The third most valuable crypto has come under scrutiny over its status again
It’s not easy to pave the way, and Ripple may know that better than anyone. Investors in Ripple’s XRP token have just filed a lawsuit against the company, alleging that XRP is an unregistered security that has incurred “injury and losses” for its investors. Investors also claim that the company violated California’s security and unfair trade and competition laws. Ripple has until September 19 to file a response to the lawsuit.
The class-action lawsuit against the company comes as a result of mounting complaints from investors since May 2018. The case cites the SEC’s Framework for Analysis of Digital Assets, which was released earlier this year, to prove that Ripple violated securities laws.
The Charges Facing XRP
The latest case against Ripple was filed by Bradley Sostack, a U.S. Navy veteran and aspiring politician, who contested and lost the Republican presidential primaries in 2018 for Florida’s 13th Congressional District. Sostack purchased 128,978.88 XRP for an amount worth approximately $307,700 in Bitcoin, over the course of one month in January 2018.
Sostack’s purchase occurred toward the end of a run-up in crypto prices during the last months of 2017. Bitcoin touched a peak of $20,000 per coin, and valuations of the overall cryptocurrency markets surpassed $800 billion. XRP itself touched an all-time high of $3.34 on January 4, 2018. But the crypto markets fell into a deep and broad slump that same month, and XRP promptly shed almost 50 percent of its value.
Sostack and the other plaintiffs claim that they invested in XRP because they were led to believe by senior management that its price would increase in the future. Specifically, the filing charges Ripple with, “a scheme…to raise hundreds of millions of dollars through sales of XRP – an unregistered security – to retail investor in violation of the registration provisions of federal and state securities laws.”
The SEC uses four prongs — an investment of money, establishment of a common enterprise, expectation of profits by investors and use of a third party to promote the enterprise — as criteria to assess whether a token is a security. Those criteria are defined by the Howey Test, a 1933 Supreme Court ruling that set a baseline for the definition of securities. In its digital asset framework defined earlier this year, the SEC reiterated the prongs of the test.
Building a Case Against XRP
Unlike Bitcoin and Ethereum, which are mined continuously and released into the crypto market, all of the 100 billion XRP to ever exist was pre-mined. Twenty percent of the total amount was awarded to founders, and another 20 percent was set aside for the markets. Ripple currently holds sixty percent of all XRP in escrow. This arrangement set the stage for the company to artificially inflate XRP’s price in the markets by calibrating supply, according to the plaintiffs.
The suit lays out several examples of where Ripple is supposed to have violated securities laws. They quote message board posts by Ripple CTO David Schwartz, in which he states that Ripple is “legally obligated” to maximize shareholder value (for XRP). “With our current business model, that means acting to increase the value and liquidity of XRP,” he wrote.
Ripple’s founders further promoted the cryptocurrency using promotional tweets and statements by the company’s senior management, advertising the run up in its price. The complaint also names TechCrunch Founder Michael Arrington and Coindesk as entities that helped promote XRP. In response, Coindesk stated that it was editorially independent from its owner, Digital Currency Group, which has stake in XRP.
Once XRP’s price took off in 2017 and early 2018, Ripple’s senior management “accelerated” its token sales. Sales figures for XRP on exchanges jumped from $32.6 million worth of XRP during the third quarter of 2017, to $71.5 million worth of XRP, and then $151.5 million during the fourth quarter of 2017 and the first quarter of 2018 respectively.
Complicating the matter further is XRP’s real or perceived utility. Ripple claims that XRP is used in the blockchain-based products it sells to banks and governments to accomplish transfers. But the filing disputes this claim. “The money raised through the sales of XRP substantially exceeds the amount of money needed to establish a functional network or digital asset,” the suit states. “There is also little apparent correlation between the purchase price of XRP and the market price of any goods or services that can be acquired in exchange for XRP, which to date has not been functionally adopted nor used in any meaningful way.”
What Happens if Ripple’s XRP is Classified as A Security Token?
The most significant effect of XRP’s classification as a security token would likely be a crash in its valuation. XRP’s market cap has skyrocketed from $6.6 billion exactly two years ago to $13.1 billion, as of this writing. In January 2018, it touched an all-time high of $119 billion. The peaks and troughs of its price reflect those of the broader market and the positive spin around cryptocurrencies.
XRP’s narrative hinges on its utility within Ripple’s ecosystem. Increased demand for XRP by Ripple’s customers is supposed to have fueled its price increase. But the filing counters that story with another one in which XRP is purely a speculative play whose price increases line the pockets of Ripple’s founders. It is not inconceivable that a security classification could bring XRP’s price crashing back to pre-2017 levels.
More importantly, Ripple’s XRP classification could have repercussions beyond its immediate ecosystem and provide further, but not absolute, clarity on cryptocurrency regulation. This is because the main contention of the complaint is that XRP is an unregistered security. And for the world’s third most valuable cryptocurrency, that’s a serious charge.