WHAT’S NEW AND NOTEWORTHY IN THE FEDERAL COURTS
CRYPTOCURRENCY ENFORCEMENT – SEC v. Ripple Labs Inc., No. 1:20-cv-10832 (S.D.N.Y., July 13, 2023) – A federal district court rules that Ripple’s XRP cryptocurrency is both a security and not a security, depending on who purchases the digital asset, thus affording protections to “sophisticated” institutional investors but not to individual retail investors purchasing crypto on a public exchange. This turns 90 years of securities investor protection priorities upside down.
The Issue. Cryptocurrency offerings continue to draw huge attention, as a steady stream of enforcement actions and criminal cases against crypto firms and their principals make headlines while the industry swarms Congress in an effort to secure light-touch regulation at the hands of the underfunded, understaffed, and industry-friendly CFTC. The SEC (under Republican and Democratic leadership) has consistently taken the position that most crypto offerings are securities in the form of investment contracts, and an enforcement action filed in December of 2020 (by Trump’s SEC) illustrates the agency’s approach. The SEC filed its case in federal district court against Ripple Labs, Inc. and two of its principals, alleging that since 2013, the defendants had been selling digital assets (known as “XRP”) that were unregistered securities under the Howey investment contract test. The SEC sought an injunction, disgorgement, and civil monetary penalties.
The SEC’s complaint explained that under the Supreme Court’s landmark decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946), investment contracts are instruments through which a person invests money in a common enterprise and is led to expect profits or returns derived from the entrepreneurial or managerial efforts of others. The theory advanced in this case is that investors are being asked to speculate on the value of XRP and that its value hinges on the “efforts of others,” i.e., the success of the promoters who are trying to generate demand for XRP as a medium for financial firms to effect money transfers. In its complaint, the SEC highlighted the risk of harm to investors and the informational vacuum created when promoters fail to register their securities offerings:
Because Ripple never filed a registration statement, it never provided investors with the material information that every year hundreds of other issuers include in such statements when soliciting public investment. Instead, Ripple created an information vacuum such that Ripple and the two insiders with the most control over it—Larsen and Garlinghouse—could sell XRP into a market that possessed only the information Defendants chose to share about Ripple and XRP.
The Decision. Following years of intense litigation dominated by discovery disputes (reportedly costing Ripple hundreds of millions of dollars in attorneys’ fees and costs), the case was ready for a much-anticipated ruling on cross-motions for summary judgment—arguments from each party claiming that based on the undisputed facts and the law, they were entitled to a judgment in their favor. On July 13, Judge Analisa Torres of the U.S. District Court for the Southern District of New York issued a 34-page ruling that is already being heralded as a victory by the crypto industry, even though it produced decidedly mixed results, some clearly in the SEC’s favor.
The court ruled that XRP was a security under the SEC’s jurisdiction when Ripple sold the digital asset specifically to institutional investors. However, it also ruled that the same investment product was not a security when it was sold on public exchanges to individual retail investors through so-called “programmatic sales.” So, according to this district court, XRP is both a security and not a security, depending on who is purchasing it and how.
The court’s decision ultimately came down to its conviction that institutional investors have more knowledge about XRP and its value in relation to Ripple’s entrepreneurial efforts than retail investors have. As the court explained, “A reasonable investor, situated in the position of the Institutional Buyers, would have been aware of Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts.” In other words, these institutional investors purchased the asset with the expectation that they would derive profits from Ripple’s efforts. As a result, under the standard set forth in the Howey case, these transactions constituted the purchase of a security. Conversely, reasoned Judge Torres, individual retail investors are “generally less sophisticated” and should thus not be expected to have “similar ‘understandings and expectations’” of Ripple and XRP. Thus, for these “less sophisticated” investors, who purchased XRP on digital asset exchanges, the purchase of XRP “did not constitute the offer and sale of investment contracts” with the expectation of profits derived from the efforts of others.
The court was certainly correct in holding that XRP offerings were investment contracts from the standpoint of the institutional investors. However, the court erred in finding that XRP tokens were not securities as to the retail investors who acquired XRP via exchange trading. On this issue, the court’s analysis was internally contradictory, based on erroneous assumptions about retail investors, and at odds with the remedial purposes that underlie the Howey test and the securities laws.
First, while generally insisting that retail investors did not understand to whom or for what they were investing their money, the court conceded that at least some of those investors may have purchased XRP “with the expectation of profits to be derived from Ripple’s efforts” to support and develop its token. Yet the court held fast to its view that none of the “programmatic” investors purchased securities.
In addition, the court relied on assumptions about the supposedly limited knowledge of retail investors regarding Ripple and XRP that were inconsistent with the record. It claimed that the Howey test involves an objective assessment of the promises and offers made to investors, not a search for subjective motives. But the court’s “objective assessment” was wrong based on the extensive evidence. The court itself recounted “Ripple’s marketing campaign and public statements connecting XRP’s price to its own efforts,” which appeared through a variety of social media platforms and news sites over several years. Based on this “objective” evidence, it is far more reasonable to conclude that even the programmatic retail investors trading via the exchange had a good grip on what Ripple was up to and in fact were counting on returns derived from Ripple’s efforts. In short, the court failed to persuasively explain how XRP could be a security in one context but lose its fundamental character simply because it was traded in a secondary market—which is a common feature in today’s securities markets.
Finally, the decision is equally troubling from a policy standpoint, as it turns the remedial purposes of the securities laws on their head. Under the court’s holding, those who need protection the least — like the “sophisticated” hedge funds who purchased XRP — are afforded the many protections provided by the securities laws, while those who need protection the most — the retail investors who buy cryptocurrency on a public exchange — are denied those very same protections. And here too the court was inconsistent. It recited with approval the familiar attributes of the Howey test, pointing out it was intended to be a flexible, not static principle, capable of adapting to the countless schemes devised by those seeking investors’ money. It further noted that the Howey test was intended to effectuate the statutory policy of broad investor protection, a goal not to be “thwarted by unrealistic and irrelevant formulae.” Yet the court arrived at a decision that at least in part conflicted with these principles.
There was certainly some comfort in the court’s decision, not only as to the status of XRP as a security with respect to the institutional investors but also as to a number of other issues presented in the case. For example, the court acknowledged that a wide variety of ordinary assets—including crypto tokens—can be packaged and sold as investment contracts, depending on the circumstances. It also rejected Ripple’s attempt to graft an elaborate assortment of new requirements onto the investment contract test, including a requirement that there be a contract conferring specific rights and obligations. And it firmly rejected the defendants’ due process arguments, holding that they had ample notice of the Howey test based on the Supreme Court’s decision and subsequent cases. Finally, as to whether the individual defendants aided and abetted Ripple’s violations, the court held there were genuine issues of material fact surrounding those claims that would have to be resolved at trial.
Why It Matters. The ultimate impact of the decision will hinge on whether the SEC eventually lodges a successful appeal and has the court’s ruling reversed on the status of the XRP tokens sold via the programmatic trading. Meanwhile, the crypto industry will not only tout its win but also adapt its offerings and trading platforms to gain maximal protection from the court’s holding that secondary trading by retail investors can strip a digital asset of its character as an investment contract. That will energize the crypto industry, likely protect at least some of their offerings from securities regulation, and spawn new platforms, all adding to the already massive harm inflicted on investors by this lawless and predatory industry.
Other Notable Cases We’re Tracking
(For more detailed descriptions of the cases reviewed below, click here.)
- PROTECTING WHISTLEBLOWERSWHISTLEBLOWER ASKS SUPREME COURT TO OVERTURN LOWER COURT RULING, WHICH WEAKENS PROTECTIONS AGAINST WHISTLEBLOWER RETALIATION – Murray V. UBS Securities, LLC, No. 22-660 – The Supreme Court has agreed to review a Second Circuit decision holding that a whistleblower’s Sarbanes-Oxley Act claim for retaliation requires a showing that the employer took an adverse employment action against the whistleblower with “retaliatory intent,” as opposed to merely showing that the whistleblower’s actions were a “contributing factor” in the adverse employment action. This case has broad implications for whistleblowers and whether they can feel safe coming forward without fear of reprisal from their employers. Oral argument is set for October 10, 2023.
- FUNDING CONSUMER PROTECTION: SUPREME COURT WILL DECIDE CONSTITUTIONALITY OF CFPB’S FUNDING STRUCTURE, WITH IMPLICATIONS FOR THE FEDERAL RESERVE AND OTHER SIMILARLY-FUNDED AGENCIES – Consumer Financial Protection Bureau v. Community Financial Services Association of America, No. 22-448 – The Supreme Court has agreed to review the 5th Circuit’s decision that the Consumer Financial Protection Bureau’s funding structure violates the Appropriations Clause of the U.S. Constitution. This case is part of the relentless and ongoing assault on one of the most effective consumer protection agencies in the history of financial regulation. Oral argument is set for October 3, 2023.
- PUNISHING SECURITIES LAWBREAKERS: SUPREME COURT TO REVIEW CONSTITUTIONALITY OF THE SEC’S ADMINISTRATIVE ENFORCEMENT PROCESS – Securities and Exchange Commission v. Jarkesy, No. 22-859 – The Supreme Court recently decided that next term it will review the Fifth Circuit’s decision that the SEC’s administrative enforcement proceedings before administrative law judges or “ALJs” violate the Constitution’s separation of powers doctrine, the non-delegation doctrine, and the Seventh Amendment right to a jury trial. The lower court decision delt a serious blow to a vitally important mechanism the SEC uses to fight fraud in the securities markets.
- DENYING INJURED INVESTORS THEIR DAY IN COURT: NINTH CIRCUIT CLOSES THE COURTHOUSE DOORS TO WRONGED INVESTORS, JEAPORDIZING THE RIGHT OF SHAREHOLDERS TO HOLD COMPANIES ACCOUNTABLE – Lee v. Fisher, No. 21-15923, 2023 WL 3749317 (3:20-cv-06163-SK) (9th Cir., June 1, 2023) (en banc); Lee v. Fisher, 34 F.4th 777 (9th Cir. May 13, 2022) – Can a company adopt bylaws to cancel or nullify federal securities laws, including those designed to hold companies accountable for misconduct that hurts shareholders? Unfortunately, an en banc panel of the Ninth Circuit recently said “yes” in an opinion issued on June 1st in Lee v. Fisher. In a recent procedural move, the plaintiff/appellant, Lee, petitioned the court for another rehearing, this time by all of the judges on the Ninth Circuit. In November 2022, Public Citizen, joined by Better Markets and the Consumer Federation of America, filed an amicus curiae brief in the case in support of Lee. We weighed in again on July 3rd with another amicus brief to support this latest bid by Lee to correct the court’s flawed decision, which leaves her with no forum in which to bring her derivative claim that The Gap made misrepresentations in its proxy materials. We continue to watch the case closely.
- ALLOWING INVESTORS TO GET INDEPENDENT ADVICE: FEDERAL COURT REJECTS CHAMBER OF COMMERCE’S CHALLENGE TO SEC’S PROXY ADVICE RULE – Chamber of Commerce v. SEC, No. 3:22-cv-00561 (M.D. Tenn., Apr. 4, 2023) – The U.S. District Court for the Middle District of Tennessee sided with the SEC and investors in a strong opinion rejecting industry’s attacks on the SEC’s improvements to its proxy advice rule. Those rule changes were necessary to ensure that shareholders can get independent and timely advice on how to vote their proxies. The Chamber of Commerce has recently appealed the ruling to the Sixth Circuit (No. 23-5409).
- DISCLOSING BUYBACK INFORMATION TO INVESTORS: CHAMBER OF COMMERCE CHALLENGES SEC STOCK BUYBACK RULE IN FIFTH CIRCUIT COURT OF APPEALS – Chamber of Commerce v. SEC, No. 23-60255 (5th Cir., May 12, 2023) – The Chamber of Commerce has challenged the SEC’s newly approved share repurchase or “buyback” disclosure rule, alleging it violates the rulemaking procedures set forth in the Administrative Procedure Act. In fact, the SEC’s rule simply ensures that investors have more information about when, how, and why companies are spending their excess capital on buybacks, often used to enrich executives, instead of enhancing operations and employee welfare.
- PROTECTING INVESTORS’ BEST INTERESTS: SEC HAS BEGUN TO ENFORCE REGULATION “BEST INTEREST” – SEC v. Western International Securities, Inc., 2:22-cv-04119 (C.D. Cal.) – The SEC is litigating its first enforcement action alleging violations of its “Best Interest” rule aimed at protecting investors from conflicted investment advice. The outcome will help determine whether the so-called “best interest” rule will have any teeth and provide real protections for investors who are sold inferior investments by advisers seeking to line their own pockets. For now, a jury trial has been set to begin January 30, 2024.
- DIVERSITY DISCLOSURE: INDUSTRY OPPOSES TRANSPARENCY ABOUT DIVERSITY ON CORPORATE BOARDS – Alliance for Fair Board Recruitment v. SEC, 21-60626 (5th Cir.) – Opponents challenge the SEC’s approval of a new rule issued by the NASDAQ that would help advance the cause of racial and gender justice by requiring each company listed on the NASDAQ exchange to publicly disclose the self-identified gender, racial, and LGBTQ+ status of each member of the company’s board of directors. The rule also requires each listed company to have, or explain why it does not have, at least two members of its board who are diverse, including at least one director who self-identifies as female and at least one director who self-identifies as an underrepresented minority or LGBTQ+. The court heard oral argument on August 29, 2022, but it has yet to issue a decision.
- STOPPING MARKET MANIPULATION: INVESTORS SEEK TO HOLD MARKET MANIPULATORS ACCOUNTABLE– In re: Overstock Securities, et al., 21-4126 (10th Cir.) – Investors seek to recover damages for a brazen market manipulation scheme allegedly perpetrated by Overstock’s CEO, Patrick Byrne, and others. A Utah district court wrongly dismissed the claims under the theory that deception is an essential element of market manipulation claims. In the appeal, Better Markets and Consumer Federation of America filed an amicus brief in February 2022 explaining not only the legal errors in the district court’s decision but also the more far-reaching harm that the decision threatens unless it is reversed. In our brief, we showed that the securities laws and rules were written broadly to cover fraud and manipulation as two separate forms of illegal conduct, driving home the point that manipulation schemes distort share prices and inflict harm on investors regardless of whether they were carried out using lies or deceit. The court heard oral argument on February 9, 2023, but it has yet to issue a decision.
- STOPPING BANK LYING TO INVESTORS: WILL BANKS BE GRANTED A LICENSE TO LIE, AS LONG AS THEIR FALSEHOODS ARE SUFFICIENTLY GENERIC?– Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc., (In re Goldman Sachs Group, Inc.), No. 22-484 (2d Cir.) – Shareholders allege Goldman Sachs artificially propped up its share price by misleading the public about its management of conflicts of interest. In the Second Circuit, Goldman Sachs has defended itself by arguing that its deceptive assurances, which concealed profound conflicts of interest, were too immaterial or generic to have any impact on the bank’s stock price. By arguing that it should not be liable for its false statements because they were supposedly too generic, Goldman is effectively asking the courts to give them a license to lie. In July 2022, we filed an amicus brief urging the court to consider the context and history of Goldman’s conflicts of interest, something every investor would care about regardless of how “generic” the false representations may have been. Oral argument was held before the Second Circuit on September 21, 2022, and we await that Court’s decision.
- PUTTING RETIREES’ BEST INTERESTS FIRST: THE INSURANCE INDUSTRY ATTEMPT TO TEAR DOWN EVEN MODEST PROTECTIONS FOR RETIREMENT SAVERS – Federation of Americans for Consumer Choice v. DOL, No. 3:22-cv-00243(N.D. Tex., filed February 2, 2022) and American Securities Ass’n v. DOL, No. 8:22-cv-00330 (M.D. Fla., filed February 9, 2022) – Industry associations filed two challenges to pro-investor guidance issued under the Department of Labor’s December 2020 best interest rule. That guidance clarifies when even a single piece of advice to roll over retirement assets can be considered the beginning of an ongoing relationship and therefore covered under the DOL’s rule. In the Florida case, American Securities Ass’n v. DOL, the court resolved cross-motions for summary judgment in February 2023. In that ruling, the court rejected some of the plaintiffs’ claims but also vacated part of the Department of Labor’s guidance. In the Texas case, Federation of Americans for Consumer Choice v. DOL, dispositive motions have yet to be resolved.