For CFOs considering adding digital assets to their cash management strategy, there hasn’t been much guidance from the U.S. Securities and Exchange Commission. As a result, answers to such questions as “What are the risks?” and even “Are digital assets subject to SEC regulation?” are unclear.
But transparency of a sort may be coming, as perhaps the SEC’s most significant case to date against a cryptocurrency firm picks up steam in New York federal court.
In March, a judge there ruled that Ripple Labs could argue it did not have “fair notice” that sales of its XRP digital tokens violated federal securities laws.
Under the fair notice doctrine, the SEC’s guidance at the time of an allegedly illegal security sale must “give the person of ordinary intelligence a reasonable opportunity to know what is prohibited.” In addition, the U.S. Supreme Court has defined a security as an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”
U.S. District Judge Analisa Torres said in her ruling: “At the very least,” Ripple had raised “legal questions as to whether Ripple had fair notice that the term ‘investment contract’ covered its distribution of XRP.” She concluded that the SEC had “not met its burden of demonstrating that there are no questions of fact or law that might allow the [fair notice] defense to succeed.”
Ripple officials went on a celebratory Twitter blitz after the decision. “Huge win for Ripple today!” gushed CEO Brad Garlinghouse, while General Counsel Stuart Alderoty tweeted that Judge Torres’ “order makes it clear there’s a serious question whether the SEC ever provided Ripple with fair notice that its distributions of XRP — 1.46 billion units since 2013 — would ever be prohibited under the securities law.”
As things stand, many CFOs are hesitant to dip their toes in the cryptocurrency waters. Last year, a Gartner survey found that 84% of finance executives did not plan to ever hold bitcoin, for example, as a corporate asset. While financial risk due to volatility was the primary concern, nearly a third cited regulatory issues.
Classifying digital tokens as securities would bring issuers under the SEC’s disclosure requirements. For example, they would have to file registration documents spelling out the potential risks of an investment. The SEC seems to be using the Ripple case as a way to effectuate that classification through the courts.
If the SEC lawsuit succeeds, it “would impose immense costs on Ripple,” according to The Motley Fool. “Not only would the developers have to pay out $1.3 billion-plus interest, but they’d also be regulated as issuers of securities from that point forward.”
In its answer to the SEC’s complaint, Ripple argued that the lack of clarity involved its obligations under the law and the commission’s interpretation of the law.
Defenses like fair notice are often not litigated until an advanced stage of a securities fraud case. But the SEC made an unusually aggressive move, filing a motion in April 2021 to strike Ripple’s fair notice defense.
The SEC said its message to digital token issuers has been “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 company “actually had notice that its offers and sales of XRP could run afoul of the federal securities laws,” the motion said, citing, among other things, a February 2012 letter to Ripple in which Ripple’s lawyers said digital tokens, if sold to investors, “will likely be considered securities.”
The SEC also said its message to digital token issuers has been “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.”
Section 5 of the Securities Act of 1933 states only that it is unlawful to sell a security “unless a registration statement is in effect as to [the] security.” In denying the SEC’s motion, Judge Torres ruled narrowly that accepting Ripple’s pleaded facts as true, the statute had not “fairly apprised Ripple that its conduct was prohibited.”
According to Fortune, “Ripple’s legal woes have become emblematic of the murky regulation enveloping digital currency, reflecting the mismatch between laws largely developed during the Great Depression and today’s burgeoning fintech ecosystem.”
For CFOs, though, the case may be what helps that fog to begin to lift.