SDNY Issues Two Rulings in Closely Watched Enforcement Action Against Ripple Labs

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.