Overreach and Misrepresentation: The SEC’s Pursuit of Emergency Relief in ‘DEBT Box’

Reprinted with permission from the June 11, 2024, edition of the New York Law Journal. © 2024 ALM Global, LLC.

Picture this: you’re a cutting-edge cryptocurrency platform, with your native token boasting a market capitalization soaring into the hundreds of millions. Suddenly, the Securities and Exchange Commission (SEC) swoops in with a bombshell lawsuit, accusing you of fraud and seeking to shut down your operations overnight.

Before you even have an opportunity to respond, a federal judge grants the SEC’s ex parte request for a temporary restraining order (TRO), freezing your assets and installing a court-appointed receiver to take over your company.

The damage is instantaneous and devastating—your business grinds to a halt, your customers panic, and your reputation lies in tatters. Later, it comes to light that the SEC made several material misrepresentations to secure the TRO, without which the court would not have granted such drastic relief.

This nightmare scenario is not just hypothetical—it is the stark reality faced by the defendants in SEC v. Digital Licensing Inc., d/b/a DEBT Box, et al., 2:23-CV-00482 (D. Utah). As recently reported, the court recently ordered the SEC to pay parties in the case more than $1 million.

The SEC is armed with robust enforcement powers, including the ability to seek TROs, asset freezes, and the appointment of receivers in cases where the SEC believes immediate action is necessary to halt ongoing misconduct and preserve assets for potential recovery. While the SEC may believe these measures are essential for protecting the market, they can also cause irreparable damage to those accused but not yet proven liable.

This article will explore the DEBT Box saga, examining how an aggressive attempt to halt alleged fraud evolved into a case of regulatory overreach. It will also discuss the less stringent standard the SEC claimed was necessary for the imposition of a TRO, the court’s rejection of this argument, and consider the potential implications of this decision.

‘DEBT Box’: A Cautionary Tale

In July 2023, the SEC filed a sealed complaint against DEBT Box and 18 defendants, including the company’s principals. The SEC alleged that the defendants engaged in a fraudulent scheme that raised at least $49 million from investors. Concurrent with the complaint, the SEC sought an ex parte TRO, an asset freeze, and the appointment of a receiver over DEBT Box and its affiliates.

Judge Robert J. Shelby initially granted the requested relief based on the SEC’s representations, particularly regarding the alleged risk of irreparable harm. In its TRO application and during the ex parte hearing, the SEC made several key representations to demonstrate the need for immediate action. The SEC claimed that defendants were actively closing bank accounts and moving investor funds overseas to evade jurisdiction.

Indeed, an SEC attorney stated at the ex parte TRO hearing that “even in the last 48 hours Defendants have closed additional bank accounts.” DEBT Box, TRO Hearing Tr., ECF No. 111 (Hearing Tr.), at 20.

The SEC also represented that defendants’ principals had stated they were relocating operations to the United Arab Emirates expressly to avoid the agency’s oversight, had taken action to block SEC staff from viewing their social media sites, and had deleted websites containing relevant evidence.

The emergency relief had swift and severe consequences for the defendants. The court’s TRO shut down DEBT Box’s operations, froze the defendants’ personal and business assets, and installed a receiver to take control of the company.

Within days, the company’s native token crashed by more than 56%, wiping out over $340 million in market value. The individual defendants suffered major disruptions to their personal and professional lives, with some reporting inability to access funds for basic living expenses, damage to their businesses and reputations, and even symptoms of post-traumatic stress.

Several months later, after the defendants had been afforded an opportunity to challenge the emergency relief, Judge Shelby dissolved the TRO and receiver appointment, finding that the SEC had failed to present sufficient evidence of imminent, irreparable harm.

More troublingly, the judge expressed concern that the SEC had made “materially false and misleading representations” in obtaining and defending the ex parte TRO. Id., Ord. to Show Cause, ECF No. 215, at 17.

For example, the SEC had falsely claimed that the defendants were actively closing bank accounts and moving assets overseas to evade jurisdiction, when in fact no such activity had occurred. In defending against defendants’ motions to dissolve the TRO, the SEC doubled down on these misrepresentations, asserting that “the facts on the ground” showed defendants had made “significant efforts to move investor funds outside of the court’s jurisdiction in the months leading up to the SEC’s filing.” Id., SEC’s Opp. to the DEBT Council Defendants’ Motion to Dissolve, ECF No. 168, at 2.

However, the court found the SEC lacked evidence to support this claim because the only overseas transfer the SEC identified occurred seven months before the TRO application.
About four months after issuing the TRO, Judge Shelby issued an order directing the SEC to show cause why sanctions should not be imposed for its apparent misrepresentations in seeking the TRO.

The order identified specific instances of concern, including the SEC’s misrepresentations about account closures, asset transfers, and obstruction of the investigation, and the order required the SEC to explain the factual basis for these assertions.

In its response, the SEC acknowledged making “inaccurate” statements but argued sanctions were not appropriate because it had not acted in bad faith. The SEC stated that it did not intend to mislead the court or act with improper purpose, but rather failed to accurately characterize the bases for their factual assertions and correct inaccuracies once discovered. Id., SEC’s Response to Ord. to Show Cause, ECF No. 233, at 1, 19.

After considering the parties’ submissions, Judge Shelby issued a scathing order, finding that the SEC had engaged in a “gross abuse of the power entrusted to it by Congress” and that the SEC’s defenses for its misrepresentations to the court were “entirely without color.” Id., Mem. & Ord., ECF No. 275, at 2, 61.

Shelby further found that “the [SEC’s] repeated misstatements were made wantonly for an improper purpose—to improperly harm Defendants by obtaining and defending the extraordinary ex parte relief the [SEC] was not entitled to through abuse of judicial process.” Id. at 61.

As a sanction, the judge ordered the SEC to pay over $1.8 million to cover the defendants’ attorneys’ fees and costs arising from the improvidently granted TRO and receiver appointment. Id., Mem. & Ord., ECF No. 312, at 23-24.

The Dispute Over the Applicable TRO Standard

In addition to the gross misrepresentations by the SEC, a central issue in the case was the legal standard applicable to the SEC’s request for a TRO. In its application, the SEC argued that it was entitled to a more “relaxed” standard than the usual standard applied to a TRO, requiring only a showing of (1) a likelihood of success on the merits and (2) a reasonable likelihood that the alleged wrong would be repeated, rather than the traditional four-part test for injunctive relief. Id., SEC TRO Application, ECF No. 3, at 12. The SEC cited cases from the U.S. Court of Appeals for the Second Circuit and district courts within the U.S. Court of Appeals for the Tenth Circuit suggesting this lower standard applied when the SEC sought a TRO. Id. at 12-13.

The Second Circuit decision the SEC relied on was SEC v. Unifund SAL, 910 F.2d 1028, 1035-36 (2d Cir. 1990), in which the court held that the SEC, when pursuing injunctions, need not demonstrate irreparable harm or the absence of adequate legal remedies.

This holding was based on the settled principle in the Second Circuit that the SEC is not an “ordinary litigant,” as it acts as a “statutory guardian charged with safeguarding the public interest in enforcing the securities laws.” SEC v. Management Dynamics, Inc., 515 F.2d 801, 808 (2d Cir. 1975).

However, this lenient standard came under intense scrutiny in DEBT Box, where Judge Shelby called into question the appropriateness of granting such extraordinary relief without a more rigorous showing.

At the ex parte TRO hearing, the judge quoted Tenth Circuit precedent stating that “any modified test which relaxes one of the prongs for preliminary relief and thus deviates from the standard test is impermissible.” Hearing Tr., at 7.

The court indicated it was prepared to deny the TRO without prejudice because the SEC had not argued and satisfied the four standard requirements for obtaining a TRO: (1) likelihood of success on the merits, (2) irreparable harm absent the TRO, (3) balance of harms favoring the movant, and (4) the TRO being in the public interest.

In response, the SEC offered to orally argue the standard factors. After a recess, the court allowed the SEC to do so, finding relevant facts were included in the written application. Based on the SEC’s oral representations, including its claim that defendants had closed 33 bank accounts in the past 48 hours (a representation later shown to be false), the court granted the TRO.

In the later order dissolving the TRO, the court reiterated that the SEC bore the burden of establishing all four factors and had failed to show irreparable harm even considering additional evidence. DEBT Box, Mem. & Ord., ECF No. 214, at 5-7.

The court specifically rejected the SEC’s argument that it was entitled to a relaxed standard under Unifund SAL, citing the Tenth Circuit’s clear guidance in Diné Citizens Against Ruining Our Env’t v. Jewell, 839 F.3d 1276, 1281 (10th Cir. 2016) that any modification of the traditional preliminary injunction test is impermissible. Id.

In emphasizing the requirement to show irreparable harm, the court highlighted that this “is the single most important prerequisite” for a TRO and “is not an easy burden to fulfill.” Id. at 13-14. The movant must demonstrate the anticipated injury is “certain, great, actual and not theoretical” and of “such imminence that there is a clear and present need for equitable relief to prevent irreparable harm.” Id at 13. The court then systematically refuted each of the SEC’s arguments attempting to establish irreparable harm.

Looking Ahead

The DEBT Box decision, while indicating that the District of Utah will adhere to the typical standard for SEC TROs, is unlikely to impact the well-established precedent in the Second Circuit, where the SEC is entitled to a relaxed standard when seeking such relief.

The Second Circuit has long held that the SEC’s injunctive actions are statutory creatures that do not require a showing of irreparable harm, as articulated in Unifund and reaffirmed in numerous subsequent decisions. E.g., SEC v. Collector’s Coffee, Inc., No. 19-CV-4355, 2023 WL 6453709, at *8 (S.D.N.Y. Oct. 4, 2023) (granting the SEC’s motion for a preliminary injunction using the two-part standard). However, DEBT Box could be a harbinger of the agency’s willingness to aggressively push for a more lenient standard in seeking emergency relief, even in jurisdictions where the legal basis for such an argument may be tenuous.

While the court’s rejection of Unifund aligns with the Tenth Circuit’s broader skepticism toward a relaxed standard for injunctive relief absent clear statutory authority, the Second Circuit is not the only circuit to adopt this two-part standard.

By way of example, a district court in the Middle District of Florida has recently reiterated the U.S. Court of Appeals for the 11th Circuit’s prior decisions that the two-part test is applicable in SEC enforcement cases. SEC v. Harbor City Cap. Corp., No. 6:21-CV-694-CEM-DCI, 2021 WL 3111587, at *2 (M.D. Fla. May 19, 2021) (citing SEC v. Unique Fin. Concepts, Inc., 196 F.3d 1195, 1199 n.2 (11th Cir. 1999)).

In 2023, a district court in the Central District of California, recognizing that the U.S. Court of Appeals for the Ninth Circuit “has not expressly adopted” this two-part standard, decided to apply the two-part test in light of the SEC’s statutory authority and the general acceptance of this standard by other district courts in the Ninth Circuit. SEC v. Zera Fin. LLC, No. 23-CV-01807, 2023 WL 8269775, at *4 (C.D. Cal. Oct. 30, 2023).

Looking ahead, the DEBT Box decision may also serve as a cautionary tale for the SEC, potentially chilling some of the agency’s aggressive tactics in seeking ex parte TROs. While the Second Circuit and some other jurisdictions may continue to apply a more lenient standard for SEC injunctive actions, the stark consequences of the agency’s overreach in this case could prompt it to be more judicious in its pursuit of emergency relief, particularly in jurisdictions that adhere to the traditional four-part test.

Ultimately, while the SEC’s mission to combat fraud and protect investors is crucial, the DEBT Box decision underscores the importance of pursuing these goals through means that are both lawful and ethically sound.

James V. Masella III is a partner in Ballard Spahr’s securities enforcement and corporate governance litigation group. Brad Gershel is an associate in the group.

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