Will Howey Progeny Stifle Ripple's Fair Notice Affirmative Defense?

• Jurisdiction: United States,Federal
• Law Firm: Holland & Knight
• Subject Matter: Finance and Banking, Corporate/Commercial Law, Technology, Financial Services, Corporate and Company Law, Contracts and Commercial Law, Securities, Fin Tech
• Author: Alex Englander, Dennis Gonzalez, Scott Mascianica and Jessica B. Magee
• Published date: 15 May 2023

In the latest chapter of the high-profile SEC v. Ripple Labs, Inc., et. al. litigation, the SEC revisits its prior attempt to strike down the defendants' due process affirmative defense. Nearly a year after the SEC failed to convince U.S. District Court for the Southern District of New York Judge Analisa Torres to strike Ripple's "fair notice" affirmative defense, the agency is again targeted it in its motion for summary judgment (MSJ). The SEC recently supplemented its MSJ with a new opinion out of the U.S. District Court for the District of Massachusetts, arguing that court's ruling - rejecting a party's fair notice defense premised on the same precedent Ripple relies upon - is the latest example of federal courts striking down such arguments. Ripple pushed back, arguing that the recent opinion - as are other cases cited by the agency - are distinguishable given the ample evidence within the SEC's own files about regulatory confusion.

In this post, we provide a brief overview of the fair notice affirmative defense, an overview of the back-and-forth of this defense in the Ripple litigation and some key takeaways.

Fair Notice Defense

Under the Due Process Clause of the Fifth Amendment, all persons "are entitled to be informed as to what the State commands or forbids."¹ This is a fundamental principle of the American legal system - what a law forbids or requires cannot be so vague that a person of "common intelligence" cannot determine the law's meaning or its application.² A governmental regulation will be found to be void where it is "so standardless that it authorizes or encourages seriously discriminatory enforcement."³ Courts often find that "economic regulation is subject to a less strict vagueness test because its subject matter is often more narrow, and because businesses, which face economic demands to plan behavior carefully, can be expected to consult relevant legislation in advance of action."⁴

In SEC enforcement actions involving digital assets, defendants have unsuccessfully asserted this defense on several occasions. For example, in SEC v. Kik Interactive Inc., the SEC alleged that Kik violated Section 5 of the Securities Act of 1933 (Securities Act) when it engaged in the unregistered offer and sale of its digital asset called Kin.⁵ Kik asserted a fair notice affirmative defense, claiming that the term "investment contract" was unconstitutionally vague.⁶ Specifically, Kik relied on the U.S. Court of Appeals for the Second Circuit opinion in Upton v. SEC, wherein the defendant's vagueness challenge to a customer protection rule applicable to broker-dealers succeeded on facts demonstrating the SEC had inconsistently enforced the rule for years.⁷ But in analyzing Upton in connection with the defendant's fair notice argument the Kik court sided with the SEC, holding that Howey provided a clearly expressed test for determining what constitutes an investment contract and, unlike in Upton, every cryptocurrency's issuance requires a fact-specific analysis for enforcement.⁸

Similarly, in SEC v. LBRY, Inc., the SEC brought an enforcement action against LBRY for its unregistered offering of a digital token named LBC.⁹ LBRY argued that it lacked fair notice that its offerings were subject to securities laws, not because it did not know the Howey test applied, but because the SEC "historically and consistently focused its guidance, as well as its enforcement efforts, exclusively on the issuance of digital assets in the context of an Initial Coin Offering ["ICO"]."¹⁰ The LBRY court rejected this argument, stating that the holding of Howey would not lead a reasonable issuer to conclude that only ICOs are subject to the registration requirement.¹¹ The court likewise rejected LBRY's reliance on Upton, holding that the facts of Upton bared no resemblance to the facts at issue in the case.¹² The court held that "the SEC has its claim on a straightforward application of a venerable Supreme Court precedent that has been applied by hundreds of federal courts...