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Crypto & Pre-Enforcement Challenges: Another Tool in the Arsenal

Updated: Jun 20

Earlier this year, DEF and Beba, an apparel company, sued the SEC using a relatively rare legal strategy known as a pre-enforcement challenge (PEC). Beba airdropped $BEBA tokens as part of its marketing efforts and now seeks a court order declaring that: (1) its free airdrop was not a securities transaction and (2) $BEBA tokens are not investment contracts. In addition, DEF and Beba argue that the SEC’s behind-closed-doors adoption of its policy that nearly all digital assets and digital asset transactions are securities violated the Administrative Procedures Act.


To understand the legal procedure behind the suit, this blog post dives deeper into what a PEC is and the history of its use.


Legal Requirements of a PEC

A PEC permits plaintiffs to obtain judicial review of a legal question before a government agency enforces the law against the plaintiff.  In other words, "where threatened action by government is concerned,” a plaintiff need not “expose himself to liability before bringing suit to challenge the basis for the threat.” Instead, the plaintiff can seek clarity from a court before engaging in conduct an agency may deem unlawful or before the agency actually takes action against the plaintiff. Review, in most cases, centers on either one of two issues: whether the law itself is unlawful or whether the agency’s application of the law to a certain set of facts is unlawful. Traditionally, this tool has been used in the context of protecting American civil rights and liberties, ranging from freedom of speech to the right to bear arms and reproductive freedom. Consider the following hypothetical: California passes a new law requiring social media companies to submit so-called “controversial” ad-buys to the state for approval. The former form of review would ask courts to determine whether that law is constitutional, the latter would ask courts to determine whether the law applied to a specific set of circumstances, for example enforcing the law against a specific company who did not comply with it, is constitutional. Pre-enforcement actions are offensive, allowing a plaintiff to be proactive rather than sit around and wait to find out whether an agency will enforce against them.


To bring claims to court, a plaintiff must satisfy a constitutional requirement known as “standing.” A party has standing when they have been or will be harmed in connection with the conduct central to the dispute. One of the corollaries of standing is the ripeness doctrine, which requires that cases be sufficiently developed into a present, substantial controversy warranting judicial intervention. This simply means the case is ready for judicial review and is intended to keep hypothetical or abstract disputes out of court. By way of example, standing and ripeness would be implicated if a plaintiff attempted to sue their neighbor for theoretical future damage to their driveway due to new pine tree saplings the neighbor planted along her fence-line. Generally, courts review events that have already happened, not uncertain future possibilities.

 

PECs challenge a type of possible future action, requiring additional considerations beyond the traditional rules of standing. In order to allege ripeness, a plaintiff must plead a credible fear of enforcement by the agency in question. This fear cannot be abstract; the plaintiff must show that there is a substantial risk that the law will be enforced against them, and that this enforcement will harm them in some way. A plaintiff can demonstrate a credible fear by showing the plaintiff’s conduct or planned conduct falls within the language of the law itself, a final rulemaking by the agency, statements from regulators or other enforcement officials, or a history of enforcement actions against similar plaintiffs. 


If successful, a plaintiff can use a PEC to obtain declaratory relief, which means a court’s clarification on the meaning of statutory terms that a legislature failed to adequately define or left vague and ambiguous, or on law that a government actor unlawfully interprets. Plaintiffs can also use PECs to obtain the full arsenal of equitable and legal remedies ranging from injunctions against further action by the agency to striking down statutes. In sum, plaintiffs can utilize PECs to obtain certainty from government agencies, leveraging the courts to cut through and clarify uncertain positions and alleviate credible fears which threaten to harm lawful business.


How PECs Have Been Used In The Past

With the high-level explanation aside, history provides more context to understand what PECs are and how they work. The first PEC was brought in 1887 in the case of Mugler v. Kansas. This case involved a statute prohibiting the manufacturing of alcoholic beverages. Mugler, a brewer, brought a PEC claiming he feared the government would target his business and alleged what would now be referred to as a credible fear of enforcement. Building off English common law precedent, the Supreme Court of the United States affirmed the judiciary’s ability to hear and decide cases related to possible future injuries. This holding was affirmed in Pennsylvania v. West Virginia in 1923, where the Court stated plainly that a plaintiff does not have to wait until the injury actually occurs: “If the injury is certainly impending, that is enough.” These cases paved the way for future actions brought on similar principles.


In 1974, following the height of Vietnam War protests, the Court heard the case Steffel v. Thompson. Steffel, a protester in Georgia, along with other individuals was standing outside a shopping center on an external sidewalk handing out fliers criticizing U.S. foreign policy in Vietnam. At some point, shopping center employees confronted the group and asked them to stop hand-billing and threatened to call the police if they failed to comply. After rejecting this request, the police arrived at the scene and threatened the group with arrest for criminal trespass if they failed to disperse. The group and Steffel heeded the threat and left. However, two days afterwards, Steffel and others decided to return to the shopping center and continue hand-billing. Once again, the police were called and Steffel left the scene; this time, members of the group stayed and were arrested for criminal trespass by the police. Those arrests formed the basis for the suit. Steffel claimed that the police weaponized criminal trespass to chill their hand-billing protest, essentially abridging their freedom of speech. This suit was brought to adjudicate their rights and determine whether application of the criminal trespass law to this activity was facially unconstitutional. 


The district court and the Fifth Circuit denied Steffel’s request on procedural grounds, so Steffel appealed to the Supreme Court.  Ultimately, the Supreme Court held that federal declaratory relief is available when “a federal plaintiff demonstrates a genuine threat of enforcement of a disputed criminal statute.” A plaintiff need not “expose himself to actual arrest or prosecution to be entitled to challenge a statute that he claims deters the exercise of his constitutional rights.” Although the case fizzled out on remand, the Court highlighted the credible fear posed by the arrest and prosecution of Steffel’s fellow protestors, which may have been dispositive if the case had continued. Clarifying the availability of declaratory relief in PECs, Steffel represents the Court upholding the use of the judiciary to proactively combat government overreach.  


The 2014 case Susan B. Anthony List v. Driehaus provides further insight into the standing requirements for a PEC plaintiff. Another example of the Supreme Court protecting the freedom of speech through PECs, Susan B. Anthony List dealt with an Ohio law criminalizing false statements made during a political campaign. The plaintiff claimed restrictions on their expression and characterization of the Affordable Care Act and their assessment of what it meant to voters unconstitutionally restricted their First Amendment rights. Like in Steffel, the plaintiff in this case lost at both the trial and appellate levels. The issue on appeal was whether the question of ripeness was correctly decided. The Court held that a plaintiff may challenge a law before its enforcement if the plaintiff alleges “an intention to engage in a course of conduct arguably affected by a constitutional interest, but proscribed by a statute, and there exists a credible threat of prosecution.” This means that plaintiffs can bring a PEC if they intend to act in a way protected by the constitution, such as by engaging in free speech, but a statute seems to prohibit such conduct.


Conclusion

PECs are a vehicle for change, allowing plaintiffs to take the offensive against a state or federal government that has targeted the legal activities of a given party. In the context of crypto, the legislature has yet to provide a regulatory framework for digital assets, and in the meantime, agencies have brought numerous enforcement challenges raising more questions than answers about the current state of the law. They have created a hostile environment where U.S. digital asset industry participants do not know what is required to act lawfully and live in fear that they will be the next recipient of a subpoena or enforcement action. Although relatively unknown in this particular space, PECs are a reliable and battle-tested tool to create change through the judiciary. While Congress acts as if encircled by a deluge of molasses, PECs can cut through the malarkey and obtain meaningful answers for parties simply trying to express their constitutionally guaranteed rights. 


This piece was written by Jonathan Obeda, a legal intern with the DeFi Education Fund.


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