The phrase “the million dollar question” is an idiom that is frequently used to represent a question or idea that is “very important, or very difficult to answer.” Ripple and XRP have one of these types of questions being asked right now and I do not think it would be an understatement to say this question could be “the trillion dollar question” by the time it is officially answered.
What is a Security?
The Supreme Court helped to define a “security” in SEC v. Howey Co., which was argued 1946. In this case the Supreme Court stated that a security is one where “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.” So the components that define a security are 1) an investment of money, 2) in a common enterprise, 3) with an expectation of profits, 4) from the efforts of the promotor or a third party. This ruling helped to better define what a security is based on the Securities Act of 1933, Section 2(a)(1):
The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
The million dollar question then is this: is XRP a security? We may get the answer to this question sooner rather than later.
Coffey vs. Ripple Labs. Inc.
On May 3, 2018, Ryan Coffey, through his attorney, James Q. Taylor-Copeland, filed a lawsuit against Ripple Labs, Inc., XRP II, LLC., Bradley Garlinghouse, and (Jane/John)DOES 1 through 10 (which I will collectively call “Ripple”) in the Superior Court of California in San Francisco (link to filed lawsuit here). In this suit, Coffey alleges that Ripple is in violation of several Security and Exchange Commission (SEC) regulations and is selling an unregistered security (XRP) in a “never ending ICO” with tokens that Ripple made “out of thin air.” Coffey claims that XRP is a security because:
- XRP Purchasers Made an Investment of Money in a Common Enterprise.
- XRP Investors Had a Reasonable Expectation of Profits.
- The Success of XRP Requires the Efforts of Ripple Labs and Others
The analysis below looks at each of the three security claims made by Coffey:
An Investment of Money in a Common Enterprise
Coffey begins this part of his complaint by pointing out that investors must purchase XRP with fiat or other digital assets such as Bitcoin or Ethereum, highlighting that this “meets the first prong of Howey.” Next, Coffey alleges that Ripple sells/has sold XRP on exchanges and that investors are able to purchase XRP on those exchanges, that the success of XRP is reliant upon Ripple’s development capabilities, thus, purchasing XRP is purchasing a “security” in the operational and development capabilities of Ripple because Ripple is the enterprise associated with building the network XRP relies on for execution.
The SEC compiled a report based on such a thought: Slock.it and the Decentralized Autonomous Organization (DAO) that ran on the Ethereum Blockchain (link here). In a nutshell the SEC found that the DAO was designed to operate similarly to a corporate entity with each holder of DAO tokens having voting rights and an opportunity to earn a “return on their investments” through the operations of the DAO and the management of Slock.it. While there are other nuances, these three items alone earned the DAO the right to be considered a security. However, neither one of these items applies to XRP or Ripple.
XRP does not in any way, fashion, or form, represent an interest in Ripple the company. If I am wrong someone please point me to where this statement is available. Additionally, XRP and the XRP Ledger (XRPL) are not solely reliant upon Ripple for further development and operational consistency. The XRPL “relies on a common shared ledger,” “is managed by a network of independent validating servers that constantly compare their transaction records…Servers could belong to anyone, including banks or market makers,” and the protocol is open source and is available for other developers to contribute to its design and development. Recent announcements by Omni, Coil, Ripple’s investment in Blockchain Capital Parallel IV, LP, and Ripple’s own Xpring for investing in and incubating companies that build upon the XRPL help prove that anyone is able to use the XRPL to develop use-cases for XRP. As it happens to be, Ripple uses the XRPL to develop applications that help banks and other financial institutions (FI’s) move money quickly and more efficiently through cross-border transactions.
If XRP ends up being defined as a security, Ripple could be in violation of Section 3 of the Act and could be defined as an investment company. The SEC states an investment company is “an issuer which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in ‘securities.'” Additionally, “Section 3(a)(1)(C) of the Investment Company Act defines an investment company as an issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire ‘investment securities’ having a value exceeding 40 percent of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis.”
There are two points about the above SEC statements: First, is XRP a “security” as defined? If not, Ripple does not have to be concerned about being an investment company. Second, can Ripple prove that it does not “engage primarily in the business of investing, reinvesting or trading in ‘securities'” if XRP is deemed to be a security? The answer to this question could come down to minutiae not available to the public and would include records such as income generated from application (xCurrent, xRapid, xVia) sales and ongoing maintenance, pending partnerships, development costs, etc., versus XRP sales.
To conclude this point, based on information publically available, I do not believe XRP will be classified as a security which represents an interest in Ripple because XRP exists outside of Ripple and does not need Ripple to continue to exist.
Expectation of Profits
In his argument, Coffey presents many statements by Ripple that caused him to conclude he had a “reasonable expectation of profits.” These statements include Ripple presenting a “Buyer’s Guide” and a “how to buy” XRP link on Ripple’s website; a statement by Brad Garlinghouse where he says he is “very, very, very long XRP”; Ripple’s escrow of XRP as a means of upward price control; Ripple’s funding of outside projects to increase demand for XRP and thus increase XRP’s price; and Ripple’s $25 million investment in Blockchain Capital Parallel IV, LP., as a means of developing the XRP ecosystem and thus improving XRP’s price.
It appears that Coffey argues against himself in this section. First, providing a “Buyer’s Guide” that explains how retail investors can purchase XRP on a multitude of exchanges from other XRP investors does not constitute an expectation of profits but a way to purchase XRP. Next, Garlinghouse’s comments about being “very, very, very long XRP” does not imply any expectation of price increases, especially in the near term. Garlinghouse has been more than clear that he is viewing any potential change in XRP prices over a 3-5 year period, not the period of approximately 2 weeks in which Coffey purchased and sold XRP. The last items listed (escrow, funding outside projects, and investment in Blockchain Capital) seem to contradict Coffey’s allegations of reliance upon Ripple for price movements: Ripple is intentionally NOT selling XRP to just anyone, and is reserving the XRP they have in escrow to use to develop the XRP community through other entities. Ripple is doing this because, as they have stated over and over again, they are hyper-focused on cross-border transaction settlements. However, other companies can develop API’s (application-programming interfaces) using the XRPL that focus on other use-cases. Ripple recognizes that for the XRP ecosystem to be healthy other entities and organizations must play a part in that ecosystem. While, yes, this could give the illusion that Ripple is working to increase the price of XRP and thus the expectation of “profits” from XRP, Ripple has made no promises or guarantees that its efforts on cross-border transactions or that the efforts of others will produce any upward price movement of XRP.
The Success of XRP Requires the Efforts of Ripple Labs and Others
Well, yeah. Honestly, I am confused by Coffey’s complaint here. He makes the point that Ripple has taken the lead in developing the XRPL and that they hold about 60% of all XRP created. That said, he is wrong to state that Ripple created the 100 billion XRP. Instead, the XRP were created and gifted to Ripple for use as it developed the XRPL. It cannot be claimed that Ripple created 100 billion XRP “out of thin air” when Ripple was not the creator of those XRP. Ripple is like any other person or entity who has received XRP as a gift (tip?) from someone else who holds XRP. Otherwise, any person who has received XRP as a gift (tip) could be considered as a “creator” of XRP, which is ludicrous.
Coffey is trying to make a similar point that the SEC made in the DOA report. The SEC’s DAO report states:
The DAO’s investors relied on the managerial and entrepreneurial efforts of Slock.it and its co-founders, and The DAO’s Curators, to manage The DAO and put forth project proposals that could generate profits for The DAO’s investors.
Coffey begins this section of his complaint with the sentence “Lead Plaintiff and the class have entirely passive roles vis-à-vis the success of the XRP Ledger and XRP.” They key here is that this is the role Coffey chose to take with XRP. As with anyone else, he has the opportunity to use the open-source nature of the software and begin contributing to the XRP ecosystem. That said, I realize many individuals who own XRP at this point probably make this same choice, however, that does not change the fact that it is still a choice. I think of Wietse Wind (@WietseWind on Twitter) and his contributions to the XRP community. Instead of being a passive holder of XRP he has chosen to develop various apps that utilize the XRPL for the benefit of the community. Additionally, Wietse and numerous others participate in the continuation of the XRP community by running validators and nodes, helping to ensure that if Ripple (the company) ever went away, the XRPL and XRP would survive and thrive. And that last part is key: if Ripple went away the XRPL and XRP would be able to continue operating because of the decentralized nature of the XRPL and the efforts of other developers in the XRP community. A recent example is provided by a company called Data443 Risk Mitigation, Inc., based out of Raleigh, NC. This company began as a XRPL Validator and has since begun using the network for General Data Protection Regulation (GDPR) compliance mandates through its own API available for companies that use distributed ledger (DL) technology to store private information. This latest example, and many others, prove the success of XRP is NOT reliant upon Ripple or any other single developer. Rather, whether XRP is utilized in a commercial form will be determined by the combined efforts of the XRP community.
XRP and DAO are completely different constructs. XRP was in no way created to allow those who hold XRP to “create a profit” just by holding XRP through the managerial efforts of others. XRP is designed to make cross-border transfers capable at much faster speeds versus technology that is currently available. Yes, an individual or a business can purchase and hold (HODL) XRP, but that does not change the function of XRP. Coffey is trying to say holding 1 XRP is like holding 1 share of Disney, where the value of 1 DIS share is determined by the profits generated by the managerial efforts of the Disney leadership team. By owning 1 XRP what company, entity, or developer does one acquire the right to profit from? There is not one. However, anyone who owns XRP could benefit by an appreciation in price due to XRP adoption and utility which is being driven by Ripple and others within the XRP community.
XRP a Commodity?
Rather than being a “security” and held to the standards of the SEC, a Federal judge recently ruled that “virtual currencies like bitcoin can be regulated as commodities by the U.S. Commodity Futures Trading Commission.” The CFTC determined that “virtual currencies” are commodities in 2015. That said, in the ruling above, the issue was fraud based on “trading advice” about digital assets and misappropriation of funds from trades, specifically related to the operations of Coin Drop Markets. With this ruling, the precedent has been set that digital assets are commodities and fall under the purview of the CFTC rather than the SEC, except when ICO’s are involved.
The above mentioned ruling also deals with a company defrauding its customers which IS a major concern in the digital asset environment. Anyone who is contemplating purchasing a digital asset should ensure that the asset is compliant with the SEC (for ICOs) and the CFTC before making a purchase. Additionally, purchasers should know who is supporting the digital asset they wish to purchase. Are the developers clearly known? Is there a company (or multiple companies, in the case of XRP) supporting the asset and the network? How is the network controlled? Can someone gain a majority control of the network and cause double-spend issues like have happened this past week with three digital assets?
But Who am I?
No one, really. I am someone who hodl’s XRP and enjoys researching the digital asset environment. I have taken many classes on business law and securities law while working on my B.S. in Business and Accounting and my first Master’s in Accountancy, but I am no expert. There are those who are, though. For example Michael Arrington, founder of Arrington XRP Capital, used to practice corporate and securities law. His tweet below explains his thoughts on whether XRP is a security:
And Arrington has staked tens of millions of dollars worth of XRP on not being a security. Not only Arrington, but other Ripple partners, too. Western Union, MoneyGram, et al, would not have invested the capital to deploy xRapid (Ripple’s enterprise solution that utilizes XRP for cross-boarder transactions) if they, and their attorneys thought that XRP would be deemed a security.
A recent article explains that “the SEC is holding internal talks regarding whether certain cryptocurrencies should be called securities. There are little details about these talks, but it is known that regulators have held the talks on May 7.” Additionally, the former head of the CFTC under the Obama administration is quoted as saying, “he would refer XRP as a ‘non-compliant security’ as a result of its distribution structure.” However, both Tom Channick, Ripple’s Head of Communications, and Cory Johnson, Ripple’s Chief Market Strategist, are both on the record stating that XRP does not meet the guidelines as currently defined by the SEC and the Supreme Court. Based on the information available, I cannot help but agree. It appears we have our answer to the million dollar question.
XRP FUD Bingo
Would you like to learn a little more about the truth of XRP? A new website fudbingo.com has gone live with answers to questions that are frequently asked about XRP. And yes, they even answer the “security” question.
Until next time…stay strong XRP Community, and HODL.
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