Securities and Exchange Commission v. Payward, Inc.

• Court: District Court, N.D. California
• Decided: December 16, 2024
• Docket: 3:23-cv-06003
• Status: Unknown

Opinion

1 2 3 4 UNITED STATES DISTRICT COURT 5 NORTHERN DISTRICT OF CALIFORNIA 6 EUREKA DIVISION 7 8 SECURITIES AND EXCHANGE Case No. 23-cv-06003-WHO (RMI) COMMISSION, 9 Plaintiff, ORDER RE: FIRST DISCOVERY 10 DISPUTE LETTER BRIEF v. 11 Re: Dkt. No. 108 PAYWARD, INC., et al., 12 Defendants. 13 14 Now pending before the court is a jointly-filed discovery dispute letter brief through which 15 Defendants seek to compel the production of documents and information falling into the following 16 categories: those concerning Bitcoin and Ether; those concerning Plaintiff’s public statements and 17 testimony regarding digital assets; and those concerning Plaintiff’s internal trading policies on 18 digital assets. See Ltr. Br. (dkt. 108) at 1. Pursuant to Federal Rule of Civil Procedure 78(b) and 19 Civil Local Rule 7-1(b), the court finds the matter suitable for disposition without oral argument. 20 For the reasons stated below, Defendants’ request to compel the information they seek is denied. 21 In this case, Plaintiff, the U.S. Securities and Exchange Commission (the “SEC”), brought 22 an enforcement action pursuant to the provisions of Section 21(d) of the Exchange Act of 1934 23 (15 U.S.C. § 78u(d)) against Defendants (hereafter collectively referred to as “Kraken”) – the 24 owners and operators of an online trading platform through which customers can buy and sell 25 crypto assets, many of which the SEC alleges to constitute the basis of investment contracts that 26 are covered under U.S. securities law. See Compl. (dkt. 1) at 2, 4. The SEC alleges that Kraken, 27 without registering with the SEC in any capacity, has simultaneously acted as a broker, dealer, 1 SEC contends that Kraken has created risk for investors and taken in billions of dollars in fees and 2 trading revenue from investors without adhering to or even recognizing the requirements of the 3 U.S. securities laws that are designed to protect those investors. Id. at 1, 5. 4 At the heart of this case is the SEC’s contention that “[b]y operating a platform on which 5 crypto assets are offered and sold as investment contracts, Kraken’s operations place it squarely 6 within the purview of U.S. securities laws.” Id. at 3. As set forth in the Complaint, investment 7 contracts are instruments or vehicles through which someone invests money in a common 8 enterprise and reasonably expects profits or returns derived from the entrepreneurial or managerial 9 efforts of others. Id. at 5-6. As to what does, or does not, constitute an investment contract in this 10 context, the SEC submits that “courts have found novel or unique investment vehicles to be 11 investment contracts, including those involving orange groves, animal breeding programs, cattle 12 embryos, mobile phones, enterprises that exist only on the internet, and crypto assets.” Id. at 6. 13 Further, the SEC adds that in order “[t]o protect investors and fulfill the purposes of the 14 Exchange Act, Congress imposed registration and disclosure obligations on certain defined 15 participants in the national securities markets, including but not limited to broker-dealers, 16 exchanges, and clearing agencies [and] [t]he Exchange Act empowers the SEC to write rules to, 17 among other things, protect investors who use the services of those participants and provide for 18 stability of the nation’s securities markets.” Id. At bottom, the SEC submits that its claims in this 19 action turn on a single question: whether the 11 crypto assets identified in the Complaint were 20 offered and sold as investment contracts under the Exchange Act and the Supreme Court’s 21 decision in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). See Ltr. Br. (dkt. 108) at 5. The gist of 22 the currently-pending discovery dispute centers, in large part, on the fact that Kraken seeks to take 23 discovery as to Bitcoin and Ether (which are not included in the 11 Kraken-Traded Securities at 24 the heart of this action), as well as other documents, that the SEC contends are unrelated to the 25 court’s analysis under Howey. See id. at 4-5, 6-7. 26 An application of the Howey standard was initially understood to mean that “an investment 27 contract for purposes of the Securities Act means a contract, transaction or scheme whereby a 1 the efforts of the promoter or a third party, it being immaterial whether the shares in the enterprise 2 are evidenced by formal certificates or by nominal interests in the physical assets employed in the 3 enterprise.” Howey, 328 U.S. at 298-299 (emphasis added). Subsequently, however, in Hocking v. 4 Dubois, 885 F.2d 1449, 1455 (9th Cir. 1989) (en banc), cert. denied, 494 U.S. 1078 (1990), it was 5 stated that “[w]hile Howey’s third prong demanded an expectation of profits ‘solely’ from the 6 efforts of the promoter or a third party, we have dropped the term ‘solely’ and instead require that 7 the efforts made by those other than the investor are the undeniably significant ones, those 8 essential managerial efforts which affect the failure or success of the enterprise.” Id. (quoting SEC 9 v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir. 1973) (internal quotation marks 10 omitted) (“Strict interpretation of the requirement that profits to be earned must come ‘solely’ 11 from the efforts of others has been subject to criticism. [] Adherence to such an interpretation 12 could result in a mechanical, unduly restrictive view of what is and what is not an investment 13 contract. It would be easy to evade by adding a requirement that the buyer contribute a modicum 14 of effort.”) (citations omitted). Accordingly, the “distilled” version of Howey’s three-part test 15 simply requires: (1) an investment of money (2) in a common enterprise (3) with an expectation of 16 profits produced by the efforts of others. See e.g., Warfield v. Alaniz, 569 F.3d 1015, 1020 (9th 17 Cir. 2009). The third element of this standard – the expectation of profits produced by the efforts 18 of others – obviously involves two distinct notions: (1) whether a transaction involves any 19 expectation of profit; and, (2) whether those expected profits would be the product of the efforts of 20 a person other than the investor. Id. For present purposes, it is also important to note that:

21 The SEC alleges that Kraken is acting as an unregistered broker, dealer, and exchange by facilitating transactions in investment 22 contracts without registering with the SEC. Its allegations concern crypto assets that are not issued by Kraken but by other 23 cryptocurrency networks; the third party-issued tokens then form the basis of transactions on Kraken. As discussed, the fact that the 24 transactions in question occurred on a secondary market does not by itself prevent those transactions from involving investment contracts, 25 it simply means that the Howey test must be applied to the transactions as they occurred on the secondary market. 26 27 See Order Denying Motion to Dismiss (dkt. 90) at 19 (emphasis added). 1 relevance. See e.g., Soto v. City of Concord, 162 F.R.D. 603, 610 (N.D. Cal. 1995). As to 2 relevance, the Federal Rules tether relevance “to any party’s claim or defense.” See Fed. R. Civ. P. 3 26(b)(1). Thus, in the context of a motion to compel, the moving party bears the burden of 4 showing why the other party’s discovery responses or objections are inadequate or unjustified. See 5 e.g., AngioScore, Inc. v. TriReme Med., Inc., 2014 U.S. Dist. LEXIS 173700, *8 (N.D. Cal. Dec. 6 16, 2014). While it is true that the relevance standard is not very demanding (see Fed. R. Evid. 7 401, “Evidence is relevant if (a) it has any tendency to make a fact more or less probable than it 8 would be without the evidence; and (b) the fact is of consequence in determining the action”), 9 Rule 401 does require that such evidence must still “logically advance a material aspect of the 10 party’s case.” See Estate of Barabin v. AstenJohnson, Inc., 740 F.3d 457, 463 (9th Cir. 2014) 11 (internal quotation marks and citation omitted). 12 Beyond that, in order to succeed on a motion to compel, a moving party also bears the 13 burden to show that it has satisfied proportionality and other requirements of Rule 26. See 14 Rodriguez v. Barrita, Inc., No. 09-04057 RS-PSG, 2011 U.S. Dist. LEXIS 134079, at *4 (N.D. 15 Cal. Nov. 21, 2011). In light of this, courts are required to limit discovery if its burden or expense 16 outweighs its likely benefit – the balance between burden and benefit is the essence of the 17 proportionality inquiry, an oft-ignored or overlooked discovery principle. See, e.g., Om Recs., LLC 18 v. OM Developpement, SAS, 2024 U.S. Dist. LEXIS 160866, *10 (N.D. Cal. Sept. 6, 2024); see 19 also Mediatek, Inc. v. Freescale Semiconductor, Inc., 2013 U.S. Dist. LEXIS 122911, *18-19 20 (N.D. Cal. Aug. 28, 2013). 21 Given that background, the court will turn to the three categories of discovery at issue here. 22 As to the first, Kraken seeks an order compelling the SEC to produce “documents related to 23 Bitcoin and Ether.” See Ltr. Br. (dkt. 108) at 3. As mentioned above, the essence of the SEC’s case 24 against Kraken is that Kraken is allegedly acting as an unregistered broker, dealer, and exchange 25 by facilitating transactions that have occurred on a secondary market as to 11 digital assets named 26 in the Complaint – and, that these transactions meet the above-described test for investment 27 contracts. Kraken does not dispute the fact that Bitcoin and Ether are not included in the 11 digital 1 discovery as to Bitcoin and Ether (through RFPs 7, 9, 11, 12, 31, & 32) because “[t]hey trade on 2 Kraken’s platform just like the 11 digital assets named in the complaint and have many of the 3 same characteristics the SEC has alleged and argued make sales in the 11 named digital assets 4 ‘investment contracts.’” Id. (emphasis added). First, it should be noted that Kraken does not really 5 attempt to draw true equivalency between the unnamed assets (Bitcoin and Ether) and the 11 6 named digital assets when it vaguely states that they share many characteristics in common, 7 because there is some daylight between “many” and “all.” Second, Kraken’s argument here 8 mistakenly focuses on some fraction of the inherent characteristics that Bitcoin and Ether may 9 have in common with the 11 digital assets named in the Complaint by overlooking the fact – as 10 already noted by Judge Orrick – that there is an important distinction between the digital asset, 11 itself, and the offers to sell them. See Order Denying Motion to Dismiss (dkt. 90) at 19. As Judge 12 Orrick noted, “[t]he distinction is valuable . . . I do not understand the SEC to be alleging that the 13 individual cryptocurrency tokens in which Kraken enables transactions are themselves securities. 14 The meat of the SEC’s pleadings alleges that during their initial offerings and throughout 15 subsequent transactions on Kraken, those assets were offered as, or sold as, investment contracts.” 16 Id. (citing Compl. At ¶¶ 62-64). Thus, even if Bitcoin and Ether shared all (rather than many) 17 inherent characteristics in common with the 11 digital assets named in the Complaint, it is not the 18 crypto assets themselves that come within the definition of an investment contract, but rather the 19 circumstances surrounding their sale; or, as Judge Orrick put it: “[o]range groves are no more 20 securities than cryptocurrency tokens are. But the contracts and expectations surrounding the sale 21 of both may form an investment contract, bringing them within the purview of the Act.” Id. at 19- 22 20. 23 Thus, Kraken’s arguments that attempt to draw parallels between Bitcoin and Ether, on the 24 one hand, and the 11 digital assets named in the Complaint, on the other hand, are unpersuasive. 25 By way of example, Kraken notes that the SEC’s case places some reliance on the alleged “initial” 26 fundraising by the “issuers” of the named 11 digital assets to support its “investment contract” 27 theory (citing Compl. at ¶ 243), while adding that “Ether involved initial ‘fundraising’ too.” See 1 their tokens’ ‘ecosystems’ and the steps they would take to grow them” (citing Compl. at ¶ 252), 2 while adding that “[t]he Ethereum Foundation has done the same with Ether.” Id. The upshot of 3 these assertions, according to Kraken, is that “[t]he requested discovery [into Bitcoin and Ether] 4 could demonstrate that the digital assets [themselves] are related—either because the SEC itself 5 acknowledged they have similar characteristics or because SEC documents reflect such market 6 perceptions.” Id. But, even if one were to assume, arguendo, that discovery into Bitcoin and Ether 7 transactions by Kraken were to show that they could have been, but were not, included in the list 8 of the 11 digital assets at the heart of this case, it is far from clear how that might “logically 9 advance a material aspect of the [Kraken’s] case.” See Estate of Barabin, 740 F.3d at 463. Even 10 assuming a modicum of relevance, which is difficult under the circumstances, Kraken addresses 11 the issue of proportionality simply by stating that the documents it seeks are proportional to the 12 needs of the case, and by asserting that “[t]he SEC has not articulated any reason why these 13 requests would impose a disproportionate burden other than its say-so.” See Ltr. Br. (dkt. 108) at 14 5. As to this line of argument, the court finds that Kraken has failed to carry its burden of 15 establishing the relevance of the discovery it seeks regarding Bitcoin and Ether – and, even if a 16 thin logical connection could be drawn between this line of discovery and the advancement of a 17 material aspect of Kraken’s case (which, again, is not the case), the court finds that Kraken has 18 failed to present any argument that would tip the proportionality balance in its favor because the 19 court finds that any benefit Kraken could adduce in this case from receiving this discovery would 20 be grossly outweighed by the SEC’s burden in producing it. 21 Kraken also submits that, at least, discovery as to “[t]he SEC’s communications regarding 22 Bitcoin and Ether are also relevant to Kraken’s fair notice defense, including whether the SEC’s 23 actions and statements have sown ‘substantial uncertainty’ regarding the application of the 24 securities laws to digital asset transactions.” See Ltr. Br. (dkt. 108) at 4. Here, Kraken expends 25 little, if any, effort in explaining how its fair notice defense as to the 11 named digital assets might 26 be aided or bolstered by discovery regarding the SEC’s communications regarding Bitcoin and 27 Ether. See id. In other words, instead of making a clear case as to how discovery into the SEC’s 1 defense, Kraken expends all of its ink on quibbling with the applicability of the cases cited by the 2 SEC in opposition to Kraken’s effort to compel this discovery on this basis. This leaves the court 3 with only Kraken’s declarative statement that this discovery is relevant to its fair notice defense 4 without any substantial explanation as to how or why. While citing the SEC’s involvement in other 5 cases, Kraken states that “. . . since these cases, the SEC has advanced new and shifting theories – 6 including that a digital asset ‘embodies’ an investment contract – which Kraken is entitled to rebut 7 through discovery about Bitcoin and Ether.” Id. However, this assertion is inconsistent with Judge 8 Orrick’s description to the effect that “[t]he meat of the SEC’s pleadings” in this case alleges that 9 during their initial offerings and throughout subsequent transactions on Kraken, the 11 digital 10 assets at issue “were offered as, or sold as, investment contracts.” See Order Denying Motion to 11 Dismiss (dkt. 90) at 19. Kraken has not advanced a cogent argument as to how discovery into the 12 SEC’s communications regarding Bitcoin and Ether could advance a fair notice defense in this 13 case. 14 To be clear, the undersigned is not suggesting that it would be impossible for Kraken to 15 ever put forth any argument that this sort of discovery could be relevant to a constitutional fair 16 notice defense; that is, a defense through which Kraken might plausibly assert that one or another 17 applicable regulation might be impermissibly vague – or, at least that it should be considered as 18 such in light of the lack of guidance issued by the SEC. Indeed, in the abstract, the undersigned 19 could conceive of various circumstances where discovery practice, along the lines suggest by 20 Kraken, may lead to the unveiling of admissible information relevant to a fair notice defense in 21 this context. See, e.g., Ohio Cast Prods., Inc. v. Occupational Safety & Health Rev. Comm’n, 246 22 F.3d 791, 799 (6th Cir. 2001) (industry practice may be considered in ruling on fair notice 23 defense); see also General Elec. Co. v. EPA, 53 F.3d 1324, 1332, (D.C. Cir. 1995) (confusion and 24 inconsistent interpretations within an agency may support a fair notice defense). Instead, the court 25 only holds today that Kraken has failed to advance such an argument in the Letter Brief currently 26 before the court (dkt. 108) – to any degree of specificity – as to how exactly the discovery it seeks, 27 as phrased, would advance a fair notice defense in this case. If Kraken is later able to clearly 1 reasons stated above, Kraken’s request to compel the SEC to produce the requested documents 2 and information regarding Bitcoin and Ether (RFPs 7, 9, 11, 12, 31, and 32) is DENIED. 3 The second category of disputed discovery sought by Kraken pertains to “[d[ocuments 4 related to the SEC’s policies and guidance governing its employees’ ownership and trading of 5 digital assets” (as set forth in RFPs 49 and 51), which Kraken suggests “are also relevant to 6 Kraken’s Howey and fair notice defenses.” See id. at 4. Kraken supports its entitlement to this line 7 of discovery by asking the following rhetorical question: “If the SEC allowed trading in digital 8 assets by its employees as consistent with the securities laws during the very time that it asserts 9 Kraken had ‘fair notice,’ then how could it have been reasonable for a purchaser to believe she 10 was entering into an investment contract?” Id. Through RFP 49, Kraken seeks “[a]ll SEC policies 11 governing SEC employees’ ownership, trading in, or purchase or sale of, Digital Assets and/or 12 Virtual Currencies, including all changes and updates to those policies.” See Ltr. Br., Exh. A (dkt. 13 108-1) at 40. Through RFP 51, Kraken seeks “[a]ll Documents or Communications Concerning 14 any policy, guidance, clearance or other permission or restriction given to current or former SEC 15 Commissioners, staff members, officers or employees Concerning ownership or trading in Digital 16 Assets, including but not limited to ADA, ALGO, ATOM, FIL, FLOW, ICP, MANA, MATIC, 17 NEAR, OMG, and/or SOL by such Person or their family members, including, but not limited to 18 general SEC policies and Communications with individuals.” Id. at 42. As is relevant to the 19 analysis of RFP 49, nowhere in the definitions sections of its RFPs does Kraken limit the 20 definition of “Digital Assets” to the 11 digital assets involved in this case. As is relevant to the 21 analysis of RFP 51, Kraken’s inclusion of the phrase, “included, but not limited to,” renders RFP 22 51 impermissibly broad. In short, assuming arguendo that Kraken’s rhetorical question establishes 23 the relevance of the discovery it seeks by logically tethering the discovery it seeks to its fair notice 24 defense1, there remains the problem that Kraken’s failure to limit its discovery request to the 11 25 digital assets at the heart of this case (that is, the 11 assets involved in this case, as handled by 26 Kraken on its platform) renders the request – as asserted by the SEC – irrelevant, overbroad, and 27 1 not proportional to the needs of the case. Accordingly, Kraken’s request to compel the production 2 of documents and information pursuant to RFPs 49 and 51 is DENIED. 3 The third, and final, category of disputed discovery currently sought by Kraken pertains to 4 certain evidence related to various public statements rendered by the SEC pertaining to digital 5 asset regulation (as set forth in RFPs 15 and 77-84). Id. at 5. Specifically, RFP 15 seeks all 6 documents concerning a June 14, 2018, statement made by a former SEC division director 7 regarding the status of Bitcoin and Ether under federal securities laws. See Ltr. Br., Exh. A (dkt. 8 108-1) at 17. Aside from its general arguments in favor of taking discovery as to Bitcoin and 9 Ether, Kraken does not expend any independent effort to justify its request to compel information 10 pursuant to RFP 15. See Ltr. Br. (dkt. 108) at 5. For the reasons stated herein, the court finds that 11 Kraken has failed to carry its burden in seeking discovery regarding Bitcoin and Ether in the 12 context of the claims and defenses involved in this case. Consequently, the request to compel 13 discovery pursuant to RFP 15 is DENIED. 14 As to the remainder of the RFPs encompassed in this final category of disputed discovery, 15 Kraken submits that “[i]n 2021, Chair Gensler testified to Congress that ‘exchanges trading in 16 these crypto assets do not have a regulatory framework [] at the SEC.’” Id. (citation omitted). As 17 to this statement, without really specifying which crypto assets were being discussed in that 18 speech in its portion of the Letter Brief, Kraken submits that “[d]iscovery into the documents and 19 communications underlying the Chair’s testimony, and the basis for his assertion, is relevant to 20 whether and how the Exchange Act applies to Kraken.” Id. Kraken also seeks “documents 21 concerning the June 14, 2018[,] speech by former SEC Director of the Division of Corporation 22 Finance William Hinman” which it contends to bear on “issues that are relevant (Bitcoin and 23 Ether’s status under the securities laws) and in serious dispute (how Howey applies to secondary 24 trading).” Id. In cursory fashion, and without any explanation as to the usefulness of the 25 information it seeks to this case, Kraken simply mentions that, “[a]s in Ripple, discovery into the 26 bases for this assertions is relevant to Howey. This discovery is also relevant to fair notice, as it 27 may underscore the widespread uncertainty among market participants about the regulatory status 1 RFPs 77-84 (see Ltr. Br., Exh. A (dkt. 108-1) at 58-62), the court finds them all to be phrased too 2 || broadly — such that they go too far beyond being logically limited or tethered to the claims and 3 || defenses involved in this case. See e.g., id. at 61 (RFP 82, seeking “AlJ Documents and 4 || Communications Concerning meetings between any SEC Commissioner and any founders, CEOs, 5 || Board members, officers, or employees of any Digital Asset company, nonprofit, or foundation.”). 6 || Itis therefore not surprising that Kraken’s argument in support of compelling the SEC to produce 7 || this broad swath of information — most of which would have no bearing on any claim or defense 8 involved in this case — consists of little more than a few indeterminate, vague, and conclusory 9 || assertions as to the relevance of the vast constellation of information that would be captured by the 10 || requests. See, e.g., Ltr. Br. (dkt. 108) at 5 (“This discovery is also relevant to fair notice, as it may 11 underscore the widespread uncertainty among market participants about the regulatory status of 12 || digital asset transactions and secondary trading on platforms.”). As the undersigned sees it, it is far 5 13 || from clear what use Kraken could make of discovery that might reveal “widespread uncertainty 14 || among market participants” pertaining to assets and transactions and platforms that are not at issue 15 || in this case. Such information would neither call into question any of the SEC’s claims here, nor a 16 || bolster Kraken’s defenses thereto. In short, because the discovery sought here by Kraken is 3 17 phrased so broadly as to capture broad swaths of irrelevant and useless information, and because 18 || Kraken has failed to meet its burdens as to relevance and proportionality, Kraken’s request to 19 compel information pursuant to this third category of disputed discovery (as set forth in RFPs 77- 20 || 84) is likewise DENIED. 21 IT IS SO ORDERED. 22 Dated: December 16, 2024 23

25 ROBERT M. ILLMAN United States Magistrate Judge 26 27 28