The Situation: The U.S. Securities and Exchange Commission ("SEC") has taken the position that many digital assets are securities subject to regulation under the U.S. federal securities laws, and has sought to make that position clear through the use of enforcement actions. In 2021, Ripple Labs, Inc. ("Ripple") asserted that the SEC had not provided "fair notice" that the digital asset XRP was a security subject to regulation under the federal securities laws, and two Ripple executives challenged the SEC’s claims against them on extraterritoriality grounds.
The Result: On March 11, 2022, the U.S. District Court for the Southern District of New York denied the SEC's motion to strike Ripple's "fair notice" defense and rejected the SEC's arguments regarding its viability. In a separate order, the court denied the individual defendants' motions to dismiss, concluding that their offers and sales of XRP were sufficiently domestic for the U.S. federal securities laws to apply, and that the SEC had adequately pled its aiding and abetting claims.
Looking Ahead: The court's rulings were preliminary in nature, and the SEC will still have to survive summary judgment and prove its claims at trial (absent a settlement). However, the court's denial of the SEC's motion to strike Ripple's "fair notice" defense is significant, as it preserves a potential path to victory for Ripple and will, in some sense, allow Ripple to put the SEC's efforts to regulate digital assets like XRP on trial. In addition, the court's findings regarding the territorial reach of Section 5 provide some guidance to companies involved in the creation, marketing and sale of digital assets.
The SEC's Enforcement Action Against Ripple
In December 2020, the SEC commenced an enforcement action against Ripple and two of its senior executives alleging that the defendants violated Section 5 of the Securities Act of 1933 through the unregistered offering and sale of XRP. Ripple argued that XRP is not a security subject to SEC regulation, and that even if it is, the SEC failed to provide Ripple with "fair notice" that its unregistered sales of XRP violated federal law. The SEC moved to prevent Ripple from asserting this "fair notice" defense. Separately, the individual defendants moved to dismiss the SEC's claims, arguing that their offers and sales of XRP occurred abroad and were beyond the reach of the U.S. federal securities laws, and that the SEC failed to adequately plead its aiding and abetting claims.
The digital assets community was watching this case closely to see if the court would provide guidance on whether digital assets such as XRP are securities subject to regulation under the federal securities laws, and whether the SEC adequately put market participants on notice that they could be subject to potential claims. Market participants were also closely monitoring the individual defendants' extraterritoriality argument, as the court's decision had the potential to provide guidance on the criteria that should be used to determine whether the federal securities laws can be applied to offers and sales of digital assets, which often have significant foreign contacts.
Ripple's "Fair Notice" Defense
Ripple asserts that it did not have fair notice that its distribution of XRP violated U.S. securities laws. Ripple points to, among other things, the SEC's lack of action in 2015 when Ripple reached a settlement with the U.S. Department of Justice and the Financial Crimes Enforcement Network ("FinCEN") that described XRP as a "convertible virtual currency," and permitted future sales of XRP subject to the laws and regulations applicable to money services businesses. The SEC moved to strike this defense, arguing, among other things, that it was not required to provide specific notice of the illegality of Ripple's conduct prior to commencing an enforcement action, and even if it was, the defendants had actual notice that their conduct violated the federal securities laws.
The court denied the SEC's motion to strike, concluding that Ripple had raised serious legal questions as to whether it had "fair notice" that XRP was considered an "investment contract" subject to regulation under the federal securities laws (including because Ripple alleged that XRP was not sold as an investment and that its price was not tied to Ripple's activities). The court also rejected the SEC's argument that it would suffer undue prejudice if the defense was permitted to proceed. The court concluded that Ripple had raised the defense in a timely fashion, and that it should therefore be permitted to proceed.
The Territorial Reach of Section 5 of the Securities Act
In their motions to dismiss the SEC's claims that they engaged in unregistered offers and sales of securities in violation of Section 5, the individual defendants argued that their sales of XRP did not occur on domestic exchanges (but rather on digital asset trading platforms with worldwide operations) and that irrevocable liability for those sales was not incurred in the United States. The individual defendants argued that their offers and sales were therefore foreign (or at least "predominantly foreign"), and thus beyond the reach of the federal securities laws under the Supreme Court's decision in Morrison v. National Australia Bank Ltd and its progeny (including the Second Circuit's decisions in Absolute Activist Value Master Fund Ltd. v. Ficeto and Parkcentral Glob. Hub Ltd. v. Porsche Auto. Holdings SE). The SEC, on the other hand, argued that the individual defendants' offers and sales did not qualify as "foreign" under Regulation S, or "predominantly foreign" under Parkcentral, and that Section 5 could therefore be applied.
In denying the individual defendants' motions, the court used two different tests to analyze whether the SEC's Section 5 claims were impermissibly extraterritorial. First, the court used the transactional test established by the Supreme Court in Morrison (rather than the criteria set forth in Regulation S as advocated by the SEC) to analyze whether the individual defendants' "sales" of XRP were sufficiently domestic for Section 5(a) to apply. The court determined that the SEC adequately alleged that irrevocable liability for at least some of the sales was incurred in the U.S., as those sales purportedly occurred on trading platforms incorporated and based in the U.S., and that Section 5 could therefore be applied consistent with Morrison.
Second, the court applied a different test focused on the "location of the offerors" to analyze whether the defendants' "offers" were sufficiently domestic to impose Section 5(c) liability. The court concluded that the SEC plausibly alleged that the individual defendants offered XRP in the U.S. because they resided in California when the offers were made and utilized a trading firm with an office in the U.S. to place their offers. Thus, the individual defendants' offers were also sufficiently domestic for Section 5 to be applied.
The court also rejected the individual defendants' argument that their offers and sales were so "predominately foreign" as to be outside the reach of the federal securities laws. The court concluded that since the offers and sales were made by U.S. residents and in some instances involved U.S.-based trading platforms and U.S. purchasers, applying Section 5 would "enhance confidence in U.S. securities markets [and] protect U.S. investors" (quoting Cavello Bay Reins. Ltd. v. Shubin Stein).
The SEC's Aiding and Abetting Claims
The court also denied the individual defendants' motion to dismiss the SEC's aiding and abetting claims. In doing so, the court rejected the individual defendants' arguments that the SEC was required to plead that they knew Ripple's conduct was illegal or improper. The court concluded that the SEC was only required to plead that the individual defendants knew the facts underlying Ripple's alleged misconduct, not the legal implications of those facts. The court also explained that the SEC's civil aiding and abetting claim did not require a showing of willfulness, and that reading a willfulness requirement into the statute would be inconsistent with the Dodd-Frank Act (which expanded rather than contracted aiding and abetting liability).
Alyssa Aubuchon, in the New York Office, assisted in the preparation of this Commentary.
Three Key Takeaways
- The court's decision to deny the SEC's motion to strike Ripple's "fair notice" defense was a significant victory for Ripple; it will allow Ripple to place the SEC's own conduct and statements regarding digital assets at issue later in the case. Market participants should watch for further developments on this defense as the case proceeds.
- The court's decision provides some indication of how Section 5 of the Securities Act may be applied to offers and sales of digital assets, which often have significant foreign components. If applied in other cases, the court's reasoning could expose individuals affiliated with other unregistered digital assets to potential liability where their offers to sell emanate from the United States. Market participants should consider the court's conclusions in structuring future marketing efforts.
- While the court concluded that the individual defendants' offers and sales were sufficiently domestic for the federal securities laws to apply, the court's rejection of the SEC's argument that Regulation S (rather than Morrison's transactional test) should govern the extraterritoriality analysis for Section 5 claims was nonetheless a setback for the commission.