If Ripple’s arguments prevail in the Southern District of New York and on appeal, this case could … [+]
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The regulatory future of cryptocurrency seems destined to be decided by the courts, thanks to an ill-conceived lawsuit filed by the Securities and Exchange Commission. If Ripple’s arguments prevail in the Southern District of New York and on appeal, this case could give the Supreme Court a chance to review the 1946 Howey decision which set a standard for what constitutes a security.
Courtroom Showdown
I’ve covered the SEC’s case against Ripple Labs case since it was filed by the SEC in December 2020 because it had all the hallmarks of classic enforcement overreach. Ripple and cryptocurrency investors have fought back with robust arguments while the SEC has stumbled and exposed its former leaders’ troubling conflicts of interest. It look like something bigger than a mere lawsuit. The historical moment adds urgency to resolving whether XRP is a currency or security, a question which financial innovation makes difficult, but also demonstrates the SEC’s abuse of its authority.
The total market cap of all cryptocurrencies, including the XRP digital token at the heart of the Ripple case, tops $2 trillion dollars. The sum of these digital assets is now worth more than the total number of U.S. dollars in circulation. Global companies like Goldman Sachs and PayPal are racing to adopt the technology for consumer products. But more ominously, China has already rolled out a central bank digital currency (CBDC) called the Digital Yuan for domestic commercial and consumer use on a big scale. Mastercard has opened talks to act as a financial bridge for China to expand the Digital Yuan’s global network, export its applications and compete against both cryptocurrencies as the U.S. dollar in the emerging digital economy.
Investors reject the agency designed to protect them
Clearly, it is time to re-examine the Howey Test when it comes to cryptocurrencies. That is already obvious in the pre-trial stage, in which the court seemed to recognize that the complexity of building a payments network with distribution of digital currencies like XRP is not always the same thing as starting a company through an IPO. A fatal flaw has already been exposed in one of the SEC’s central arguments. The agency insists that all of Ripple’s sales of XRP have been one long unregistered securities offering since 2013, and that XRP has never had any utility other than being an investment contract in Ripple. Millions of XRP retail holders around the world, many of whom never heard of Ripple, immediately howled in disagreement, apparently to the agency’s surprise.
Rhode Island attorney John E. Deaton filed a motion to intervene against the SEC on behalf of thousands of XRP retail holders, and dismantled the SEC’s arguments by detailing use cases for XRP unrelated to Ripple. The agency’s response was to attack Deaton’s character and sweepingly argue that no retail holders should be allowed to intervene as their interests are amply represented by the defendants in the case. The agency created to defend the interests of retail investors ended up categorizing retail XRP holders as adversaries. A higher court will likely struggle to conclude that the Howey Test was meant to stretch quite that far.
SEC’s disregard for due process
Ripple has also raised a basic question of due process. The SEC says it has the right to levy billion of dollars in fines over sales that began seven years before the case was filed. The problem is that those seven years have a broad public record of refusal by the SEC to provide any clarity over XRP. SEC officials made many speeches and interviews in which they made distinct conclusions on the classification of bitcoin (BTC) and ether (ETH) but were frustratingly vague on XRP. How could Ripple know XRP was a security if the agency itself didn’t know until December 2020? Worse yet, its top two executives – Brad Garlinghouse and Chris Larsen – are also named as defendants even though Garlinghouse didn’t join the company until 2015. Therefore, it isn’t just a company’s due process rights at stake but two individuals, raising bigger constitutional implications if the defendants’ “fair notice” defense is permitted in trial.
Conflict of interest with former SEC leaders Clayton and Hinman
Finally, there is the nagging question of why exactly Jay Clayton decided to authorize the filing of this case on his final day as SEC chairman. Even the New York Times has raised a series of troubling facts that point to what Deaton calls possible “corrupt intent.” It’s a matter of public record that as SEC chair, Clayton said in a market-moving interview in 2018 that BTC is not a security. Hedge fund One River Digital Asset Management bet heavy on BTC days before Clayton advanced the Ripple lawsuit in December 2020, plummeting the competing XRP and causing exchanges to suspend trading it. One River hired Clayton right after he left the SEC.
The optics are bad enough but even worse for Clayton’s former director of corporations finance, William Hinman. Deaton has published public disclosure forms that show Hinman collected over $15 million in payments from the Ethereum-connected law firm Simpson Thacher over the four years while he was at the SEC. Hinman’s 2018 speech while at the SEC detailed why ETH is not a security, sending the token on a rocket ride to its current all-time-high price. He left the SEC a few weeks before the Ripple case was filed and quickly re-joined Simpson Thacher, which sits on the Ethereum Enterprise Alliance. An online petition to SEC Chairman Gary Gensler by a crypto enthusiast, calling for an investigation by the SEC’s Inspector General into Clayton and Hinman’s possible conflicts of interest, quickly gained over 30,000 signatures and was submitted. The longer the case goes on, the more attention will be paid to these questions.
The best solution—immediate Congressional action with the Biden Administration hammering out the regulatory framework—isn’t on the agenda. Instead Gensler has been tasked with cleanup. If he settles the Ripple case, key questions could remain unresolved. While Ripple would likely receive relief from a settlement, there is little to stop the SEC from pulling the same stunt again. More largely, some investors want to punish the SEC for its bad behavior and reduce the temptation for it to abuse its authority in the future. In any event, the SEC needs its own “Ripple Test” to restore its credibility.