On April 6, 2021, Ripple Labs Inc. (Ripple) scored an important win in a discovery dispute in a US Securities and Exchange Commission's (SEC) enforcement action when SDNY Magistrate Judge Sarah Netburn granted "in large part" Ripple's motion to compel. Sec. & Exch. Comm'n v. Ripple Labs, Inc., No. 1:20-cv-10832 (S.D.N.Y.). Ripple is a payments technology company that uses blockchain innovation, including the cryptocurrency token XRP, to send value around the world. The SEC sued Ripple, its CEO, and its chairman, alleging that XRP is a security and that Ripple sold 14.6 billion XRP tokens since 2013 without filing a registration statement.
Judge Netburn directed the SEC to comply with many of defendants' discovery requests, including those that called for the SEC's communications with third parties (which included other government agencies) about whether two other comparable cryptocurrencies-Bitcoin and Ether-were securities, and whether XRP itself was a security. Judge Netburn denied defendants' request for wholly internal SEC communications.
Defendants argued in their motion that SEC communications concerning Bitcoin, Ether and XRP potentially could show the SEC's own uncertainty around the regulation of cryptocurrencies. A key premise of that argument was that the SEC is a "focal point" in the ongoing market-wide discussion about the character of XRP and other digital assets. Therefore, for purposes of Ripple, the SEC's views articulated to third parties would be relevant to defendants' arguments about lack of fair notice that XRP could be considered a security.
Individual defendants also argued that these communications could be relevant to their argument that they lacked scienter. Because Ripple executives were charged with aiding and abetting Ripple's alleged violations of Section 5 of the Securities Act of 1933, the SEC must show that the individual defendants knew or recklessly disregarded that Ripple was engaged in a securities law violation and the executives nonetheless "substantially assisted" Ripple in committing that violation. Sec. & Exch. Comm'n v. Apuzzo, 689 F.3d 204, 211, 211 n.6 (2d Cir. 2012); 15 U.S.C. § 77o(b). For this reason, the individual defendants argued that the SEC has put at issue whether XRP sales were securities offerings and whether individual defendants knowingly or recklessly failed to recognize them as such.
In its response, the SEC framed its enforcement action against Ripple as a straightforward application of the US Supreme Court's ruling in Sec. & Exch. Comm'n v. W.J. Howey Co., 328 U.S. 293 (1946), which set the standard for determining whether an asset is a security. Because the Howey test looks at each asset on its own facts, the SEC argued that facts about other digital assets are irrelevant. The SEC took the position that the Howey test generally puts market participants on notice of what assets may be considered securities, such that any action or inaction by the SEC would not properly support a defense of lack of fair notice.
Judge Netburn ruled from the bench, directing the SEC to produce "the discovery related to Bitcoin and Ether," and communications "between the SEC and third parties" (including other government agencies) relating to XRP, from 19 SEC custodians that defendants had identified. These custodians included SEC staff and three current/former commissioners or chairs, who were identified by their initials. Judge Netburn denied the motion to compel as to internal SEC communications.
Judge Netburn's ruling may be significant for defendants faced with these types of questions in the future. First, she accepted, at least for the purposes of this motion, defendants' arguments as to the relevance of the SEC's views articulated to third parties-including other government agencies-about Bitcoin and Ether. She observed that such evidence could be "relevant to the Court's eventual analysis with respect to the Howey factors," because it goes to individual "defendants' understanding" of their own conduct, and "to the fair notice defense that Ripple is raising." She appeared to be influenced by defendants' arguments that to deny their motion at this stage would be tantamount to a merits determination. Second, the court distinguished third-party communications from internal SEC communications on multiple grounds. The court reasoned that wholly internal SEC communications are "less relevant," could "seriously chill government deliberations," and likely would raise "extensive privilege issues." The ruling therefore avoided thorny issues delineating the SEC's information-gathering and deliberation functions, at least for now.
Ripple continues to be a significant case both in the crypto space, and as to SEC regulation and enforcement more broadly. Of particular interest is how the reasoning underlying the court's decision may be used to compel discovery in ongoing and future enforcement actions, particularly as the SEC takes a more aggressive stance concerning accounting treatment for warrants and other issues related to special purpose acquisition vehicles (SPACs), an area that has garnered attention due to recent statements by the SEC's Director of Corporation Finance. For more information about SPACs and recent regulatory developments, please see our recent Advisory on this topic.
Additional developments are likely in coming weeks, as the court considers whether to allow a group of XRP holders to intervene and the recent motion to dismiss filed by one of the individual defendants. We will continue to monitor and post updates on other significant rulings in this litigation.
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