SEC and CFTC Crypto Enforcement Highlight Securities and Litigation Issues

This article relates to Shearman & Sterling's upcoming inaugural Digital Finance Summit on November 15-16. Learn more about the Summit.

Enforcement actions brought by the Securities and Exchange Commission (SEC) against companies in the digital assets space continue to raise significant questions, with the ongoing SEC v. Ripple Labs [1] case a particularly rich example.

One fundamental question that the court has been asked to address in Ripple is whether any particular digital asset should be deemed a security, and thus subject to the securities laws, including registration requirements. Other questions include novel collateral effects of contending with a decentralized structure when considering traditional litigation issues, such as jurisdiction (e.g., where, geographically, do offers and sales take place within a globally distributed ledger).

Ripple and the SEC Complaint 

Ripple is a private financial technology company founded in 2012, whose global payments products generally operate on the “XRP Ledger,” an open-source blockchain created by Ripple, and include an associated XRP native virtual currency. When the XRP Ledger was created in 2012, a fixed supply of 100 billion units of XRP was also created and distributed among Ripple and its founders.[2]  

Over the years, Ripple has sold and distributed billions of units of XRP currency, transactions which are being challenged by the SEC as unregistered (and thus impermissible) sales of securities.[3] The SEC’s view is that XRP should be considered a “digital asset security”[4] by applying the Supreme Court’s 1946 Howey test.[5] According to the SEC’s Complaint, XRP sales violate the federal securities laws’ registration and disclosure requirements.[6] 

Should digital assets be treated as securities?

The SEC’s aggressive position in Ripple is unsurprising given the agency’s view that most digital assets are securities and thus fall within the SEC’s jurisdiction. Another recent manifestation of that view is the SEC’s July 21, 2022 insider trading charge against a former Coinbase Global, Inc. exchange manager (SEC v. Wahi).[7] In both Ripple and Wahi, the SEC relied on its broad interpretation of the term “investment contract” under Howey to assert authority over transactions involving digital assets. 

The SEC’s arguments in Ripple and Wahi are also consistent with the agency’s public pronouncements.[8] SEC Chairman Gary Gensler has stated that “nothing about the crypto market is incompatible with securities laws,” concluding that “most crypto tokens are investment contracts under the Howey Test” and thus subject to the securities laws and SEC jurisdiction.[9] Even though many in the digital asset industry have questioned this position and asked the SEC to provide greater clarity through rulemaking,[10] Chairman Gensler has dismissed these concerns and reaffirmed his view that traditional securities laws (and interpretation from courts and the SEC itself) provide more than sufficient guidance, concluding that the SEC has “spoken with a pretty clear voice.”[11] Gensler has warned digital asset companies that they should “come in, talk to us, and register.”[12] 

Ripple has pushed back, arguing that distribution of XRP lacks the “essential ingredients” to be considered “investment contracts” under Howey.[13]  In essence, Ripple asserts that sales of XRP represent sales of assets, not securities. Defendants claim these sales established no post-sale obligations for Ripple or rights for the purchaser of XRP to share in profits from the Company’s efforts,[14] pointing to the absence of a “common enterprise” as required under Howey.[15] 

The Defendants’ arguments (together with concerns articulated by the industry over several years) raise significant questions about the wisdom of applying Howey – an orange grove case from 1946 – to a class of assets developed only in the last ten years, particularly as the term ‘digital assets’ encompasses a broad spectrum of assets with varying properties and characteristics. While clear agency rulemaking is the preferred course, the Ripple court may soon shed some additional light on this issue as both the SEC and the Defendants filed motions for summary judgment on September 17, 2022.

Collateral effects of litigation involving decentralized organizations

In addition to the question about how to determine whether a digital asset is a security, the Ripple matter has showcased additional issues that will likely continue to arise in litigation involving digital assets and decentralized organizations. 

For example, Defendants Larsen and Garlinghouse (former and current CEOs of Ripple) moved to dismiss the claims against them on the grounds that their personal offers and sales of XRP were made mainly by foreign market-makers and through foreign cryptocurrency exchanges.[16] Accordingly, they argued, their offers and sales were not domestic, but rather “predominantly foreign” and as such outside the territorial jurisdiction of US securities laws regardless of whether XRP was deemed a security.[17]  

Though Ripple is a US-based company, the XRP Ledger and XRP currency holders are distributed over multiple countries. This decentralized and globally distributed nature of the XRP Ledger, on which XRP transactions are ultimately recorded, illustrates how traditional arguments on extraterritoriality and jurisdiction may need to be revisited in litigation involving digital assets. 

The question of jurisdiction turns on where the at-issue offers and sales occurred, and the Court ultimately declined to dismiss the case as to the two CEOs, but without fully accepting the SEC’s arguments.[18] The Court found dispositive that Larsen and Garlinghouse were in the US when directing at least some of the XRP sales and that “at least some offers and sales [were] made on U.S.-based platforms and included at least some offers and sales made to U.S. purchasers.”[19]

Enforcement actions against DAOs

Beyond the Ripple case, we have also seen interesting and novel questions regarding service of process when complaints are directed at a decentralized autonomous organization (DAO) and its members. 

A recent example is the enforcement action by the Commodities Futures Trading Commission (CFTC) against the Ooki DAO.[20] The CFTC filed a complaint against the Ooki DAO as an “unincorporated association comprised of holders of Ooki Tokens” who voted with those tokens to govern the protocol underlying the DAO.[21]  In order to serve process to what the CFTC argued was a “completely decentralized unincorporated association of anonymous individual Ooki Token holders,” the Court allowed the CFTC to provide notice by merely posting a copy of the complaint and summons on the Ooki DAO’s Help Chat Box and Online Forum.[22] 

The CFTC’s actions in the Ooki case raise important questions, such as whether an unincorporated DAO – in essence, an application of blockchain-based, open-source software – can be considered an entity subject to service of a complaint.[23] If so, plaintiffs will need to contend with how to adequately serve process in the absence of a centralized entity, with token holders largely anonymous and able to trade such tokens over time.

Looking forward

As the digital asset space grows, it will become increasingly subject to private litigation and enforcement. Courts will be asked to consider novel and consequential questions such as those highlighted in Ripple and Ooki. The fundamental question of whether any particular digital asset should be deemed a security has already garnered significant attention within the industry and among regulators. Likewise, we expect many traditional litigation issues – such as jurisdiction and service of process – will also require careful consideration from authorities, plaintiffs and courts as litigation in the crypto space intensifies. 

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1. SEC v. Ripple Labs, 20-cv-10832 (S.D.N.Y. Dec 22, 2020).
2. Defendants’ Memorandum of Law in Support of Their Motion for Summary Judgment at 1, SEC v. Ripple Labs, 20-cv-10832 (S.D.N.Y. Dec. 22, 2020).
3. Complaint at 1-2, SEC v. Ripple Labs, 20-cv-10832 (S.D.N.Y. Dec 22, 2020).
4. Id.
5. Id. at 6-7. The traditional Howey securities test provides that an ‘investment contract’ is “an instrument through which a person invests money in a common enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial efforts of others.”
6. Id
7. SEC Charges Former Coinbase Manager, Two Others in Crypto Asset Insider Trading Action, SEC (Jul. 21, 2022).
8. Chair Gary Gensler, Kennedy and Crypto, SEC (Sept. 8, 2022).
9. Id.
10. Coinbase, Petition for Rule-making—Digital Asset Securities Regulation, (Jul. 21, 2022).
11. Chair Gary Gensler, Kennedy and Crypto, SEC (Sept. 8, 2022).
12. Id.
13. Defendants’ Memorandum of Law in Support of Their Motion for Summary Judgment at 1-2, SEC v. Ripple Labs, 20-cv-10832 (S.D.N.Y. Dec. 22, 2020).
14. Id.
15. Id. at 3.
16. Memorandum of Law in Support of Defendant C. A. Larsen’s Motion to Dismiss, SEC v. Ripple Labs, 20-cv 10832 (S.D.N.Y. Dec. 22, 2020). See also Memorandum of Law in Support of Defendant B. Garlinghouse’s Motion to Dismiss, SEC v. Ripple Labs, 20-cv-10832 (S.D.N.Y. Dec. 22, 2020).
17. Id. 
18. Order Denying Defendants Larsen and Garlinghouse’s Motions to Dismiss, SEC v. Ripple Labs, 20-cv 10832 (S.D.N.Y. Dec. 22, 2020).
19. Id. at 29.
20. CFTC Imposes $250,000 Penalty Against bZeroX, LLC and Its Founders and Charges Successor Ooki DAO for Offering Illegal, Off-Exchange Digital-Asset Trading, Registration Violations, and Failing to Comply with Bank Secrecy Act, CFTC (Sept. 22, 2022). See also the civil enforcement action at CFTC v. Ooki DAO, 3:22-cv-05416 (N.D. Cal. Sept. 22, 2022).
21. Complaint at 5, CFTC v. Ooki DAO, 3:22-cv-05416 (N.D. Cal. Sept. 22, 2022).
22. Plaintiff’s Motion for Alternative Service at 5, CFTC v. Ooki DAO, 3:22-cv-05416 (N.D. Cal. Sept. 22, 2022). See also Order Granting Plaintiff’s Motion for Alternative Service, CFTC v. Ooki DAO, 3:22-cv-05416 (N.D. Cal. Sept. 22, 2022).
    
23. LexPunk Amicus Brief, CFTC v. Ooki DAO, 3:22-cv-05416 (N.D. Cal. Sept. 22, 2022).