SDNY issues two judgments in closely watched enforcement action against Ripple Labs | Jones day

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In summary

The situation: The US Securities and Exchange Commission (“SEC”) has taken the position that many digital assets are securities subject to regulation under US federal securities laws and has attempted to clarify this position through the use of enforcement actions. In 2021, Ripple Labs, Inc. (“Ripple”) alleged that the SEC failed to provide “fair disclosure” that the digital asset XRP was a security subject to regulation under federal securities laws and two Ripple executives challenged the SEC’s claims on them on grounds of extraterritoriality.

The result: On March 11, 2022, the U.S. District Court for the Southern District of New York denied the SEC’s motion to remove Ripple’s “fair notice” defense and dismissed the SEC’s arguments regarding its viability. In a separate order, the court denied each defendant’s motions to dismiss, concluding that their offerings and sales of XRP were domestic enough to apply U.S. federal securities laws and that the SEC adequately defended their aid claims.

Looking ahead: The court’s rulings were preliminary in nature, and the SEC has yet to survive summary judgment and prove its claims in court (without a settlement). The court’s denial of the SEC’s motion to remove Ripple’s “fair notice” defense is significant, however, as it preserves a potential path to victory for Ripple and will, in a sense, allow Ripple to support the SEC’s efforts to regulate digital Assets like XRP to be banned in court. Additionally, the court’s findings regarding the geographic scope of Section 5 provide some guidance for companies involved in the creation, marketing, and sale of digital assets.

The SEC’s enforcement action against Ripple

In December 2020, the SEC launched an enforcement action against Ripple and two of its officers, alleging that the defendants violated Section 5 of the Securities Act of 1933 by offering and selling XRP unregistered. Ripple argued that XRP is not a security subject to SEC regulation and that even then, the SEC failed to give Ripple “fair notice” that its unregistered sales of XRP violated federal law. The SEC sought to prevent Ripple from asserting this “fair notice” defense. Separately, each defendant moved to dismiss the SEC’s claims, arguing that their offerings and sales of XRP occurred overseas and outside the reach of U.S. federal securities laws and that the SEC failed to adequately assert their aid claims.

The digital asset community closely watched this case to see if the court would provide guidance on whether digital assets like XRP are securities subject to regulation under federal securities laws and whether the SEC would provide adequate notice to market participants that they may be subject to regulation regarding potential claims. Market participants also closely watched each defendant’s extraterritoriality argument, as the court’s decision had the potential to provide guidance on the criteria that should be used to determine whether federal securities laws can be applied to offers and sales of digital assets, often over significant ones have foreign contacts.

Ripple’s “Fair Notice” Defense

Ripple claims it did not receive fair notification that its distribution of XRP violated US securities laws. Among other things, Ripple points to the inaction of the SEC in 2015, when Ripple reached an agreement with the US Department of Justice and the Financial Crimes Enforcement Network (“FinCEN”) that described XRP as a “convertible virtual currency” and allowed future sales of XRP is subject to the laws and regulations applicable to money services businesses. The SEC moved to this defense, arguing, among other things, that there was no need to specifically state the illegality of Ripple’s conduct before beginning any enforcement action, and even if it did, the defendants would have had actual knowledge of their conduct against violate federal securities laws.

The court denied the SEC’s strike motion, concluding that Ripple raised serious legal questions about whether it had “fair notice” that XRP was considered an “investment contract” subject to regulation under federal securities laws (among other things because Ripple claimed 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 harm if the defense continued. The court concluded that Ripple had raised the defense in a timely manner and should therefore be allowed to proceed.

The territorial scope of Section 5 of the Securities Act

In their motions to dismiss the SEC’s claims that they conducted unregistered offerings and sales of securities in violation of Section 5, each defendant argued that their sales of XRP did not occur on domestic exchanges (but rather on digital asset trading platforms with global Activities). ) and that irrevocable liability for such sales was not created in the United States. Each defendant argued that their offerings and sales were therefore foreign (or at least “predominantly foreign”) and thus outside the reach of federal securities laws following the Supreme Court’s decision in Morrison v National Australia Bank Ltd and its descendants (including the decisions of the Second Circuit in Absolute Activist Value Master Fund Ltd. v. Ficeto and Park Central Glob. hub ltd v. Porsche car. Holding SE). The SEC, however, argued that each defendant’s offerings and sales did not qualify as “foreign” for the purposes of Regulation S or “predominantly foreign” for the purposes of Regulation S park centraland that therefore Section 5 could apply.

In denying each defendant’s motions, the court used two different tests to analyze whether the SEC’s Section 5 claims were inadmissibly extraterritorial. First, the court used the transaction test introduced by the Supreme Court in Morrison (rather than the criteria set forth in Regulation S, as advocated by the SEC) to analyze whether each Defendant’s “sales” of XRP were sufficiently domestic to apply Section 5(a). The Court found that the SEC reasonably asserted that irrevocable liability for at least a portion of the sales was made in the United States because those sales were allegedly made on trading platforms that were incorporated and located in the United States, and that Section 5 was therefore consistent so could be applied Morrison.

Second, the court applied a different test, focused on “vendor location” to analyze whether the defendants’ “offers” were sufficiently domestic to create liability under Section 5(c). The court concluded that the SEC plausibly claimed that each defendant offered XRP in the United States because they resided in California at the time the bid was made and used a trading firm with an office in the United States to place their bids. Thus, the offers of the individual defendants were also sufficiently domestic to apply § 5.

The court also dismissed each defendant’s argument that their offerings and sales were so “predominantly foreign” as to fall outside the reach of federal securities laws. The court concluded that because the offers and sales were made by US citizens and in some cases involved US-based trading platforms and US buyers, the application of Section 5 “would enhance confidence in US securities markets [and] Protect US investors” (citation Cavello Brown reins. ltd against Shubin Stein).

SEC Aid Claims

The court also denied each defendant’s motion to dismiss the SEC’s aid complaint. In doing so, the court dismissed each defendant’s arguments that the SEC must assert that they knew Ripple’s conduct was illegal or improper. The court concluded that the SEC only had to argue that the individual defendants knew the facts underlying Ripple’s alleged wrongdoing, not the legal ramifications of those facts. The court also held that the SEC’s civil aid claim did not require proof of intent and that reading a requirement of intent into the statute would be inconsistent with the Dodd-Frank Act (which expands liability for aid and does not contractually establish it).

Alyssa Aubuchon in the New York office helped prepare Comment.

Three key takeaways

  1. The court’s decision to deny the SEC’s motion to remove Ripple’s “fair notice” defense was a significant victory for Ripple; it will allow Ripple to later bring its own conduct and SEC statements regarding digital assets to the case. Market participants should monitor further developments on this defense as the proceeding progresses.
  2. The court’s decision provides guidance on how Section 5 of the Securities Act may apply to offers and sales of digital assets, which often have significant foreign components. If applied to other cases, the court’s reasoning could expose individuals associated with other unregistered digital assets to potential liability if their offers for sale originated in the United States. Market participants should consider the Court’s conclusions when structuring future marketing efforts.
  3. While the court concluded that each defendant’s offers and sales were sufficiently domestic for federal securities laws to apply, the court rejects the SEC’s argument that Regulation S (rather than Morrisons transaction test) was intended to regulate the extraterritoriality analysis for Section 5 claims, but was nevertheless a setback for the Commission.
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