Leave it up to a cryptocurrency company named Ripple Labs to be at the center of a lawsuit with potentially wide-reaching consequences. In May 2018, Ripple Labs was hit by a securities class action filed in the San Francisco Superior Court and brought by Ryan Coffey, an investor in the company’s XRP cryptocurrency.

The lawsuit argues that, because of past SEC comments and the way XRP is distributed and managed, XRP is a security and as such is in violation of federal securities laws.

The lawsuit is unique in the cryptocurrency scene, where the most cases revolve around fraud allegations or the legality of certain initial coin offering (ICO) “token-presales.

” A favorable ruling for the plaintiffs in the class action could likely have repercussions for how other cryptocurrencies operate in markets for years to come.

Ripple Labs has much on the line. If its XRP cryptocurrency is found to be both a security and in violation of Section 5 of the Securities Act of 1933, which mandates that securities must register with the SEC and be offered on a registered exchange, all purchases of XRP would come to a halt.

“If they are not registered securities, if they are not listed anywhere, the general public cannot invest in them,” said Marc Elovitz, partner and chair of the Investment Management Regulatory & Compliance Group at Schulte Roth & Zabel.

But that may be the least of Ripple’s problems. After halting XRP exchanges, there is then the question of “whether the people who purchased the securities offering have the right of rescission, meaning they can go back to the company and say, ‘I bought this thing from you under false pretenses, and therefore I want to rescind my purchase, and I want to get back the money I paid for it,’” he added.

What’s more, should the lawsuit succeed, the company and its leadership may also face criminal charges. If XRP is a security, “Ripple labs and its CEO may have violated the Securities Act of 1934, because they should have been registered as a broker dealer,” said Sara Crovitz, partner at Stradley Ronon, who was a former deputy chief counsel and associate director at the SEC.

“The ramifications for acting as an unregistered broker-dealer can be severe; they can even be criminal. I’m not saying it will go that far, but that is a possible implication.”

Crypto Complications

To be sure, XRP operates much differently than other cryptocurrencies like Bitcoin or Ether, both of which William Hinman, director of the Division of Corporation Finance at the SEC, said in a June 2018 speech should not currently be defined as securities.

Though the SEC cautioned that Hinman’s speech didn’t reflect the agency’s views, Crovitz noted that “people can take that [speech] to be a pretty clear signal of what the commission thinks as well.

”While individual units or “coins” of Ether and Bitcoin have to be mined on the blockchain by individual users to become actualized property, all 100 million units of XRP are already in existence.

And, according to Fortune Magazine, 61 percent of all XRP units are still owned by Ripple Labs—their original owner—which has been slowly selling cryptocurrency to the public over several years.While the centralized XRP offering allows Ripple to directly profit, it also exposes the company to potentially high rescission liabilities.

The Securities Act of 1933 does allow some securities exemptions from having to register with the SEC or operate on registered exchanges. But Sam Waldon, partner in Proskauer Rose‘s litigation department, notes it’s far from certain Ripple could obtain an exemption. “My sense is that, if there is a strong argument that it is a security, it is going to be tough to establish there is an exemption from registration.

”But even if XRP did get classified as an exempt security, it would still face certain restrictions. Waldon notes that “most of the exemptions prohibit general solicitation” meaning Ripple could not advertise or promote. More important, “almost all the exemptions require you to sell your securities to sophisticated accredited investors who are very well off,” Waldon added, meaning XRP would be barred from being sold to the general public.

The Decentralized Debate

One big factor for determining whether XRP is a security will likely be the centralized nature of the cryptocurrency’s offering. Stephen Aschettino, chair of the payments technology group at Loeb & Loeb, noted SEC director Hinman’s speech hints that decentralization is “one of the more important of the Howey four factors” for assessing if a transaction is a security.

Aschettino was referring to the “Howey test”—a standard set forth by the U.S. Supreme Court in SEC v. Howey that defines an “investment contract,” essentially a security, around four distinct characteristics.

Under Howey, a transaction is a security if it is an investment of money, has an expectation of profits, if said profit comes from the efforts of a third party and if the investment of money is in a “common enterprise,” which is the factor where decentralization comes into play.

It’s not clear a court would place emphasis on one Howey factor over another. But, should a court rule against Ripple in this lawsuit, it would set a potentially seminal precedent about how to go about determining whether cryptocurrencies are securities. “It will be judicial opinion that will be precedent going forward,” Waldon said, noting the court may even rely other tests outside of Howey in its determination.

A court ruling could have wide impact because, the lawsuit has been shifted out of the California State Court to the U.S. District Court for the Northern District of California, meaning the precedent could be more widely applied. Also, Ripple Labs faces a similar class action lawsuit in California that aims to classify cryptocurrency as a security.Some attorneys, however, believe it is unlikely a ruling will come down in the federal case.

“The likelihood is that any class action like this will not be decided by a court,” Schulte Roth’s Elovitz said, noting that most class actions settle out of court.

Elovitz also believes it is more likely for the regulatory environment to change before a court even hands down ruling in this case.

“Regulators, even though they haven’t resolved a lot of these issues yet with cryptocurrencies, they do generally move faster than the courts.”It’s unclear how regulators may act, however, in light of the fact that classifying some cryptocurrencies like XRP as securities would fundamentally alter how they were designed to work.

Daniel Fuke, a partner working in the Securities and Mergers & Acquisitions group of Toronto-based law firm Fasken, noted that, while there is an upside to regulating cryptocurrencies as securities, doing so may be ill-suited to such nascent products.

“In my opinion, classifying digital assets as securities achieves greater investor protection, but also forces issuers to comply with rules that were not designed with digital assets in mind,” he said.

“Securities laws have not yet evolved to the point where all features of digital assets are reflected, namely their economic upside, hyper-transferability and utility.”

Rhys Dipshan

CT-born, New York-based legal tech reporter covering everything from in-house technology disruption to privacy trends, blockchain, AI, cybersecurity, and ghosts-in-the-machine. Continually waiting for law to catch up with tech. (It's like waiting for Godot, but without the clowns)