Will Howey Progeny Stifle Ripple's Fair Notice Affirmative Defense?
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
- 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.
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).
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.
14 SEC v. Ripple Labs, Inc., No. 20-CIV-10832-ATSN, 2022 WL 748150, at *1 (S.D.N.Y. Mar. 11, 2022).
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.
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.
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.
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.
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.