SEC Stumbles In Ripple Case, Lost In A Maze Of Its Own Making

When the U.S. Securities and Exchange Commission filed its multi-billion dollar lawsuit against the blockchain technology company Ripple and two executives in December, the timing was doubly peculiar. The complaint alleged that Ripple’s sales of the cryptocurrency XRP from 2013 to the present were illegal, unregistered security offerings rather than the distribution of a digital token to build a payments network. The SEC waiting seven years to make this allegation with billions of XRP tokens now coursing through the secondary crypto markets was strange enough. But the case was also filed in the final hours of outgoing SEC chairman Jay Clayton and then dumped on an evenly-split commission heading towards a new Administration.

By watching the volley of filings heat up the case docket, it has become clear that the SEC’s decision to sue Ripple was misguided. And in recent days, a series of developments are starting to make it look like a disastrous mistake that the presumed incoming chairman, Gary Gensler, will have to sort out.

The SEC probably didn’t expect the storm that Clayton’s final act has kicked up, and it has exposed the inherent weakness in the decision to sue. It began on January 1, when a group of XRP holders led by Rhode Island attorney John E. Deaton struck back at the agency. 

Deaton, a personal injury lawyer with class action experience, filed a petition in the U.S. District Court in his home state to force the SEC to exclude his XRP holdings from being defined as a security. He says he didn’t buy XRP as an investment contract and never considered it a security, and the SEC’s action against Ripple unfairly harmed him when it sent its value plunging and forced crypto exchanges to start delisting the token. After filing his action, Deaton says he was inundated with requests from thousands of fellow XRP retail holders wanting to join his case. 

Last Friday, the SEC’s response to Deaton landed in Rhode Island. For those watching the Ripple case in New York, it carried an astonishing argument: the SEC asked to dismiss Deaton’s petition because no determination has yet been made on whether XRP is a security.  Put two and two together, and the SEC is saying that Ripple and its two top executives had to have reasonable knowledge of something seven years ago that the agency itself wasn’t sure about last Friday. One wonders which part of the 1933 Securities Act the SEC will eventually use to argue that Ripple is obliged to have psychic powers to operate lawfully in the United States.

Co-defendants Brad Garlinghouse and Chris Larsen, top Ripple executives, had sent letters to the New York judge on March 3, anticipating their own motions to dismiss the lawsuit with arguments around “fair notice and due process”. Two days later, the SEC’s response to Deaton only made their arguments even more obvious.  Are the SEC staff attorneys failing to show for Zoom meetings to coordinate with each other? It’s no wonder that Ripple filed Freedom of Information Act (FOIA) requests for internal SEC documents and communications that could show that while seven years worth of high-profile developments were going on related to XRP, the agency’s actions were as unclear and confusing. Kind of like the contradictory filings they just made two days apart in New York and Rhode Island.

On March 8, the SEC seemed to panic.  It fired off a letter to the New York judge demanding she strike the “fair notice” defense from the Ripple case altogether, calling it “improper” and “spurious” and seeking an immediate hearing to decide on it. If the judge disagrees, one can only wonder what is lurking in the internal SEC communications that Ripple might find from that FOIA request and other discovery measures. What internal work went into the 2018 announcement by then-Director of Corporation Finance William Hinman that ether (ETH) is not a security, given its similarities to XRP?   Which crypto exchanges asked for clear guidance from the SEC on XRP’s legal status before listing the token, and what were the agency’s internal discussions and responses? How many opportunities was the SEC given since 2013 to give Ripple and XRP holders fair notice about XRP’s status, and what went into every decision to let those opportunities pass? 

I called this case the cryptocurrency trial of the century in December, and I’m being vindicated with each development. Not only is the future of the U.S. crypto industry at stake, but the arrogance of unrestrained regulators making policy through enforcement is on trial as well. The SEC has made clear it doesn’t care how many investors it harms or how many companies it drives overseas as it seeks to stretch its authority beyond common sense. The makings of what appears to be a class action lawsuit against the SEC on this issue confirms the backlash against its overreach.

The most heartening development this week was the introduction of bipartisan legislation by Rep. Patrick McHenry (R-NC), senior Republican on the House Financial Services Committee, to establish a public-private working group led by the SEC and the Commodity Futures Trading Commission (CFTC) to begin hammering out a clear regulatory framework for digital assets. I participated in a Real Clear Policy panel discussion in January with McHenry on crypto regulation, and he spoke of his determination to put an end to the agency’s overreach. It was on the same day President Biden nominated Gary Gensler to chair the SEC. 

Gensler said in his Senate confirmation hearing in February that he thinks the SEC should only use its enforcement resources when it can address big problems in the markets.  So it would stand to reason that the new chairman will address the biggest problem for crypto markets by investing SEC resources in McHenry’s working group, rather than in Jay Clayton’s misguided lawsuit that might blow up in the agency’s face.