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US regulators were dealt a setback in their effort to restrict the sale of cryptocurrencies on Thursday when a judge found that Ripple Labs did not violate securities law by selling digital tokens to members of the public.
The Securities and Exchange Commission filed a civil lawsuit against the cryptocurrency pioneer in December 2020, claiming that Ripple sold $1.38bn worth of its XRP token without filing the registrations required under securities laws.
Judge Analisa Torres threw out part of the SEC’s case on Thursday, finding that the registration requirements did not apply to about $757mn of tokens that were sold on digital asset exchanges, because retail investors did not buy XRP with any reasonable expectation of profiting from Ripple’s business activities. But tokens sold to institutional investors were securities, she ruled.
The case turns on a fiercely debated provision of US securities law that bans the sale of “investment contracts” unless they are registered as securities with federal regulators.
Conceived during the Great Depression after a spate of stock promotion scams that cost thousands of Americans their life savings, the law has become a crucial weapon in Gary Gensler’s crackdown on a cryptocurrency industry that the SEC chair has declared is “rife with fraud, scams, and abuse”.
That crackdown widened last month when the SEC filed lawsuits claiming that two big cryptocurrency exchanges, Binance and Coinbase, had also violated the registration requirements. Both companies have denied the allegations and say they intend to defend themselves in court.
The SEC’s chance of prevailing in those lawsuits hinges, experts say, on whether it can persuade judges that a 21st century financial technology matches the vague definition of an “investment contract” enshrined in a 1933 law.
Torres offered some hope to both sides with her ruling in Manhattan on Thursday.
Siding with the SEC, she found that sophisticated institutional investors who bought $729mnn worth of the XRP token understood that “Ripple was pitching . . . potential profits to be derived from Ripple’s entrepreneurial and managerial efforts”.
Consequently, she classed the tokens purchased by institutional investors as investment contracts, and found that Ripple violated securities law by failing to register them.
But Torres added that the “less sophisticated” investors who bought the same tokens on exchanges were either unaware of Ripple’s pitch or did not “parse through the multiple documents and statements” necessary to understand it.
Consequently, the tokens bought by largely retail investors were not investment contracts and did not need to be registered, Torres found.
Ripple chief executive Brian Garlinghouse welcomed the ruling on Twitter, stating that his company was “on the right side of the law, and will be on the right side of history”. The price of XRP traded on Coinbase jumped 30 per cent after the ruling.
However, Torres ordered that a jury must decide whether Garlinghouse, and his predecessor Christian Larsen, “knew or recklessly disregarded the facts that made Ripple’s scheme [to sell unregistered securities to institutional investors] illegal”.
Although the decisions of US district courts are not usually binding on other judges, the ruling in the Ripple case provides an early indication of the challenges that the SEC is likely to face as it pursues a blitz of enforcement actions against other cryptocurrencies.
Coinbase chief legal officer Paul Grewal told investors last month that “the SEC’s entire case is predicated on an understanding of what is . . . [an] investment contract”.
“We think [it] plainly does not cover the types of tokens that we list or the products and services that we offer,” he said.
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