Introduction
In the latest decision evaluating the application of federal securities laws to the digital asset context, Judge Jed S. Rakoff of the United States District Court for the Southern District of New York (“SDNY”) ruled in favor of the Securities and Exchange Commission (“SEC”) on a motion to dismiss in SEC v. Terraform Labs.1 In doing so he found that the sales of crypto assets to retail investors on public marketplaces do not exempt such tokens from being “securities” subject to the SEC’s registration requirements. Judge Rakoff’s ruling came only weeks after a major ruling by Judge Analisa Torres also of SDNY in SEC v. Ripple Labs, finding that the XRP token was not a security when sold to in secondary transactions through digital asset exchanges or through the use of trading algorithms, but was part of an investment contract (and therefore a security) when sold by Ripple Labs directly to investors.2 The SEC has already asked Judge Torres to stay her decision while the SEC appeals the court’s ruling to the United States Court for Appeals for the Second Circuit.
Background
Terraform Labs Pte. Ltd. (“Terraform”) is a Singapore-based company that develops, markets, and sells crypto assets, and Do Keyong Kwon (“Kwon”) is the company’s Founder, Chief Executive Officer, and majority shareholder. Terraform and Kwon developed and sold the Terra USD stablecoin (“UST”), as well as a companion digital asset called “LUNA.” A stablecoin is a digital asset designed to have its value pegged to the value of a given reference asset (such as the U.S. dollar). Stablecoins are often used to facilitate digital asset transactions by providing reduced settlement times. Each UST coin was a stablecoin that has its price algorithmically pegged to the U.S. dollar. Owners of a UST coin could swap their coin for $1.00 worth of LUNA coin, which was a native digital asset of the Terraform blockchain. Likewise, any holder of a LUNA coin could exchange that coin for $1.00 of UST coin. Following the collapse of both LUNA and UST in 2022, the SEC charged Terraform and Kwon in February 2023 with orchestrating a multi-billion-dollar crypto asset securities fraud involving an algorithmic stablecoin and other crypto asset securities. The defendants strongly deny the charges.
The “Howey Test”
Courts generally apply the “Howey test”3 to determine whether a digital asset constitutes an “investment contract,” and therefore a security under the U.S. securities laws. The Howey test requires (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits to be derived from the efforts of others. A given digital asset may be determined to be an investment contract (and therefore a security) if, for example, it is promoted and marketed in a manner that emphasizes the profit-earning potential or secondary market liquidity of the digital asset, such that the purchaser would be acquiring the digital asset for investment-related reasons. A digital asset may also be considered an investment contract (and therefore a security) where promotional and marketing efforts emphasize the managerial expertise of the issuer in the future success of the digital asset project (such as through the development of future use cases for the digital asset).
The Earlier Ripple Decision
On July 13, 2023, Judge Torres ruled in SEC v. Ripple Labs that “programmatic sales” of XRP token on public digital asset exchanges or through the use of trading algorithms did not constitute an impermissible offer and sale of investment contracts, while “institutional sales” did. “Institutional sales” of XRP refer to direct sales of XRP to investors, such as institutional buyers and hedge funds, while “programmatic sales” of XRP refer to selling XRP on public digital asset exchanges or through the use of trading algorithms. In so ruling, Judge Torres determined that the third Howey prong was not satisfied because the programmatic sales were blind bid/ask transactions and investors could not know the seller from which they purchased XRP. Therefore, such sales did not constitute an investment in Ripple at all, and investors could not reasonably expect that Ripple would receive the purchase proceeds and use them to improve XRP.
The Terraform Decision
Judge Rakoff explicitly rejected Judge Torres’s distinction in Ripple between a token having been sold directly to an institutional purchaser in a primary issuance and it being sold through secondary transactions with retail investors. Judge Rakoff observed that Howey and its progeny makes no distinction between purchasers, since the manner of sale would not change a purchaser’s reasonable belief in the promise of future profits based on…
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