEC v. W.J. Howey Co — a landmark decision made by the U.S. Supreme Court in 1946 and claimed that: (i) Ripple led investors to reasonably expect that Ripple’s and its agents’ entrepreneurial and managerial efforts would drive the success or failure of Ripple’s XRP projects; (ii) purchasers of XRP invested into a common enterprise; and that (iii) Ripple led investors to reasonably expect a profit from their investment derived from defendants’ efforts.
In addition, the U.S. SEC also countered Ripple’s claim that XRP is a “currency” exempt from the U.S. Securities Act as XRP is not classified as legal tender in any jurisdiction. This is contrary to Ripple’s earlier 2015 settlement with the U.S. Financial Crimes Enforcement Network (FinCEN) in which XRP is classified as a currency with corresponding compliance obligations before the U.S. Departments of Justice and Treasury.
In the wake of SEC v. Ripple, XRP has seen its value tumble with major cryptocurrency exchanges halting its trades and/or delisting the token, causing panic and inability for its holder-investors to move or liquidate their positions.
A Precedent for the Philippines
In the battle for regulation of the nascent but booming digital asset industry, Ripple sought a securities law titan to defend it: no less than former U.S. SEC Chair Mary Jo White. In its defense, Ripple’s primary stance is to invoke XRP as a digital currency — consistent with its previous settlement with the U.S. FinCEN. This is also aligned with a declaration by Japanese securities regulators — the Financial Services Agency (FSA) — that XRP is not a security but is a digital currency used as a means of payment.
Ultimately, Ripple is expected to disclaim XRP’s categorization as an investment contract by negating the elements of the Howey Test as alleged by the U.S. SEC in its complaint.
While the Howey Test has long been adopted by our Philippine Supreme Court and domestic securities law regulator — the Philippine SEC — the extent to which the said test has been drawn out and assessed by the U.S. courts in SEC v. Ripplewill be precedent-setting for any prospective legal analysis here and abroad in determining whether a digital asset should be classified as a security and thus, should be subject to the registration requirement under the local Securities Regulation Code (SRC) and the issuances of the Philippine SEC.
Notably, the long-anticipated Digital Asset Offering — currently in its draft form — issued by the Philippine SEC is known to shift the burden to all issuers of digital assets to prove that their instruments are not security tokens. Ultimately, to avoid classification as a security token and the corresponding registration and disclosure requirements for a security offering, an issuer must pass the initial assessment test by the Philippine SEC to determine whether the submitted digital asset does not exhibit any security-like properties — i.e. qualifying as an investment contract under the Howey Test. An issuer can do this by establishing that its instrument is purely a payment, utility, or asset token — or simply put, without any speculative characteristics promising profits which are directly tied to the efforts of its issuer.
What is interesting with XRP’s case is its publicly-known success at being a highly-decentralized asset, by which Ripple may disclaim that the value and success of XRP as an asset is not reliant on the efforts of its organization or its officers.
While the case is still pending before the U.S. courts, the anticipated aftermath poses crucial market and regulatory consequences for the future of digital assets. Should XRP win, it can further strengthen the use case and acceptance of digital assets as means of payment, which would push regulators to apply compliance standards similar to that of fiat or legal tender to purely payment tokens.
Consequently, should the U.S. SEC win, the next in the line of fire to be classified as securities would be native digital assets ran by identified issuers exhibiting similar — albeit distinctively smaller — operations and market reach than Ripple and its XRP. The consequent onerous regulatory requirements for issuance — not to mention the penalties for non-compliance — will set back the industry and demand herculean administrative and regulatory efforts in maintaining all holder-investor records, rescinding contracts if warranted, and fulfilling all mandatory disclosure requirements consistent with securities laws and regulations. Crypto exchanges will also be more constrained to limit onboarding of digital assets — even those which are substantially decentralized — to avoid sale and distribution of potentially unregistered securities.
While still looming in the horizon, the undeniable rise and adoption of digital assets in the country puts pressure on domestic regulators such as the Philippine SEC to examine the realities of regulating an industry whose technology is inherently averse to institutional intervention and prefers free market forces. In any case, the discussion sparked by SEC v. Ripple is inevitable at worst and welcome at best, given the need of the digital asset industry to push for a concrete legal framework if it were to move further for mass adoption.
Liane Candelario is a Junior Associate and a member of the Technology Media and Telecommunications, Corporate, and Data Privacy Groups of Gorriceta Africa Cauton & Saavedra (www.gorricetalaw.com). Liane’s practice area centers on finance & technology — spanning securities, banking, data privacy, and cybersecurity. She also assists clients in determining licensing and in complying with legal and regulatory requirements for their specific industries and activities.