Financial Ratios: The Secret Weapon in Securities Fraud Litigation

Financial Ratios: The Secret Weapon in Securities Fraud Litigation

J.W. Verret, JD, CPA/CFF, CVA, CCFI

In the high-stakes world of securities litigation, the numbers tell the story if you know how to read them. Using publicly available numbers to tell a story about a defendant in a securities fraud suit has become even more important since Congress and courts have limited early discovery.  Congress enacted the Private Securities Litigation Reform Act (PSLRA) in 1995, since that time securities fraud plaintiffs have faced a formidable challenge: pleading fraud "with particularity" and establishing a "strong inference" of fraudulent intent without the benefit of discovery. 

Many plaintiffs have worked to meet this hurdle using confidential whistleblowers whose informed perspective can buttress the complaint. This article explores how forensic accounting and ratio analysis can also come into play at this early stage of litigation, transforming dry financial statements into powerful evidence for both plaintiffs and defendants to defend their positions during the earliest stages of this litigation.

The PSLRA Obstacle Course

The PSLRA created significant hurdles for plaintiffs:

1. Pleading falsity with particularity: Plaintiffs must specify which statements were false and exactly why they were false—general allegations of "GAAP violations" aren't enough.

2. Strong inference of scienter: Perhaps the highest bar, plaintiffs must plead facts that create an inference of fraudulent intent that is "cogent and at least as compelling as any opposing inference of nonfraudulent intent," as the Supreme Court clarified in Tellabs.

3. Automatic discovery stay: While defendants can freely access internal documents, plaintiffs are prevented from obtaining discovery until after surviving a motion to dismiss.

Plaintiffs must find evidence of fraud in public filings—which is exactly where forensic accounting shines.

Reading Between the Numbers: How Ratios Reveal Fraud

Financial ratios serve as a sort of corporate lie detector test. When executives manipulate financial statements, these manipulations leave fingerprints in the relationships between different accounts. Analysts can connect the dots between information across the financial statements, contained within the footnotes to the financial statements, and presented in transcripts of company earnings calls that demonstrate unexpected relationships that require explanation by the company.

Financial ratios can help to meet PLSRA particularity requirements on their own, or can work in conjunction with confidential witnesses to corroborate the red flags raised by confidential witnesses.

Some key ratio categories include:

Revenue Recognition Red Flags

Revenue fraud often involves recognizing sales too early or booking fictitious revenue. These tricks manifest in several key ratios:

• Accounts Receivable Growth vs. Sales Growth: When receivables grow much faster than sales, it may signal premature revenue recognition or "channel stuffing" (pushing excess inventory to distributors). A plaintiff might plead: "Receivables grew at triple the rate of sales, suggesting defendants were recording revenue far faster than they could collect cash."

• Days Sales Outstanding (DSO): This ratio shows how long it takes to collect payment after a sale. A sharp increase often indicates quality problems with recorded revenue. For example: "DSO ballooned from 45 to 75 days during the class period, a warning sign that sales were being booked without legitimate customer demand."

• Increase in Sales Returns/Total Sales Ratio: This may indicate a lack of real demand for products being stuffed into the sales channel.

Expense and Liability Manipulation Metrics

Companies may also manipulate expenses through aggressive capitalization or extended depreciation:

• Asset Quality Index (AQI): This measures the proportion of assets other than property and equipment. Rising AQI often indicates companies are capitalizing what should be expenses. Plaintiffs could argue: "The company's 'deferred project costs' assets ballooned by 300%, suggesting normal operating expenses were being improperly parked on the balance sheet."

• Depreciation Index (DEPI): When companies stretch asset lives to reduce expenses, this shows up as declining depreciation rates. This provides another concrete allegation: "Depreciation expense as a percentage of assets dropped by half with no disclosure of methodology changes—a deliberate accounting choice to boost short-term earnings."

• Total Accruals to Total Assets (TATA): High accruals relative to assets indicate earnings created by accounting entries rather than cash-generating operations. The Beneish M-Score model, developed by Professor Messod Beneish, uses this and other ratios to detect earnings manipulation.

Flipping the Script: How Defense Counsel Responds

Defense attorneys can effectively counter ratio-based allegations using the same analytical toolkit:

1. Alternative Explanations: The PSLRA's "strong inference" standard requires showing fraud is at least as likely as innocent explanations. For example, if receivables spike, defense might argue: "The company secured new large, credit-worthy customers who negotiated longer payment terms, fully disclosed in the 10-K's footnote 7."

2. Industry Benchmarking: Context matters. If everyone in the industry experienced similar ratio changes, the inference of fraud weakens. Defense counsel might show: "All semiconductor manufacturers saw extended DSO during the supply chain disruption, as noted in analyst reports."

3. Time-Series Analysis: Plaintiffs often cherry-pick quarters. Showing that ratios returned to normal in subsequent periods, or followed a predictable seasonal pattern, counters scienter allegations.

4. Challenging Materiality: Even if unusual patterns existed, a company can argue they were immaterial to investors (price impact) or already understood by the market and thus a part of the total information already available in the market.

Practical Advice for Litigators

For Plaintiffs' Counsel

• Comparative context: Show how the company's ratios diverged from its own history, industry peers, or economic conditions.

• Connect the dots: Explicitly link ratio anomalies to the alleged fraud scheme and scienter. Explain why management must have known about the red flags.

• Corroboration: Where possible, pair ratio analysis with other evidence—confidential witnesses, analyst questions, subsequent restatements—to strengthen the inference of fraud.

• Mind the materiality: Choose ratios that meet the materiality definition in the securities laws.

For Defense Counsel

• Verify the math: Did the plaintiffs miscalculate ratios or use inconsistent time periods?

• Present the full picture: Show all relevant ratios, not just the potentially cherry-picked ones, and place them in appropriate context.

• Contemporaneous explanations: Highlight any disclosures, analyst call discussions, or industry news that explained the ratio changes at the time.

• Cross-checks: Demonstrate that other related ratios remained normal, undercutting the inference of manipulation.

• Expert support: Consider early retention of accounting experts to provide alternative explanations for ratio anomalies.

Conclusion

In the challenging world of securities litigation under the PSLRA, forensic accounting ratios serve as a powerful tool for both sides. For plaintiffs, they transform public filings into a roadmap of fraud that can clear the "strong inference" hurdle. For defendants, they provide context and alternative narratives that can defeat those same inferences.

As courts continue to demand particularized allegations of fraud, mastery of financial ratio analysis has become not just helpful but essential for securities litigators. The numbers don't lie, but they do tell different stories depending on who's interpreting them and how they're presented. The attorneys who best understand how to wield these financial tools gain a decisive advantage in the high-stakes battle of the motion to dismiss.

Op-Ed: Ripple's legal champion, a conversation with Stu Alderoty

By J.W. Verret | George Mason University School of Law 22 hrs ago

This piece originally published in Center Square here.

Stu Alderoty, chief legal officer at Ripple, brings over three decades of legal experience to crypto's frontlines. Before joining Ripple six years ago, he spent 30 years in private practice – first at LeBoeuf, Lamb, Greene & MacRae, and later as general counsel for major financial institutions, such as HSBC. J.W. Verret, George Mason University School of Law professor, sat down with him to discuss Ripple's landmark battle with the SEC and its implications for the broader crypto industry.

What made you transition from traditional law to crypto?

"I was attracted to being on the front line and helping to develop laws, rules and regulations from scratch for a relatively new industry. I would have hoped that would have been done outside of the courtroom and done legislatively, collaboratively with regulators. We took a five or six-year detour into the courtroom. We're now out of the courtroom, and we can get back to working collaboratively with regulators and policymakers to get principle-based laws, rules and regulations in this country when it comes to crypto."

What was your initial reaction when the SEC filed its lawsuit in December 2020?

"We had probably at least a year and a half, if not two years, of discussion with the SEC where we were responding in good faith to their investigative inquiries. I naively thought we would come to a rational resolution, as I often did in traditional financial services. What I learned was that the SEC, at least under the prior administration, was not looking to solve a legal problem but a political problem – crypto. When they sued us, we put the legal machine into full gear but also the public relations machine because we needed to seize the narrative. We said we'd defend this case not only on Ripple's behalf but on behalf of the entire industry. Those were really dark days – nearly every crypto exchange in the U.S. delisted XRP, most U.S. clients stopped doing business with us, and the SEC targeted our international relationships. But we stood firm with the resources to withstand this onslaught."

As a lawyer, what was it like having this crowd-sourced ally in the public, including John Deaton's amicus briefs?

"That was one of the unique aspects of this case. The SEC's mission is supposedly to protect consumers, but in reality, their lawsuit sucked $15 billion of market cap out of XRP markets, hurting the rank-and-file holders. John Deaton filed his own lawsuit within 48 hours on behalf of XRP holders. Judge Torres gave him what I call 'amici plus status' – allowing him to speak more expansively about what it meant to be an XRP holder affected by the SEC's actions. We ended up with probably 15 amici briefs in this case, which is extraordinary for a district court case. I think all of that weighed very favorably on Judge Torres in reaching her decision."

Tell me about growing the fight beyond the courtroom and into the public and political arena.

"It starts with Brad Garlinghouse and Chris Larsen, the leaders of our firm, and their courage and conviction. The SEC gave us no choice – their theory was that everything came under their jurisdiction, meaning you had to 'come in and register' with them. But everyone knows there was no means to register a crypto company with the SEC. What they wanted was to destroy the company. Every smaller company they had targeted either went bankrupt or surrendered and left the United States. Ripple wasn't going to declare defeat or leave. We were founded in the U.S. by entrepreneurs and believe in American innovation and technology. We would have accepted any reasonable settlement involving significant compromises, but they wanted surrender. So we grew our business in Asia, the Middle East, the UK, EU, and Latin America during the lawsuit, but refused to fold in the U.S."

You're becoming president of the new National Cryptocurrency Association. What will its role be?

"The seed of the NCA was born about six or eight months ago, long before anyone knew the election outcome. What we don't have in this country is a non-profit that is apolitical, not beholden to any project or protocol, not a lobbying organization, but simply there to be a voice for everyday Americans who own and use crypto. The NCA will be that megaphone and also a one-stop shop for the crypto-curious to learn more. The goal is to demystify crypto, de-villainize it, and provide a platform for everyday users. It's even more important now with an administration committed to making the U.S. the crypto capital of the world."

How do you see Ripple's future engagement with regulators?

"The industry had a common enemy in the SEC and came together to fight it. Having defeated that enemy, the worst thing we can do is retreat into tribalism. We need to continue working in a coordinated way, with a relatively uniform voice about rational laws, rules and regulations. Ripple has always been a regulatory-first company because our customers are enterprise-level and regulated themselves. We're excited to engage with policy makers who have an open mind to crypto. The scar tissue we earned through litigation gives Ripple a certain gravitas, but we'll continue to fight for clear regulations not only for ourselves but for the entire industry."

J.W. Verret is a professor at George Mason University School of Law

Ripple Settlement Offers Hope For Better Regulatory Future

This op-ed originally published in Law360 (April 14, 2025, 2:56 PM EDT) --

J.W. Verret

Editor's note: Law360 welcomes opinionated commentary and debate in our Expert Analysis section. To submit op-eds or rebuttals, or to speak to an editor about submissions, please email expertanalysis@law360.com.

Four years ago, I wrote that the U.S. Securities and Exchange Commission's approach to cryptocurrency regulation was "haphazard and inconsistent." I argued that the agency's decision to wait eight years before filing a complaint against Ripple Labs in December 2020 was irresponsible, and that the SEC needed to provide more clarity about when and how cryptocurrencies would be regulated.

In the waning days of Chair Jay Clayton's tenure, the commission, in SEC v. Ripple in the U.S. District Court for the Southern District of New York, brought its first major action against developers of a blockchain token alleging the unregistered sales of a security. This started a chain reaction of dozens of such cases during Chair Gary Gensler's tenure alleging the unregistered sales of securities against crypto developers in actions where no fraud occurred and where no pathway to registration was even available.

The March 25 settlement agreement between the SEC and Ripple — in which the agency agreed to return $75 million of a $125 million fine and drop its appeal of U.S. District Judge Analisa Torres' July 2023 ruling — vindicates those criticisms and highlights the urgent need for a complete overhaul of cryptocurrency regulation at the SEC.

The SEC's enforcement-first approach was always flawed.

The SEC's retreat in the Ripple case represents a tacit acknowledgment of what many in the cryptocurrency industry have long argued: The agency's enforcement-first approach, without clear rulemaking or guidance, was fundamentally flawed.

Throughout both the Clayton and Gensler eras, the SEC steadfastly refused to provide regulatory clarity to the cryptocurrency market. Instead, the agency relied on a patchwork of enforcement actions that left founders and investors to read the tea leaves of complaints and settlements, trying to make educated guesses about why the SEC chose to charge one cryptocurrency founder but not another.

This approach created an environment of regulatory uncertainty that stifled innovation while failing to provide meaningful investor protection. The SEC's handling of the Ripple case exemplifies this failure.

A better way is possible — and is already happening.

What makes the SEC's past approach all the more inexcusable is that we now see a better path forward. Remarkably, two commissioners, prior to the confirmation of Chair Paul Atkins on April 9, demonstrated what responsible cryptocurrency regulation looks like.

Commissioners Hester Peirce and Mark Uyeda, the latter of whom was then-acting chair, organized roundtables, solicited public comments, held stakeholder meetings and established a task force — all while waiting for a new chair to be confirmed. This collaborative, transparent approach is precisely what the Clayton-era SEC should have done and what the Gensler SEC never considered.

The stark contrast between the current commission's thoughtful engagement with the cryptocurrency industry and the previous enforcement-first approach underscores how much time and resources have been wasted pursuing ill-conceived litigation like the Ripple case.

The Ripple case showcased enforcement overreach.

The Ripple case will likely be remembered as a low point for SEC enforcement. The SEC's initial demand for nearly $2 billion in civil penalties, disgorgement and prejudgment interest was not only disproportionate but appeared retributive — seemingly in response to Ripple's courageous decision to fight back against the agency rather than settle.

It is fundamentally un-American that a company that defrauded and harmed no one should be required to pay hundreds of millions of dollars in penalties. The SEC's pursuit of excessive disgorgement also blatantly ignored the U.S. Supreme Court's 2020 ruling in Liu v. SEC, which significantly curtailed the agency's disgorgement power by limiting it to a defendant's net profits from wrongdoing.

Liu requires linking securities law precedent to accounting concepts like revenue recognition, expense allocation and netting principles when calculating disgorgement.[1] The SEC's disregard for these principles in its Ripple litigation suggests either a troubling ignorance of Supreme Court precedent or a willful attempt to circumvent it.

The real victims were XRP holders.

Perhaps the most tragic aspect of the Ripple saga is that while the SEC claimed to be protecting investors, its actions caused substantial harm to the very people it purports to protect. When the SEC filed its complaint against Ripple, the price of XRP plummeted, costing token holders millions of dollars in losses.

These investors — many of whom were ordinary individuals who had purchased XRP in good faith — suffered real financial harm not because of any action by Ripple, but because of the SEC's decision to bring this case in the first place. The irony is palpable: In its zeal to protect investors, the SEC inflicted significant damage on them.

What's the path forward?

The tentative settlement between Ripple and the SEC, with the agency returning 60% of the fine it collected, represents more than just the resolution of a single case. It signals the beginning of a necessary recalibration of the SEC's approach to cryptocurrency regulation.

The current commission's more collaborative approach offers hope that we may finally see the regulatory clarity and consistency that markets crave. This would involve developing a more precise test for determining when cryptocurrencies constitute securities, one that recognizes the evolutionary nature of decentralized digital assets.

The SEC could, for instance, elaborate on the level and type of founder involvement that will deem a cryptocurrency a security, give recognition to cryptocurrencies previously classified as currencies by the U.S. Department of the Treasury, or implement Peirce's proposed safe harbor that would give cryptocurrencies time to become decentralized.

Whatever specific approach the SEC ultimately adopts, it must be guided by principles of regulatory consistency, transparency and proportionality. The days of regulation by enforcement action must end.

Conclusion

The Ripple case stands as a stark reminder of the costs of regulatory overreach and the importance of clear, consistent rules. As I wrote four years ago, "regulatory consistency and the rule of law deserve a better way." The SEC's retreat in this case suggests that, perhaps, we may finally get one.

For cryptocurrency founders and investors who have long operated in a climate of uncertainty, the resolution of the Ripple case offers a glimmer of hope that a more rational regulatory approach may be on the horizon. It's long overdue.

J.W. Verret is an associate professor at George Mason University's Antonin Scalia Law School.

Fraud Magazine’s Top Frauds of 2023

Fraud Magazine’s Top Frauds of 2023

Fraud Magazine has again spotlighted last year's most scandalous fraud cases in their annual roundup here. Here are the top cases that shaped the year:

1. The Fall of FTX: Sam Bankman-Fried's FTX crumbled, revealing a billion-dollar fraud involving misappropriation of customer funds. 

This fraud featured crypto but it was a traditional bread and butter fraud. Crypto wasn’t the problem, someone stealing customer’s crypto at a custodial central exchange was the problem. 

The case featured massive red flags: a related party conflict that was generally known (market rumors were common about potential frontrunning by Alameda, we didn’t know about the related party transfers of customer funds though), a lack of an audit committee or even a board, a lack of a CFO. VCs didn’t do the necessary diligence because of Fear of Missing Out.

2. Arizona Sober Home Scams: Fraudulent sober-living homes in Arizona exploited Medicaid loopholes to siphon off millions by billing for non-existent treatment services to Native Americans, massive exploitation and system manipulation. What was meant to be exemptions in spending authorization processes to help facilitate housing to those suffering from addiction became a massive fraud engine.

The money quote from the WSJ is that “the state first noticed something was improper when totals for substance-abuse treatments jumped from $53 million in 2019 to $668 million in 2022.” Wow!

3. Southeast Asian Cyberfraud Hubs: In Southeast Asia, empty buildings were transformed into centers of cyberfraud, where trafficked individuals were forced into committing online scams. 

Individuals were trafficked by the thousands into these fraud mills to use as themselves perpetrators of online romance scams. This one makes you lose faith in humanity.

4. Casino Vishing Attacks: Major casinos like MGM and Caesars faced cyberattacks through vishing, where hackers used social engineering to infiltrate networks and access sensitive customer data.

Massive casinos are thought of as impregnable for their imposing physical security, the basis for safecracker fantasy movies like Ocean’s 11. And yet MGM was temporarily shut down by a single employee responding to a phishing attack. The chain is only as secure as the weakest link.

5. Guo Wengui's Billion-Dollar Scam: Exiled Chinese billionaire Guo Wengui allegedly defrauded thousands through fake investment opportunities in media and technology, using his platform and hundreds of millions in investor flows to fund personal spending, using his personal spending to prop up investor pitches, and so on. It’s an old fraud pattern but a common one.

These cases not only underline the diversity and complexity of modern fraud but also the critical need for expert intervention in litigation and fraud examination. For legal professionals grappling with such deceit, forensic accountants at Veritas Financial Analytics offer invaluable expertise. Through the combination of deep legal and financial knowledge ensures rigorous examination and reliable litigation support in complex fraud cases.

For detailed insights into these cases and to explore how our forensic accounting services can support your legal strategies, visit us at Veritas Financial Analytics.

Harvard Published Primer on New SEC v. Panuwat Shadow Insider Trading Case

Paper on SEC v. Panuwat, which is a massive expansion of insider trading liability, published at Harvard Corporate Governance Blog HERE.

Wharton Professor Dan Taylor Joins Veritas

Wharton Professor Dan Taylor, a leading expert in empirical financial forensics, joins as a new affiliate with Veritas Financial Analytics. Looking forward to some exciting work together ahead!

DOJ Convicts A Bitcoin Fog User As Its Administrator

My piece HERE about what the government did to Roman Sterlingov in the Bitcoin Fog mixer case as they prosecuted a user of the mixer as if he was its administrator.

WSJ Op-Ed, From Nevertrump to Encore

I published an article in the Wall Street Journal today explaining why I have abandoned the “NeverTrump” camp to endorse Trump available here. And pasted below for those who are not subscribers.

From ‘Never Trump’ to ‘Encore’

In 2019 I wanted him impeached. Now I’ve become convinced that Biden is worse.

By

J.W. Verret

Jan. 25, 2024 3:24 pm ET

I called for President Trump’s impeachment in 2019. I stand by what I said then. But if Mr. Trump is the Republican nominee, I will vote for him in November.

Like many voters in 2020, I hoped Joe Biden would govern reasonably from the center. Instead, his administration has sought the furthest reaches of leftist ideology. What were once fringe progressive talking points have become national policy. Even the military has been infected with a divisive and unyielding woke doctrine. The economic landscape has been equally distressing: inflation, coupled with a ballooning national debt and deficit. Four more years of this means a bleak future for my children.

My work in financial regulation and cryptocurrency has shown me the havoc wrought by policies seemingly chosen not to foster economic growth but to appease the likes of Elizabeth Warren, who has enjoyed outsize influence over Mr. Biden’s nominations. One nominee to run the leading banking regulator, the Office of the Comptroller of the Currency, was an open member of Marxist groups and called for the Federal Reserve to provide retail bank accounts. It took a few brave Democrats to stop her nomination.

Before, I didn’t embrace the rallying cry of “Build the wall.” Yet the crisis at our border compels me to acknowledge that Mr. Trump was right. The border situation underlines a broader reality—we need practical policies, not politically expedient ones. Mr. Trump doesn’t care about the niceties of political discourse, and that is an asset.

I find myself parting ways with the Never Trump faction. I respect its stance, which was born of conviction. Yet our situation demands a re-evaluation. We can continue down a path that has led to division and economic stagnation, or pivot to a future that, while imperfect, promises governance rooted in traditional American values, economic liberty and a judiciary cut from the same cloth as the gifted nominees confirmed to the Supreme Court under Mr. Trump.

Count me as a former Never Trumper. Given the coming election, the Never Trump position is naive. No third-party candidate can win and heal America. It’s time to pick a side, and Mr. Trump is the only alternative to Mr. Biden’s hyperprogressive vision for America. This isn’t a repudiation of my past convictions but an acknowledgment that the future we face demands difficult choices.

I hope that the best parts of Mr. Trump’s administration—including the reasonable leaders tapped to head government agencies—get a second round. I hope the mistakes of the past won’t be repeated. And I hope for a future in which the federal government’s power is restrained, making the presidential election less important in our daily lives.

Mr. Verret is an associate professor at George Mason University’s Antonin Scalia Law School.

Expert J.W. Verret profiled in Cointelegraph

Veritas expert Professor J.W. Verret was profiled in Cointelegraph about his work tracing crypto transactions: https://cointelegraph.com/magazine/6-questions-for-jw-verret-an-attorney-whos-tracking-the-money-but-advocating-for-crypto/. The profile discusses his work on the US v. Sterlingov trial, the largest crypto money laundering trail in history, his work on financial regulation, and his views on government reports about aliens.

New Cointelegraph Column Re: Crypto Future Post Ripple case

Click here for my latest piece in Cointelegraph exploring what happens for crypto and for Coinbase versus SEC in this post-Ripple case environment.

New WSJ Op-Ed: The NCPPR Lawsuit Could Put the SEC Back in Its Place

Just published a new op-ed in the Wall Street Journal at this link and pasted below.

The NCPPR Lawsuit Could Put the SEC Back in Its Place

Gary Gensler’s commission has become a warrior in America’s culture war.

By J.W. Verret, Wall Street Journal, July 13, 2023 6:35 pm ET

The Securities and Exchange Commission is now a central combatant in America’s culture wars. Originally conceived as a simple guardian of financial transparency and a sentinel against fraud, the SEC has seen its role gradually reshaped by progressives who envision the agency as a force for cultural change. The SEC has even begun trying to compel corporate speech on woke issues indirectly, but a recent lawsuit could help steer it back on the right path.

The SEC, under the stewardship of Biden-appointed Chairman Gary Gensler, has ratcheted up its authority over proxy voting to turn mundane company ballots into battlegrounds of cultural conflict. These ballots were once the simple mechanism through which shareholders asserted their voice on board elections and merger decisions. Today they have become engulfed in ideological warfare.

For decades, the SEC maintained that proposals concerning the ordinary business or everyday workings of a company weren’t fit for inclusion in proxy statements. It was a sensible position, acknowledging that decisions about what a company should sell or how it should operate were best left to the professionals running the business, not shareholder plebiscites.

Yet on Mr. Gensler’s watch the SEC executed a dramatic reversal. The agency determined in November 2021 that shareholder proposals could be exempt from the ordinary-business rule as long as they “raise significant social policy issues.” That reinterpretation has not only turned a neutral and sensible process into a political fight but has also put the SEC in a position to decide arbitrarily what counts as “significant social policy issues.” This has allowed the agency essentially to compel progressive speech, according to the National Association of Manufacturers’ intervention in a recent lawsuit by the National Center for Public Policy Research against the SEC.

The NCPPR sued the SEC after it denied the conservative foundation’s proxy proposal that retail giant Kroger issue a report on the risks of not guarding against viewpoint discrimination in its equal employment opportunity policy. The NCPPR is a longtime Kroger investor and submitted the proposal after the company paid $180,000 to settle claims from former employees that they were fired for refusing to wear aprons they thought endorsed the LGBT community. By any reasonable interpretation, the NCPPR proposal dealt with a significant social policy issue that could be material to Kroger and investors. Yet the SEC still denied it, even though it approved similar proposals dealing with discrimination regarding race and sexual orientation, such as a Pfizer proposal to report on its diversity, equity and inclusion efforts.

The SEC has sought to have the NCPPR’s suit dismissed because Kroger ultimately included NCPPR’s proposal for a shareholder vote, but the larger issues raised by the NCPRR and the National Association of Manufacturers remain unaddressed by the SEC. The National Association of Manufacturers argues that the SEC is violating the First Amendment by compelling corporate speech. As an example, its court filing alleges that the agency compelled Mastercard to include an antigun proposal in its proxy statement but allowed American Express to exclude a very similarly worded pro-gun-rights proposal. The National Association of Manufacturers also contends this runs afoul of securities law, which doesn’t give the agency the authority to dictate proxy statements’ content.

This suit could help steer the SEC back toward its original purpose of mandating disclosures of basic financial information and policing fraud.

Anything further is principally the purview of state law, not the SEC. The Supreme Court’s “internal affairs doctrine” approach to interpreting federal securities laws recognizes state law as the primary regulator of the internal governance matters between shareholders and boards. It is states that can intervene in the selection of company directors, changes to major governance policies in company bylaws, and major mergers and acquisitions decisions. By extending the reach of shareholder proposals, the SEC may be overstepping its bounds, encroaching on an area traditionally under state jurisdiction.

The Gensler proxy interpretation also seems to contravene the will of investors, who mostly seem to be rejecting social proposals outright. In the past year alone, investors voted down the overwhelming majority of socially framed proposals. The SEC still harms companies, however, by forcing them to deal with the costs associated with such proposals and potential reputational damage. And of course, it gives an important opportunity to investors who want to play social activist.

The SEC’s transformation into a tool for cultural conflict marks a departure from its original mission. It is a shift that may have turned the ratchet one too many times, possibly breaking the system it was designed to uphold. Hopefully, the courts can put things back in working order.

Mr. Verret is associate professor at the Antonin Scalia Law School at George Mason University and a former member of the SEC Investor Advisory Committee.

Let First Republic and Credit Suisse Burn: Cointelegraph Op-Ed

Read my latest op-ed here arguing that after traditional bankers suggested regulators should “let crypto burn” after FTX, now its their turn to burn.

Law360 Op-Ed: Crypto Is a Major Question Only Appellate Courts Can Answer

My latest op-ed in Law 360 is available here and pasted below.

Crypto Is 'Major Question' Only Appellate Courts Can Answer

By J.W. Verret (March 6, 2023), Law360

Crypto enthusiasts and securities lawyers alike are awaiting the resolution of the U.S. Securities and Exchange Commission's case against Ripple Labs Inc. and its founders over their distribution of the cryptocurrency XRP.

The SEC alleges that there was an unregistered sale of securities when XRP was first distributed, as well as unregistered subsequent distributions. Under former SEC Chair Jay Clayton, the Ethereum network was appropriately blessed in guidance from the SEC's Division of Corporation Finance director as not meeting the Howey test for what is considered a security, but the distribution of XRP instead was met with a midnight enforcement action approved in Clayton's last days in the role.

The deck is usually stacked against defendants in cases of this type, as existing interpretations of what must register with the SEC are fairly flexible, but Ripple has argued strenuously that there are limits to that flexibility when it comes to this new asset class. Yet no matter how SEC v. Ripple Labs Inc. is resolved at the U.S. District Court for the Southern District of New York, conventional wisdom is that the losing side will appeal. When it does, this case may become the vehicle by which administrative law itself is transformed by the U.S. Court of Appeals for the Second Circuit and the U.S. Supreme Court.

The SEC has recently brought a series of cases against other cryptocurrency operators, including stablecoins and staking services, with more expected imminently. Meanwhile, the commission has proposed rules to require decentralized finance protocols in crypto — which are essentially just computer code written onto a blockchain like Ethereum to autonomously settle financial transactions — to register as licensed exchanges, which is impossible.

The Supreme Court has long held that when federal agencies seek to determine a matter of national significance, they must do so using clear authorization from Congress. This has been described as the "major questions doctrine" by lower appellate courts. In essence, for a federal agency to regulate a major question, the statute must clearly state that the agency shall regulate this issue.

The phrase "major questions doctrine" was used for the first time by the Supreme Court in 2022 in West Virginia v. U.S. Environmental Protection Agency, a landmark opinion that overturned one of the EPA's signature rules from the Obama administration. The major question in the case was whether the agency had the authority to regulate greenhouse gas emissions from power plants under the Clean Air Act.

Specifically, the EPA had issued a rule, known as the Clean Power Plan, that set carbon dioxide emissions limits on power plants and required states to develop plans to meet them, but there was no clear authority in the act for the EPA to do so. The agency tried to thread together a number of vague statutory references to justify a congressional grant of authority, but the Supreme Court was not convinced.

The Supreme Court has previously used the doctrine in a number of opinions limiting agency discretion, from stopping the U.S. Food and Drug Administration's attempt to regulate cigarettes using its authority over drugs in its 2000 decision in FDA v. Brown & Williamson Tobacco Corp. to similarly blocking the U.S. attorney general's regulation of assisted suicide using his authority over controlled substances in 2006's Gonzales v. Oregon.

The appellate courts invoke this doctrine when faced with something unique about the history and breadth of the authority asserted, or when dealing with a matter of distinct national political or economic importance that an agency is attempting to regulate using vague or outdated statutory authorization. Conservative lawyers are excited that the Supreme Court's renewed focus on the major questions doctrine may constrain agency discretion, and they are increasingly talking about how efforts to defend against the SEC's crypto enforcement cases are a prime vehicle toward that end.

One irony appreciated by, and sometimes embarrassing to, conservative constitutional and administrative lawyers is that the Supreme Court opinion most deferential to executive agencies, 1984's Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., was endorsed by Justice Antonin Scalia in a speech early in his tenure.

Times change, and so goes both law and politics. The progressives who once vigorously defended free speech against the overreach of conservative politicians are now fighting conservatives over the same principle. Those fights bleed into the political and legal realms. Similarly, Justice Scalia's deference for administrative agencies in a time that predated the exponential growth in the sheer size of the Code of Federal Regulations now gives way to a renewed push among conservative lawyers and judges to constrain the beast.

The SEC is using its authority to regulate traditional securities and stock exchanges to here regulate the transfer of value as computer code. This is different from the commission's transition to regulating online stock transfers in the 1990s, where the transfer may have taken place online but the assets transferred themselves were little different from what stocks and bonds were in the 1930s. With crypto, the asset only exists as numbers and letters in a blockchain computer code.

This is a revolution in finance that hopes to replace traditional banks and stock exchanges, as well as the existing system of property ownership fiat money itself. Whether this revolution in finance succeeds or not, it has surely reached the point where the major questions doctrine applies.

The SEC's reliance on a 1946 opinion in SEC v. W.J. Howey Co., which gave the SEC authority to regulate a contract to sell an interest in an orange grove, is an odd fit for crypto-assets and well ripe for the application of the major questions doctrine.

And to make matters worse, the Wall Street Journal and Bloomberg recently reported that these actions by the SEC appear to be part of an administration wide effort to simply freeze crypto-assets out of the traditional financial system rather than regulate them. That's one more unique fact that heightens the odds that appellate judges will apply the major questions doctrine to the Ripple case.

If the U.S. Postal Service had sought to regulate email using its authority over P.O. boxes and required that only certified postmen were allowed to deliver this new "email," courts would have rightly overturned it with the major questions doctrine.

The SEC's assertion over jurisdiction of what is now a trillion-dollar asset market — and has been as large as $3 trillion — is surely a matter of such significance that the vague language contained in the securities laws granting the SEC authority over investment contracts implicates the major questions doctrine.

Rather than predict the outcome of the Ripple lower court opinion, it would be safer to predict that litigation over the Ripple case and the SEC's other crypto regulations will continue for years, as the legal questions are far too big to settle at the district court level.

Eventually, the SEC's discretion to regulate crypto may well be substantially constrained by the major questions doctrine. Until then, this hope will prove little solace to crypto entrepreneurs seeking to come into compliance and those who just want to understand the rules of the road.

J.W. Verret is an associate professor of law at George Mason University's Antonin Scalia Law School. He is a former member of the SEC's Investor Advisory Committee.

New Edition of My Crypto Newsletter BlockProf, 11/22

Published a new edition of my newsletter, BlockProf, here. Topics this week are The Monopoly Man, I Told Ya So, Zebras, The Dev.

Real Clear Markets Article Re: SEC v. Ripple

My latest take in an op-ed in Real Clear Markets about the SEC’s case against Ripple here. I suggest they go all the way to SCOTUS!

Wall Street Journal Opinion piece: The SEC's Cryptocurrency Confusion

The SEC’s Cryptocurrency Confusion

By: J.W. Verret, 5:55, August 2, 2022, The Wall Street Journal

After years of threatening to sue Coinbase for listing unregistered securities, the Securities and Exchange Commission is now rumored to have launched an investigation into the company and other exchanges. If it proceeds, the SEC may be on track to make a serious mistake.

Skeptics wonder why Coinbase doesn’t simply register the tokens it sells with the SEC. It’s not that simple. Since its inception, cryptocurrency has confounded regulators because it is unlike any traditional financial instrument. Like regular money, crypto can be used to pay for ordinary goods. Bitcoin is one example, which has a growing base of thousands of merchants who accept payments directly over the currency’s Lightning Network.

Some leading cryptocurrencies can be sent to an app and then used to generate a QR code, which is accepted in 20 national chains like Petco, Chipotle, Office Depot and Regal Cinemas. Last week I used crypto tokens that the SEC has previously alleged were unregistered securities to buy an ice-cream cone and a burrito.

But here’s where things get confusing. Some crytpo tokens appear to function as a type of equity, from which you expect profit. Governance tokens in crypto exchanges, which allow users to vote on changes to how the protocol operates, will share their profit with you. But in a way, profit-sharing tokens aren’t like equity securities at all. The traditional corporate structures—boards of directors, executives, even companies—aren’t present on the other end of the transaction. There’s no one who could file or sign the financial statements for such projects.

There’s even more diversity among tokens. Some are like those you might get from a Chuck E. Cheese to play videogames. These often take the form of tokens used to store data. Imagine if every time you saved a document to the cloud, you needed a token to do so. Payment for data storage is one of the more popular uses of crypto tokens.

Cryptocurrency is so difficult to categorize because many of its variants blur the lines between traditional categories of money, stock and commodities. Most are a bit of each. Some tokens can be used to store data and serve as a form of payment or an investment—all at the same time. The purpose depends on the user’s preference.

Even if cryptocurrency developers wanted to register their projects with the SEC, as traditional public companies are required to, they couldn’t. They don’t have a board, CEO or CFO to file the requisite paperwork with the commission. Nor do they have proxy voting of shares by mail, which the commission still requires companies provide to shareholders.

Consider another facet of crypto that would shock the drafters of the 1933 Securities Act. Imagine if a bank or stock exchange were run by an autonomous, open-source computer code that took deposits and processed loans. Occasionally the code is modified by a few hundred anonymous coders around the world, who collaborate over the internet to keep it running smoothly.

This isn’t some science-fiction movie. Billions of dollars are deposited and loaned out in this way each day. The combined market capitalization of these “decentralized finance” developers would be enough to make them the 18th-largest bank in the U.S.

Tokens that represent an interest in these autonomous computer banks and exchanges are some of the targets of the SEC’s investigations and regulatory inquiries. They are also the same tokens I used to buy my ice cream and burrito last week.

The SEC’s position—that most tokens are securities and must register or face enforcement—is obtuse. It’s also an approach that works to the benefit of the scammers and hucksters who have abused the crypto space.

If the SEC were instead to build a regulatory regime tailored to the needs of crypto investors, as SEC Commissioner Hester Peirce has requested, we would be better able to separate the legitimate crypto projects from the scams. Defendants in SEC actions can now use the nebulous character of crypto tokens to their advantage. When cases are brought against legitimate enterprises, such as Coinbase, that’s a good thing; when brought against fake projects that steal crypto, it isn’t. The morphable character of crypto tokens will confound cookie-cutter application of the regulated security definition.

Innovations require a rethinking of federal securities law. The SEC was 10 years late to the game on delivering financial statements electronically. It was similarly behind the curve in allowing CEOs to share company information over social media. It shouldn’t make the same mistake with crypto.

Mr. Verret is an associate professor of law at Antonin Scalia Law School and a former member of the SEC’s Investor Advisory Committee.

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