April 21, 2022 - In this article, we discuss the Southern District of New York's opinion in Securities & Exchange Commission v. Ripple Labs, Inc., et al., deciding the Securities and Exchange Commission motion to strike Ripple Labs' fair notice defense in the SEC's action alleging unregistered securities in digital assets.
The SEC claimed that the defendants failed to register transactions in its digital asset, XRP, as "investment contracts" under Section 5 of the Securities Act, while the defendants contended it is not sufficiently clear that the phrase "investment contract" applies to transactions in XRP and thus raised a fair notice defense.
The fair notice defense arises under the U.S. Constitution's Due Process Clause and requires that the language of any criminal statute be sufficiently clear to objectively give fair notice of what is prohibited (See F.C.C. v. Fox Television Stations, Inc., 567 U.S. 239, 253 (2012)).
The court denied the SEC's motion to strike Ripple's fair notice defense; its opinion represents a significant victory for the defense. This opinion will allow the defense to marshal, on summary judgment, significant and invaluable discovery from the SEC into its own views on how XRP and other digital assets should be classified.
In prior securities enforcement actions against digital assets issuers, for example SEC v. Kik Interactive, Inc., the court had denied the defense's request for similar discovery, concluding the requested discovery was not relevant to the governing legal test. (No. 1:18-cv-05244-AKH, Docs. 27, 28, 30, 33, 34, 36 (S.D.N.Y. 2019)).
This fair notice defense has the potential to cause a significant ripple effect in how securities enforcement actions against digital asset issuers are litigated. However, it remains to be seen whether this case will be resolved on summary judgment, and if so, how that may affect the precedential landscape.
In this litigation, the SEC sued Ripple Labs (Ripple), as well as two of its executive leaders, CEO Brad Garlinghouse and Executive Chairman Christian Larsen, alleging violations of Sections 5 and 15 of the Securities Act of 1933 (the Securities Act) over the defendants' undisputed failure to register transactions in Ripple Labs' digital asset XRP.
The allegations under Section 5 claim that defendants engaged in sales of unregistered securities that constitute "investment contracts" in violation of the Act (SEC v. Ripple Labs, No. 1:20-cv-10832-AT-SN, Doc. 46, at 76 (S.D.N.Y. Feb. 18, 2021)). Section 5 prohibits the offer, sale, or delivery after sale of any security without an effective or filed registration statement (15 U.S.C. § 77e(a), (c)).
As such, a prima facie case of a Section 5 violation requires the SEC to show: (1) that no registration statement was in effect or filed; (2) defendant offered or sold a security; and (3) the offer or sale took place in interstate commerce (S.E.C. v. Cavanagh, 1 F. Supp. 2d 337, 361 (S.D.N.Y.), aff'd, 155 F.3d 129 (2d Cir. 1998)).
In response to the claimed Section 5 allegation, Ripple raised a fair notice defense. The SEC then moved to strike that defense. On March 11, 2022, the court issued an opinion denying the SEC's motion to strike Ripple's fair notice defense.
And earlier this month, on April 8, Larsen and Garlinghouse joined Ripple and likewise raised the fair notice defense in their filed answers. In their answers to the SEC's complaint, all three defendants alleged that they lacked fair notice that their conduct violated Section 5 of the Securities Act, arguing that it is not sufficiently clear that the phrase "investment contract" applies to transactions in XRP.
The defendants further alleged that the SEC was partly responsible for its lack of fair notice by failing to have affirmatively warned them and other third-party market participants, despite its investigation into Ripple that began in 2018, that it interpreted XRP transactions to be investment contracts. The latter allegation is fairly novel — federal courts do not typically require the SEC to give affirmative notice to market participants that their specific activities may violate the law before bringing an enforcement action.
At the time the court denied the SEC's motion to strike Ripple's fair notice defense, it did not address whether there was any viability to Ripple's allegations intimating that the SEC had an affirmative burden to warn Ripple that it deemed XRP transactions to qualify as investment contracts.
The defense and the SEC’s objections
Ripple's fair notice defense raises an as-applied void for vagueness defense, rather than a facial challenge to Section 5. Defendants Larsen and Garlinghouse, by contrast, raise a fair notice defense as an apparently distinct defense from their as-applied void for vagueness defense, though they cite to the same underlying legal principle as the source of both claims (citing Fox Television Stations, 567 U.S. 239, 253 (2012), which lays out the void for vagueness due process standard).
The SEC's argument to strike the defense was predicated primarily on the fact that Section 5 is a long-standing statute that the 2d U.S. Circuit Court of Appeals has repeatedly found is not unconstitutionally vague and that the Southern District of New York has found not unconstitutionally vague in other digital asset litigation.
The court’s holding
The court ultimately denied the SEC's motion to strike Ripple's as-applied fair notice defense. It relied in part upon the fact that the SEC faced a high threshold to prevail at this stage, because motions to strike affirmative defenses are generally disfavored and the movant must show that there is no change, on any set of facts or interpretation of law, that the defense is colorable (see also William Z. Salcer, Panfeld, Edelman v. Envicon Equities Corp., 744 F.2d 935, 939 (2d Cir. 1984)).
The court recognized that an affirmative defense should be stricken if it is not a legally cognizable defense to the plaintiff's claims (quoting GEOMC Co. v. Calmare Therapeutics Inc., 918 F.3d 92, 98 (2d Cir. 2019)). However, the court rejected the SEC's argument that the fair notice defense should be stricken as legally insufficient. assuming as true Ripple's facts averred in its answer. Specifically, Ripple argued that its fair notice argument was tethered to its contention that XRP transactions do not qualify as "investment contracts" because, as Ripple averred in its answer, "Ripple has never explicitly or implicitly promised profits to any XRP holder[.]"
The court held that Ripple's assertions in its filed answer that its XRP sales did not qualify as an investment, if proven true, would raise legal questions as to whether it had fair notice that the term "investment contract" covered XRP transactions. Thus, the court signaled that it would give more careful consideration to the validity of this defense on summary judgment. Accordingly, the court appears to have sanctioned raising an as-applied fair notice defense under Section 5 where the defendant may plausibly aver that there was no statutory securities violation in the first place.
Significance of the ruling
Ripple's success on this motion is significant because if future digital asset defendants may successfully bring fair notice defenses under Section 5 based on allegations regarding the SEC's own conduct, that will open the door in discovery to, at a minimum, requests for the SEC's notes from meetings with third parties in the digital asset space, draft speeches from SEC leaders on how various digital assets should be categorized, and documents containing the SEC's formal positions on whether a given digital asset qualifies as a security. It may also sweep in additional categories of documents shedding light on the SEC's views on how specific digital assets should be classified.
Furthermore, if the court were to permit Ripple to build its fair notice defense around what statements the SEC did and did not make to Ripple or XRP holders generally, that would be a novel and powerful extension of the fair notice defense that would give digital asset defendants in securities litigation significant leverage in defending enforcement actions.
However, it is notable that the court foreshadowed that it believes summary judgment is a more proper stage at which to meaningfully adjudicate this issue. Moreover, the Southern District of New York, in a prior securities enforcement action against a digital asset issuer (Kik Interactive), found upon summary judgment that the term "investment contract" is sufficiently clear that it was not unconstitutionally vague as applied to the digital asset transactions at issue there (SEC v. Kik Interactive Inc., 492 F. Supp. 3d 169, 182-83 (S.D.N.Y. 2020)).
Accordingly, whether the Ripple court adopts the rationale in Kik Interactive on summary judgment will likely have a significant effect on whether Ripple's fair notice defense survives summary judgment.
Ultimately, this decision is the first of its kind and its precedential breadth remains to be seen. This opinion may be the start of a significant sea change in how digital asset securities enforcement actions are defended, or rather, it may find itself carved out as a narrow exception that proves the rule. What kinds of ripple effects might it have? Only time will tell.