Some agency chairs find an ambiguous statute hard to resist. They overinterpret their authority to regulate, and Congress too often goes along. The backstop of this excess is the courts, provided that the aggrieved have the wherewithal to defend themselves against the gargantuan administrative state. This familiar story is playing out in the U.S. Securities and Exchange Commission’s (SEC) lawsuit against cryptocurrency innovator Ripple, but the buck stops with Magistrate Judge Sarah Netburn whose discovery hearing in U.S. District Court for the Southern District of New York on Tuesday exposed the SEC’s unfounded and flawed arguments and some inconvenient truths for former SEC Chair Jay Clayton and former SEC Corporation Finance Division head William Hinman.
The hearing showed that the case the San Francisco fintech was based on an illogical premise. It alleged that XRP, the digital currency that Ripple uses for cross-border payments, has been an unregistered security since 2013 and that the SEC was just getting around to saying so on the last day of Clayton’s tenure last December. With this late in the game regulatory determination, the SEC now deems that every Ripple sale for seven years was an illegal securities trade. And that Ripple, its two top executives named in the suit, along with millions of retail holders, should have known this all along, even though the agency never did. Due process and fair notice were thrown out the window to get the case across the transom on the day that Clayton walked out the door.
The hearing detailed the many vague, contradictory statements regulators made on cryptocurrency over the years. In 2018 Clayton told CNBC that bitcoin is not a security, and Hinman gave a widely covered speech which laid out how ether was not a security, despite debuting in an initial coin offering (ICO) in 2014. With XRP they said its status had “not been determined.” Trading platforms asked the SEC if XRP was a security before listing the token, and the agency refused to clarify. When asked whether XRP was a security, the then-chairman of the Commodity Futures Trading Commission Heath Tarbert in a 2020 interview declared, “It's unclear. Stay tuned. We're working closely with the SEC to figure out what falls into what box.”
If these regulators were honest, they would admit that nothing in the 1933 Securities Act refers to cryptocurrency and then would request Congress to clarify the statue. Instead, the SEC made an unfounded determination with no warning or process.
Back to Judge Netburn’s courtroom. Ripple requested the internal documentation to explain how and why the SEC arrived at their pronouncements as well as silence on these various coins. The SEC responded that nothing that was ever said by Clayton, Hinman or any SEC official about bitcoin or ether was that was an “official determination” on whether they are securities. It appears that Netburn is not buying the SEC’s argument that their many statements were not material. In a March 22 hearing, she told the SEC her understanding of XRP: “. . . not only does it have a currency value but it has a utility, and that utility distinguishes it from bitcoin and ether.” This rejects the SEC’s story that XRP has never had utility.
Netburn ordered the SEC to produce all communications related to XRP, bitcoin, and ether where a third party was involved, and any formal internal documents “expressing the agency's interpretation or views” on cryptocurrency, and to deliver them to Ripple. She granted most of Ripple’s motion, which means that the discovery could be a treasure trove of embarrassing information for the SEC. This could mean game over for the SEC’s case against Ripple and more largely, a serious blow to the agency’s credibility. Other defendants will cite the SEC’s arbitrary and capricious nature.
These disclosures could bring new headaches to scandal-plagued Apollo Capital Management which Clayton joined upon leaving the SEC, ostensibly to clean up the mess left by founder Leon Black and his links to Jeffrey Epstein. The timing of the lawsuit on Clayton’s last day and his subsequent hiring by a crypto-focused hedge fund are very curious coincidences. Conflict of interest concerns could also intensify for Hinman, now back at his old firm Simpson Thacher, which paid him a $1.6 million annual pension while he worked at the SEC. Hinman’s influence to the determination that ether is not a security keeps the SEC’s regulatory paws off Ethereum, the blockchain platform which Simpson Thacher supports as a member of the Ethereum Enterprise Alliance. Simpson Thatcher also handled the $100 million IPO of Canaan, the Chinese maker of machines used to mine cryptocurrency. Netburn’s order should bring much-needed transparency to the case.
Gary Gensler, slated to be confirmed as the next SEC chairman, will take the helm when China is racing ahead with a closed-ledger digital currencythreatening to unseat the dollar a leading medium of global exchange. It was extremely shortsighted of the SEC to handicap Ripple at a time when the US needs every American crypto leader on board to compete with China. Moreover, the case seems to reveal that former SEC leaders put their personal gain above the well-being of the nation. When the agency repeatedly claims in filings and hearings that “the SEC is not on trial here”, it is almost certain that the opposite is true.