Discovery Ruling Gives Ripple And Its Executives Access To SEC Communications With Third Parties Concerning XRP, Bitcoin And Ether – Corporate/Commercial Law

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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