In the latest chapter of the high-profile SEC v. Ripple
Labs, Inc., et. al. litigation, the SEC revisits its prior
attempt to strike down the defendants’ due process affirmative
defense. Nearly a year after the SEC failed to convince U.S.
District Court for the Southern District of New York Judge Analisa
Torres to strike Ripple’s “fair notice” affirmative
defense, the agency is again targeted it in its motion for summary
judgment (MSJ). The SEC recently supplemented its MSJ with a new
opinion out of the U.S. District Court for the District of
Massachusetts, arguing that court’s ruling – rejecting a
party’s fair notice defense premised on the same precedent
Ripple relies upon – is the latest example of federal courts
striking down such arguments. Ripple pushed back, arguing that the
recent opinion – as are other cases cited by the agency
– are distinguishable given the ample evidence within the
SEC’s own files about regulatory confusion.
In this post, we provide a brief overview of the fair notice
affirmative defense, an overview of the back-and-forth of this
defense in the Ripple litigation and some key
takeaways.
Fair Notice Defense
Under the Due Process Clause of the Fifth Amendment, all persons
“are entitled to be informed as to what the State commands or
forbids.”1 This is a fundamental principle of the
American legal system – what a law forbids or requires cannot
be so vague that a person of “common intelligence” cannot
determine the law’s meaning or its application.2 A
governmental regulation will be found to be void where it is
“so standardless that it authorizes or encourages seriously
discriminatory enforcement.”3 Courts often find
that “economic regulation is subject to a less strict
vagueness test because its subject matter is often more narrow, and
because businesses, which face economic demands to plan behavior
carefully, can be expected to consult relevant legislation in
advance of action.”4
In SEC enforcement actions involving digital assets, defendants
have unsuccessfully asserted this defense on several occasions. For
example, in SEC v. Kik Interactive Inc., the SEC alleged
that Kik violated Section 5 of the Securities Act of 1933
(Securities Act) when it engaged in the unregistered offer and sale
of its digital asset called Kin.5 Kik asserted a fair
notice affirmative defense, claiming that the term “investment
contract” was unconstitutionally vague.6
Specifically, Kik relied on the U.S. Court of Appeals for the
Second Circuit opinion in Upton v. SEC, wherein the
defendant’s vagueness challenge to a customer protection rule
applicable to broker-dealers succeeded on facts demonstrating the
SEC had inconsistently enforced the rule for years.7 But
in analyzing Upton in connection with the defendant’s
fair notice argument the Kik court sided with the SEC,
holding that Howey provided a clearly expressed test for
determining what constitutes an investment contract and, unlike in
Upton, every cryptocurrency’s issuance requires a
fact-specific analysis for enforcement.8
Similarly, in SEC v. LBRY, Inc., the SEC brought an
enforcement action against LBRY for its unregistered offering of a
digital token named LBC.9 LBRY argued that it lacked
fair notice that its offerings were subject to securities laws, not
because it did not know the Howey test applied, but
because the SEC “historically and consistently focused its
guidance, as well as its enforcement efforts, exclusively on the
issuance of digital assets in the context of an Initial Coin
Offering [“ICO”].”10 The LBRY
court rejected this argument, stating that the holding of
Howey would not lead a reasonable issuer to conclude that
only ICOs are subject to the registration requirement.11
The court likewise rejected LBRY’s reliance on Upton,
holding that the facts of Upton bared no resemblance to
the facts at issue in the case.12 The court held that
“the SEC has its claim on a straightforward application of a
venerable Supreme Court precedent that has been applied by hundreds
of federal courts across the country over more than 70
years.”13
SEC Moves to Strike Ripple’s Affirmative Defense of Lack of
Fair Notice
Similar to LBRY and Kik, Ripple asserted fair
notice as one of its affirmative defenses, asserting that it lacked
“fair notice that its conduct was a violation of law, in
contravention of Ripple’s due process
rights.”14 On April 22, 2021, the SEC filed its
motion to strike Ripple’s lack of due process and fair notice
affirmative defense under Rule 12(f) of the Federal Rules of Civil
Procedure.15
The crux of the SEC’s argument was that Ripple’s defense
was legally insufficient, as Ripple could not prevail as a matter
of law.16 Namely, the SEC argued that it is under no
duty to warn a market participant of its legal violations, or issue
regulations or guidance, before it can exercise its authority to
enforce securities statutes.17 Further, the SEC argued
that the Securities Act requires market participants to comply with
law in the first instance, and to require otherwise would
“turn[] the statutory regime on its head.”18
As such, the SEC contended that “the only question under the
Due Process Clause is whether the term ‘investment
contract’ in the Securities Act … fails to give ‘a person
of ordinary intelligence a reasonable opportunity to know what is
prohibited.'”19
On March 11, 2022, the Ripple court denied the
SEC’s motion.20 In evaluating the motion, the court
was required to 1) deem Ripple’s well-pleaded facts in its
Answer to be admitted; 2) draw all reasonable inferences in
Ripple’s favor; and 3) resolve all doubts in favor of
Ripple.21 The court recognized that Ripple was pleading
an “as applied” challenge22 to the Section 5
of the Securities Act [??].23 This required the court to
evaluate whether the law can be constitutionally applied to
Ripple’s individual circumstances.24 In other words,
the court had to consider whether Ripple showed “that the
statute in question provided insufficient notice that his or her
behavior at issue … was prohibited.”25
In its Answer, Ripple highlighted several facts that
distinguished its situation from other matters, including: 1)
XRP’s price bears no relation to Ripple’s activities; 2) it
has not sold XRP as an investment with an expectation of future
profits; 3) it has no relationship with the vast majority of XRP
holders (who acquired their tokens from third parties on the open
market); 4) it separately has its own venture capital investors who
directly purchased shares through lawful exempt private offerings;
5) if Ripple “ceased to function tomorrow, XRP ‘would
continue to survive and trade in its fully developed
ecosystem'”; 6) its wholly owned subsidiary is a
registered money service business with the Financial Crimes
Enforcement Network (FinCEN) and is licensed by the New York
Department of Financial Services to conduct certain virtual
currency business activities; 7) in May 2015, both Ripple and its
subsidiary entered into a settlement agreement with the U.S.
Department of Justice and FinCEN, which referred to XRP as a
“convertible virtual currency”; and 8) in 2019, a digital
asset platform was considering listing XRP and met with the SEC
requesting guidance; notably, during the meeting, the SEC “did
not say that it considered XRP to be a
security.”26
As such, the court concluded that these facts, if true, would
“raise legal questions as to whether Ripple had fair notice
that the term “investment contract” covered its
distribution of XRP.27 Notably, the court specifically
distinguished many of the authorities the SEC relied upon in its
motion, highlighting material differences when considering a motion
to strike an affirmative defense.28 The court noted,
however, that it could revisit this argument on a motion for
summary judgment once the factual record was
developed.29
SEC’s Motion for Summary Judgment and Recent Delivery of
Supplemental Authority
In its September 2022 motion for summary judgment, the SEC
revisited Ripple’s fair notice defense.30 In its
motion, the SEC argued that every federal court considering the
issue has rejected the argument “that the term ‘investment
contract’ as used in the Securities Act, or as construed by
Howey and its progeny, is vague.”31 Citing
to the U.S. Supreme Court case SEC v. C.M. Joiner Leasing
Corp., 320 U.S. 344, 351 (1943), the SEC argued that
“novel, uncommon, or irregular devices, whatever they appear
to be, are also reached [by the Securities Act] if they operate as
investment contracts.”32 Ultimately, the SEC relied
on the fact that Section 5 of the Securities Act has been litigated
so many times that the case history of application of the
Howey test is sufficient to put Ripple on notice that XRP
was a security.33
On April 11, 2023, the SEC submitted a letter to the court
providing notice of supplemental authority in furtherance of its
pending motion for summary judgment.34 The letter cited
a recent District of Massachusetts decision,35 which
found that the defendant violated negligence-based provisions of
the Investment Advisers Act of 1940 (Advisers Act) by failing to
disclose certain conflicts of interest.36 Notably, that
court rejected the defendant’s due process affirmative defense
alleging “that the SEC failed to provide [defendant] with fair
notice of the disclosure obligations asserted in the
complaint.”37
Like Ripple, the Commonwealth defendant premised its
“fair notice” defense on Upton v. SEC, 75 F.3d
92 (2d Cir. 1996). Invoking Upton, the
Commonwealth defendant’s fair notice argument alleged
that the SEC had long been aware of the defendant’s practices
at issue, “expressed concerns … and considered rulemaking
relating to” such practices, but never adopted specific rules
requiring the types of disclosures at issue.38 The
Commonwealth court distinguished Upton, observing
that Upton’s defendant had “complied with the
literal terms of the [SEC] Rule at all times.”39
The Commonwealth court held that, unlike in
Upton, its defendant received fair notice by virtue of
50-year-old Supreme Court precedent regarding Advisers Act
disclosure obligations.40
In supplementing its summary judgment motion earlier this month,
the SEC argued that Commonwealth supports its motion for
summary judgment for two primary reasons.41
First, the holding aligns with the SEC’s position that
longstanding Supreme Court precedent, such as Howey and
its progeny, can provide fair notice to parties such as Ripple
concerning possible violations of federal securities
laws.42 Second, the SEC argues that the holding
provides another example of a district court rejecting this
defense, even where the SEC had “been aware of [the practices
at issue] for over two decades” and had not adopted rules
addressing that specific conduct.43
Ripple’s Response to SEC Supplemental Authority
On April 13, 2023, Ripple advised the court of its counter
position.44 Ripple argued that, unlike itself, in
Commonwealth the defendant presented no contemporaneous
evidence supporting its defense that market participants lacked
fair notice of an obligation to disclose economic conflicts of
interest under the Advisers Act.45 Instead, Ripple
pointed out, that the defendant merely quoted SEC guidance and
presented a paid expert who opined that he believed (in retrospect)
that the guidance did not require certain
disclosures.46
Here, by contrast, Ripple contends that there is ample factual
evidence from the SEC’s own files, and its communications with
third parties, that demonstrates how reasonable market participants
could not determine the parameters of what the SEC would permit or
prohibit.47 Additionally, these same market participants
concluded Ripple’s offer and sale of XRP were not
“investment contracts” and communicated the same to the
SEC.48 Further, Ripple argued that the SEC was not only
aware of this widespread regulatory confusion, but it enabled it by
repeatedly offering (and then disclaiming) vague guidance that
differed from the Howey test.49 Lastly, Ripple
noted that in Commonwealth, there was no dispute that the
Advisers Act applied to the defendant’s conduct; however, in
this case, a threshold issue – and source of widespread
regulatory uncertainty – is whether the Securities Act
applies to Ripple’s offer and sale of XRP.50
Takeaways
- There is no question that the SEC has history on its side
concerning the fair notice defense. Federal courts across the
country have repeatedly sided with the agency on this question,
including in cases involving digital assets. However, Ripple’s
deft use of discovery early in the matter, its unique history
involving XRP with regulators and unique facts about its
relationship with XRP holders could result in a different outcome
for Ripple’s “as applied” fair notice argument. - It bears reminding that the crux of the SEC’s case against
Ripple involves a violation of the Securities Act’s
registration requirement – a strict liability provision that
requires no proof of intent nor evidence of malfeasance. Although
some have argued that strict liability claims involve mere
technical violations, this case underscores that SEC enforcement
matters alleging non-scienter/non-negligence violations remain
high-stakes for companies in this space. And even if they can
prevail on these difficult matters, just defending the matters can
be extremely time-consuming and costly. - Following SEC Chair Gary Gensler’s contentious testimony in
front of the House Committee on Financial Services on April 18,
2023, where several House Republicans took the SEC Chair to task
for the agency’s approach to digital asset and crypto
enforcement, there is no question the chorus for more detailed
regulatory guidance remains loud. The chorus has grown only louder
in light of extreme volatility in crypto markets over recent
months. However, the Chair’s steadfast position that many
tokens are securities, combined with a string of contested wins on
the subject in district courts, suggests that we can expect a
continued trend of enforcement actions without additional guidance
from the agency.
Footnotes
1. Lanzetta v. New Jersey, 306 U.S. 451, 453
(1939).
2. Connally v. General Constr. Co., 269 U.S.
385, 391 (1926).
3. United States v. Williams, 553 U.S. 285, 304
(2008).
4. Vill. Of Hoffman Ests. V. Flipside, Hoffman Ests.,
Inc., 455 U.S. 489, 498 (1982).
5. 492 F. Supp. 3d 169, 176 (S.D.N.Y. 2020).
6. Id.
7. 75 F.3d 92, 98 (2d Cir. 1996).
8. Kik Interactive Inc., 492 F. Supp. 3d at
183.
9. 21-CV-260-PB, 2022 WL 16744741, at *1 (D.N.H. Nov. 7,
2022).
10. Id. at *7.
11. Id. at *8.
12. Id.
13. Id.
14. SEC v. Ripple Labs, Inc., No.
20-CIV-10832-ATSN, 2022 WL 748150, at *1 (S.D.N.Y. Mar. 11,
2022).
15. Id.
16. Id. at *4.
17. SEC Mem. at 1, SEC v. Ripple Labs, Inc., No.
20-CIV-10832-ATSN (S.D.N.Y. Apr. 22, 2021), ECF No.
132.
18. Id.
19. Id. at 2.
20. Ripple Labs, Inc., 2022 WL 748150, at
*6.
21. Id. at *3.
22. On the other hand, one may also make what is referred
to as a “facial” challenge to a statute, whereby the
court does not consider the individual facts of the challenger, but
instead analyzes whether the language of the statute itself is
unconstitutionally vague on its face. See United States v.
Bowdoin, 770 F. Supp. 2d 142, 146–49 (D.D.C.
2011).
23. Id. at *4.
24. See Copeland v. Vance, 893 F.3d 101, 110 (2d
Cir. 2018).
25. See id. at 117.
26. Ripple Labs, Inc., 2022 WL 748150, at
*2.
27. Id. at *5.
28. See id.
29. See id. n.5.
30. See generally SEC Mot. for Summ. J., SEC v.
Ripple Labs, Inc., No. 20-CIV-10832-ATSN (S.D.N.Y. Apr. 22,
2021), ECF No. 640.
31. Id. at 70.
32. Id.
33. See id. at 71–73; see also United
States v. Smith, 985 F. Supp. 2d 547, 588, 589 (S.D.N.Y.
2014), aff’d sub nom. United States v. Halloran, 664
F. App’x 23 (2d Cir. 2016) (“[I]t is not only the language
of a statute that can provide the requisite fair notice; judicial
decisions interpreting that statute can do so as well … even when
the facts at issue in those decisions were not ‘fundamentally
similar’ or ‘materially similar’ to the facts of the
defendant’s case.”); see also United States v.
Zaslavskiy 2018 WL 4346339, at *9 (E.D.N.Y. Sept. 11, 2018)
(denying a motion to dismiss an indictment based upon an argument
that securities laws are unconstitutionally vague as applied to
cryptocurrencies).
34. See generally SEC Suppl. Letter in Supp. of Mot. for
Summ. J., SEC v. Ripple Labs, Inc., No. 20-CIV-10832-ATSN
(S.D.N.Y. Apr. 22, 2021), ECF No. 817.
35. SEC v. Commonwealth Equity Servs., LLC, No.
1:19-cv-11655, 2023 WL 2838691 (D. Mass. Apr. 7, 2023).
36. SEC Suppl. Letter in Supp. of Mot. for Summ. J. at
1.
37. Id.; see Commonwealth Equity Servs.,
LLC, 2023 WL 2838691 at *9.
38. SEC Suppl. Letter in Supp. of Mot. for Summ. J. at
1.
39. Id.
40. Id.; see SEC v. Capital Gains Research
Bureau, Inc., 375 U.S. 180 (1963).
41. SEC Suppl. Letter in Supp. of Mot. for Summ. J. at
1.
42. Id.
43. Id.; see Commonwealth, 2023 WL
2838691, at *9.
44. See generally Ripple Suppl. Letter in Opp’n of
Mot. for Summ. J., SEC v. Ripple Labs, Inc., No.
20-CIV-10832-ATSN (S.D.N.Y. Apr. 22, 2021), ECF No.
818.
45. Id. at 1.
46. Id.; see Commonwealth, 2023 WL
2838691, at *9.
47. Ripple Suppl. Letter in Opp’n of Mot. for Summ.
J. at 1.
48. See id. (internal citations
omitted).
49. See id. (internal citations
omitted).
50. Id. at 1-2.
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