New York district court denies Terraform Labs’ motion to dismiss, declines to follow Ripple ruling

SEC v. Terraform Labs Pte. Ltd., et al.
Date: July 31, 2023

Issue: Whether Terraform Labs Pte. Ltd.’s sales and distribution of cryptoassets constituted the sale of unregistered securities.

Case Summary: A New York district court denied Terraform Labs’ motion to dismiss in the Security Exchange Commission (SEC)’s lawsuit alleging the company orchestrated multibillion-dollar cryptoasset securities fraud involving an algorithmic stablecoin and other crypto asset securities, declining to follow a recent ruling in Ripple v. SEC.

Terraform is a Singapore-based company that develops, markets and sells cryptoassets. Terraform is best known for developing the Terraform blockchain. Terraform also develops and sells the Terra/UST stablecoin and the Luna native token, among other crypto-assets.

The SEC sued Terraform Labs and its CEO Do Hyeong Kwon, alleging they raised billions of dollars from investors by offering and selling an interconnected suite of cryptoassets securities, many in unregistered transactions. According to the SEC, the alleged scheme took place from April 2018 until its collapse in May 2022. The SEC also alleges Terraform and Kwon marketed cryptoasset securities to investors seeking to earn a profit, repeatedly claiming the tokens would increase in value. The SEC claimed while marketing the Luna token, Terraform and Kwon repeatedly misled and deceived investors into believing a popular Korean mobile application used the Terra blockchain to settle transactions that would accrue value to Luna. Further, the SEC alleged Terraform failed to register the offer and sale of its cryptoassets. Terraform moved to dismiss the lawsuit on the basis the digital assets at issue are not securities; the registration claims even if any digital assets were securities; and the fraud claims fail even if any digital assets were securities.

Judge Jed S. Rakoff denied Terraform’s motion to dismiss. First, Judge Rakoff determined the SEC adequately pled that the court may exercise personal jurisdiction over the defendants. While Terraform and Kwon argued the court lacks personal jurisdiction under the due process clause, Judge Rakoff disagreed. Judge Rakoff found Terraform’s assertion to be an attempt to “manufacture” a fair notice defense because the SEC provided a reasonable person within defendants’ industry fair notice that their conduct may prompt an enforcement action by the SEC.

Second, Judge Rakoff found the SEC is not barred from asserting that Terraform’s cryptoassets are securities. According to Judge Rakoff, the Exchange Act sets forth the bounds of the SEC’s regulatory authority by defining what sorts of products can be considered “securities” and, therefore, are subject to SEC regulation and enforcement.

Finally, Judge Rakoff emphasized the SEC asserted a plausible claim the defendants’ crypto-assets qualify as securities. Judge Rakoff declined to differentiate between digital tokens based on their manner of sale. This differs from Judge Analisa Torres’ recent decision in SEC v. Ripple Labs. In Ripple, Judge Torres found Ripple’s digital token, XRP, is not by itself an investment contract under the Supreme Court’s Howey test to qualify as a security. Under the Howey test, an investment contact exists “when a person: (i) invests his money, (ii) in a common enterprise, and (iii) is led to expect profits solely from the efforts of the promoter or a third party.” According to Judge Rakoff, Howey does not distinguish between purchasers who bought coins directly from defendants or those who bought coins in a secondary transaction. According to Judge Rakoff, the sale transaction is irrelevant to whether a reasonable individual would objectively view Terraform’s actions and statements as a promise of profits based on their efforts.

Bottom Line: Trial is set for Nov. 17, 2023.

Documents: Opinion & Order