[Legal Analysis] Ripple Vs SEC

I've seen a lot of posts with opinions on the SEC v. Ripple case. Some people hope that Ripple will lose this case because in their opinion the whole Ripple/XRP operation is a fraud, others hope removing Ripple from the scene would mean other cryptos (they own) would increase in value.

On the other side there are the people who hope Ripple wins this case because they are XRP holders or believe that Ripple always played by the book. In this post I would like to zoom in on probably the most important aspect of this case, which is the question whether XRP qualifies as a security or currency, and how the 'Howey Test' answers this. But first I want to make clear that this post by no means guarantees in any way a certain outcome of this legal dispute nor will this provide any assurance whether XRP should or shouldn't be considered a security. I also want to state that by no means I am pretending to be an expert in financial security legislation or SEC procedures. Basically what i'm saying is that you shouldn't base your decision to buy or sell XRP on this post.

My main purpose with this post is for us to debate (the possible outcomes) of this case with the facts that have been presented to us. Feelings/(financial) hopes are not relevant in this discussion, so please don't share them. I also want to apologize for any spelling/grammar errors, I'm from Europe.

The Securities Act

In her complaint the SEC states that Ripple (and her executives) sold over 14.6 billion units of the digital asset called XRP. According to the SEC XRP qualifies as a security (we'll get to this) and therefore Ripple was obligated to comply with the laws that protect investors. These laws basically come down to the fact that the issuer of securities provides sufficient and accurate information to the public for them to make informed decisions before they invest. Think about annual reports, financial information and discolure of significant events.

According to the SEC Ripple does not comply with The Securities Act and therefore engaged in illegal securities offerings from 2013 to present. This is a serious allegation and - if ruled in favor of the SEC - could impact Ripples continuity in the USA.

Investment contracts

Under the Securities Act transactions that qualify as 'investment contracts' are considered securities. The most common type of investment contract is probably the transaction where someone buys 'a piece' of a company through shares. This gives the investor voting rights and rights to dividend (profit).

The problem is that throughout history investment contracts have been presented in countless shapes and forms, which made it impossible for lawmakers to create an exhaustive list of products that qualify as an investment contract. That's why the Howey test was created by the U.S. Supreme Court.

Summary SEC v. W.J. Howey Co. (from Investopedia: https://www.investopedia.com/terms/h/howey-test.asp)

The Howey Test refers to a 1946 case which reached the Supreme Court, SEC v. W.J. Howey Co., a lawsuit involving the Howey Company of Florida. This company was a citrus farm which operated on a large swath of land in the southern portion of the state. When the company decided to lease out half of its large property in order to "finance an additional development," the question of whether or not the land itself could be seen as a security came into play.

Purchasers of the Howey land, who themselves had none of the "knowledge, skill, and equipment necessary for the care and cultivation of citrus trees," were speculators. They purchased the land based on the assumption that it would generate a profit for them as a result of the efforts of someone else. Howey Co. ran afoul of the law when it failed to register the transactions. The U.S. Securities and Exchange Commission (SEC) responded with an injunction to block the sale of the land, and the case was eventually appealed, finally arriving in the U.S Supreme Court. The opinion of the Court in the Howey case indicated that "the transactions in this case clearly involve investment contracts, as so defined. The respondent companies are offering something more than fee simple interests in land...they are offering an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise." In the case of Howey Co., the investors in the Florida land saw the transaction as valuable only because of the work that others would perform on the land. By the standards of the Howey Test, this classifies the transaction as an investment contract. Thus, the transaction needed to be registered, and the Howey Co. was found to have violated the law by failing to do that.

The Howey Test

According to the Howey test a transaction has to fullfill the following conditions for it to qualify as a 'investment contract:

Investment of money: this is speaks for itself. The investment of money is purchasing something or providing money for a purpose.

Common Enterprise: now it gets a little more complicated. there are three ways of showing the existence of a common enterprise: horizontal commonality, broad vertical commonality, and narrow vertical commonality.

The horizontal commonality test requires multiple purchasers (more than one) who are all exposed to the risk of the enterprise. This typically means that their monetary investments have been pooled and that they stand to enjoy gain or suffer losses according to the success of the enterprise.

Vertical commonality “focuses on the relationship between the investor and the promoter.” The narrow version requires that “the fortunes of the investor are interwoven with and dependent upon the efforts and successes of those seeking the investment or of third parties.” This test typically requires that the promoter (or third party) have a financial stake in the enterprise such that the promoter bears the risk of loss and the potential for gain alongside the investor. The broad version of vertical commonality requires that the investor’s outcome be dependent on the promoter’s efforts or expertise; it does not require that the promoter’s fortune rise and fall with that of the investor (as is the case with narrow vertical commonality), only that the investors are dependent upon the efforts of the promoter. (source: https://poseidon01.ssrn.com/delivery.php?ID=325026118089092126102086066084083010034050058012070082112080123071106004085088088099038035127124020121002004066018076109121117105060069010052124005093105104001016064093039078084029000019026070026002027064023094085068075080010112118115107021023092008094&EXT=pdf&INDEX=TRUE)

Reasonable Expectation of Profits: This condition is satisfied when the 'investment' was motivated because of a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. (Inc. v. Forman, 421 U.S. 837 (1975))

Is Ripple a security?

In my opinion buying a digital asset like XRP should be considered as an investment of money according to the Howey test.

However, as opposed to the SEC's statement it's not that clear if buying and selling XRP to the public qualifies as a 'common enterprise' or 'reasonable expectation of profits'. Regarding the 'common enterprise' I don't see how buying XRP could qualify as a way of pooling monetary investments which stand to enjoy gain or suffer loss according to the succes of Ripple. And I also don't see how the fortunes of XRP holders are interwoven with an dependent upon the efforts and successes of Ripple. If the public wants to invest in Ripple they can by Ripple stock instead of XRP...

And as far as i can observe price development of XRP mainly depends on priceswings of BTC and ETH, regulation by (foreign) governments, (social) media and trader enthusiasm. I have not noticed that solely the efforts of Ripple have impacted the price of XRP.

So there are arguments to be made that Ripple does not qualify as a security. However no one (not even Ripples lawyers) can predict the outcome of this case. And even though it might not seem like it, there is still a good chance a settlement will be made between Ripple and the SEC.