Why Investors Beyond Ripple Should Be Focused On Its Lawsuit

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Ripple (CCC:XRP-USD) has been on quite the roller-coaster ride of late.

Source: Shutterstock

The crypto plunged in December when the U.S. Securities and Exchange Commission filed a lawsuit against Ripple Labs, the developer behind the Ripple protocol. That suit led XRP-USD to be delisted from a number of major exchanges, including the well-known Coinbase.

By February, the crypto had regained pre-lawsuit levels, only to fade about 12% as of this writing. Where XRP-USD goes from here truthfully is anyone’s guess.

The ultimate outcome of the lawsuit certainly isn’t clear. As Josh Enomoto noted, Ripple Labs seems to have scored an early win in the case. But the SEC isn’t going anywhere, and I’ve argued in the past that the suit itself can impact activity on the network for some time.

In other words, XRP-USD is likely to see continued volatility going forward. Any investor owning the coin at this point likely needs to have significant faith in Ripple Labs’ position — and be willing to take on the risk that such faith will not be rewarded.

But it’s important to note that XRP-USD is not the only coin to be affected by the lawsuit. In two big ways, the Ripple Labs fight should have real meaning for the rest of the cryptocurrency ecosystem.

The Howey Test

Perhaps the most important unanswered question about cryptocurrencies is how governments will react to continued growth in the space.

So far, government action has been more reactive than active. That’s particularly true for the SEC. Developers and exchanges trying to navigate the industry’s legal issues often have deal with “regulation by enforcement,” as one author put it late last year.

We’re seeing the same issue here. Ripple Labs claims XRP is a currency. The SEC says it’s a security.

Legally speaking, the dispute centers over the so-called “Howey test,” created by the Supreme Court to determine what precisely is a security.

But the Howey test has flaws. One of the most obvious is that the Howey test was created during a decision in 1946 (SEC vs. W.J. Howey Co.).

Government Involvement

The other problem is that the Howey test doesn’t offer firm rules for individual situations. The SEC in quoting Howey, admits as much in its complaint against Ripple Labs:

…[T]he Supreme Court made clear…that the definition of whether an instrument is an investment contract and therefore a security is a “flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

Regulating innovation by a “flexible rather than a static principle” is a good way to wind up with precisely this kind of lawsuit. In fact, it’s a good way to stifle precisely that innovation by leaving not only developers, but exchanges and investors in murky legal waters.

In its response, Ripple Labs makes essentially this point.

It notes that an SEC director said in 2018 that neither Bitcoin (CCC:BTC-USD) nor Ethereum (CCC:ETH-USD) counted as digital securities. Ripple Labs points to a settlement with the U.S. Department of Justice that registered XRP as a currency.

And, as CoinDesk noted, its amended complaint says that an exchange reached out to the SEC in 2018 to judge whether XRP was a security. It was not told that it was (which, notably, is different from being told that it wasn’t), and went ahead and listed XRP-USD.

Who’s right? This layman honestly doesn’t know. But the Ripple Labs case could at least create some clarity on the answer not just for this case, but for those going forward.

That in turn could impact government policy going forward. A Supreme Court decision that alters or negates the Howey test could open the floodgates for altcoin developers — or put a brake on institutional investment across the cryptocurrency case. To make a terrible pun, the Ripple Labs case is going to have ripple effects across the crypto world.

Centralized Coins Like XRP-USD

There’s another, non-legal, matter to consider for XRP-USD and other centralized coins.

The legal dispute aside, Ripple Labs doesn’t come off great in the SEC complaint. Part of the agency’s argument that XRP is a security is based on the fact that Ripple Labs itself worked hard to expand distribution of XRP.  Meanwhile, it alleges that both the company and its executives profited handsomely in the meantime.

According to the SEC, Ripple sold “at least” 3.9 billion XRP for $763 million between 2014 and 2019. Those funds went to fund the operations at Ripple Labs. (In its response, Ripple Labs questioned the description of the sales and said it denied the allegations.)

But Ripple’s executives also profited. The SEC says that Ripple Labs co-founder Chris Larsen and his wife have sold 1.7 billion XRP for $450 million. Current chief executive officer Brad Garlinghouse generated $159 million in personal sales. (Ripple Labs said in its response that it could neither confirm nor deny these allegations but did admit that co-founders retained 20 billion XRP at the time Ripple Labs began.)

Some reasonable investors (and citizens) might argue the grants and sales of XRP are fair compensation for personal risk. But to many crypto bulls, particularly those pushing decentralized solutions like Ether, they will look an awful lot like executives using the system to create massive wealth.

That’s precisely what Bitcoin and Ethereum are supposed to avoid. It’s why some crypto bulls don’t trust centralized coins like Ripple or Stellar Lumens (CCC:XLM-USD), which was developed by a Ripple co-founder. Those adherents don’t want the same old rigged systems being built on new technology.

There’s a narrative that can emerge from the Ripple Labs case — no matter the legal outcome — that further splits the crypto community. That might matter more than the court case.

On the date of publication, Vince Martin did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

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