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SEC seeks to knock out Ripple defense, says no duty to warn over XRP

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Taking aim at one of Ripple’s core legal arguments, the U.S. Securities and Exchange Commission (SEC) is asking a court to dismiss Ripple’s defense that there was “lack of due process and fair notice,” contending that the government had no duty to warn Ripple that XRP was a security, according to a new legal filing on April 22.

“The thrust of Ripple’s defense is that the SEC was obligated to but did not specifically warn Ripple that it was violating the law before the SEC filed suit,” argued the SEC in the preliminary statement of a memorandum of law filed in support of its motion to strike Ripple’s “lack of due process and fair notice” defense.

“This defense — focused on what the SEC did not do before it filed this enforcement action — is legally insufficient and should be stricken,” the SEC asserted. 

“Ripple’s contention that the SEC must warn a market participant about its legal violation, or that the SEC must issue regulations or guidance before the SEC can exercise the authority Congress conferred on the SEC to enforce the securities statutes, finds no support in the Due Process Clause or any other principle of law,” the SEC wrote.

See related article: Ripple: SEC did not give fair notice that XRP violated law

New filing takes aim at heart of Ripple’s defense

The SEC filed a lawsuit against Ripple in December, alleging that its sale of XRP was an unregistered securities offering worth over US$1.38 billion. The SEC also named Ripple’s executive chairman Chris Larsen and CEO Brad Garlinghouse as co-defendants for allegedly aiding and abetting Ripple’s violations and making US$600 million in personal profits from their unregistered sales of XRP. 

According to legal filings earlier this month, Garlinghouse and Larsen are seeking to have the charges against them dropped. Earlier this week, XRP holders filed a motion to intervene in the lawsuit as a third-party defendant in the hope of protecting their interests in the lawsuit. 

A key issue in the SEC’s lawsuit against Ripple is whether transactions involving XRP constitute “investment contracts” and therefore securities subject to registration under Section 5 of the Securities Act of 1933.

According to Ripple’s answer to the SEC’s complaint, Ripple had asserted four defenses: First, the SEC had failed to state a claim. Second, Ripple did not violate Section 5 of the Securities Act because XRP is not a security or “investment contract,” and no registration was required in connection with any distribution or sale of XRP by Ripple. Third, the SEC had failed to allege a reasonable likelihood of future violations by Ripple, and fourth, the SEC had failed to provide fair notice that Ripple’s conduct was unlawful, and a breach of Ripple’s due process rights.

See related article: SEC: no duty to warn about XRP; denies Ripple’s fair notice defense

In its new filing this week, the SEC asserted that it had provided guidance in the digital assets space, citing its 2017 DAO report concerning “Dao Tokens,” which concluded that the offer and sale of the Dao Tokens were required to comply with the federal securities laws, including the requirement to register with the SEC or to qualify for an exemption from the registration requirements of the federal securities laws.

“The SEC’s message to digital token issuers was clear: the use of distributed ledger or blockchain technology (which underlies XRP and many other digital assets) to raise capital must comply with the federal securities laws,” the SEC wrote.

Then-SEC Chairman Jay Clayton also “repeatedly gave market participants notice that the SEC could view investments involving digital assets as offerings of securities,” the SEC asserted. 

“Given the historical advice Ripple had received since 2012, questions from market participants on the obvious question of whether Ripple’s offers and sales of XRP required registration under the securities laws, and the SEC’s formal investigation, Defendants were aware for many years that the securities laws could apply. Yet Defendants never sought a “no-action” letter from the SEC,” SEC lawyers wrote.

The SEC also argued that the fair notice required to satisfy the Constitution’s Due Process clause was that the statute itself provided fair notice. 

“Ripple’s defense, if accepted, would mean that any time an agency seeks to apply a long-existing statute to a specific set of facts, the violator can argue that the agency’s silence before the filing of the enforcement action precludes liability in that very action,” the SEC wrote. “That is not and should not be the law.”

Legal observers said the law is probably on the SEC’s side on this point.

Securities lawyers Adriaen Morse Jr. and Cory Kirchert from Arnall Golden Gregory LLP told Forkast.News in an email that the SEC “is not obligated to inform any particular company, sector, or industry that the particular instrument that company is planning to sell or has sold is an ‘investment contract’ under the law.” 

“The ‘investment contract,’ which courts and the SEC have applied on numerous occasions since 1933, is a somewhat amorphous or ‘floating’ type of security that is identified by means of various ‘conditions’ applied to the instrument under scrutiny,” Morse and Kirchert wrote. “If the conditions set forth for ‘investment contract’ are satisfied, then the instrument can be considered an investment contract and security.”

The SEC also pointed out that financial regulation in the U.S. has for long been conducted by multiple agencies and departments whose jurisdiction at times overlapped — and the actions or findings of one agency do not put others under any special obligation.

“A 2015 FinCEN settlement on the money services question did not impose on the SEC any duty to remind Ripple of its obligations to comply with the securities laws — laws that market participants specifically raised with Ripple long after that particular settlement,” the SEC asserted. “Indeed, that settlement did not involve the federal securities laws, nor was the SEC a party.”

See related article: How blockchain advocates stopped FinCEN’s ‘crypto wallet rule’—for now

Some regulatory clarity in the U.S. could be emerging. Earlier this week, the U.S. House of Representatives passed an “Eliminate Barriers to Innovation Act of 2021″ bill that aimed to get the SEC and Commodity Futures Trading Commission working together on digital assets.

‘Gamesmanship’ in discovery?

The SEC v. Ripple lawsuit is currently in the discovery phase with both sides battling over what information to share with the opposing party. Earlier this week, the SEC filed a request asking a judge to stop Ripple from seeking information on internal SEC staff communications that had been excluded from discovery

See related article: 12,600 XRP holders demand their day in court in SEC v. Ripple lawsuit

“The SEC is in the process of complying with the Court’s April 6, 2021 Order, Ex. 1 (the “Order”) and has begun reviewing tens of thousands of external emails from the identified custodians for production pursuant to the Order,” the SEC wrote.

“Defendants’ approach is part of a pattern of gamesmanship with respect to discovery,” the SEC wrote. “Defendants do not actually seek relevant evidence, but rather seek to harass the SEC, derail the case’s focus away from its merits, and bog down the SEC with document review.”

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