SEC v. Terraform Labs Pte. Ltd.: SDNY Judge Rakoff Denies Defendants’ Motion to Dismiss SEC’s Claims, Rejects the Ripple Court’s Interpretation of the Howey Test

On July 31, 2023, Judge Jed S. Rakoff in the Southern District of New York ruled that the U.S. Securities and Exchange Commission (SEC) may proceed with its case against Terraform Labs (“Terraform”) and its CEO, Do Hyeong Kwon, alleging, among other things, a failure to register the offer and sale of Terraform’s crypto-assets and fraud in connection with those transactions.[1] Judge Rakoff’s opinion denying defendants’ motion to dismiss is the latest installment in a growing number of district court opinions examining, in actions brought by the SEC, when digital assets should be treated as securities under the Supreme Court’s “Howey test,” as articulated in SEC v. W.J. Howey Co., 328 U.S. 293 (1946). The opinion is particularly notable for, in Judge Rakoff’s words, “reject[ing] the approach recently adopted by another judge in [the Southern District of New York] in a similar case, SEC v. Ripple Labs, Inc.,” in applying the Howey test.[2] 

Takeaways

While only one decision in a growing sea of precedent, Terraform supports the SEC’s arguments that:

• Crypto-assets do not cease to be securities when traded through digital asset exchanges—any suggestion to the contrary in Ripple should be met with caution while additional courts weigh in on the SEC’s pending crypto-asset cases;
• Promoting digital assets to U.S. investors is sufficient to establish personal jurisdiction; and
• Neither the “Major Questions Doctrine” nor the principles of due process prohibit the SEC from treating digital assets as securities and regulating transactions involving those assets.

Background

As described by Judge Rakoff, Terraform is a Singapore-based company that develops, markets, and sells crypto-assets. It is best known for developing the Terraform blockchain and developing and selling the “Terra/UST” stablecoin and “LUNA” native token, among other crypto-assets, on the blockchain. Terraform pegged UST coins to the U.S. dollar, meaning they could be purchased or sold for exactly $1.00. UST was “algorithmically” backed by or linked to its “sister token,” LUNA. In May 2021, UST became unstable and lost value, but Terraform was able to artificially restore UST’s peg following an allegedly secret arrangement with a third-party trading firm. One year later, UST dropped below $1.00 again, but this time, absent external intervention to prop up its price, the value of UST crashed, as did its sister token, LUNA. The crash wiped out over $40 billion in total market value for investors. 

Judge Rakoff’s Decision

Judge Rakoff held that the SEC asserted a plausible claim that Terraform’s crypto-assets qualified as securities under the Supreme Court’s Howey test, which defines an investment contract as a contract, transaction, or scheme whereby a person (1) invests his or her money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party. Unlike Judge Torres in Ripple—whose summary judgment decision is described in more detail in our July 17, 2023 client alert—Judge Rakoff declined to distinguish between investors who purchased tokens directly from defendants and those who obtained their tokens through secondary transactions, explaining that “Howey makes no such distinction between purchasers.”

“That a purchaser bought the coins directly from the defendants or, instead, in a secondary resale transaction has no impact on whether a reasonable individual would objectively view the defendants’ actions and statements as evincing a promise of profits based on their efforts.” Judge Rakoff found that such representations would reach purchasers on secondary markets, and “motivated those purchases … as much as it did institutional investors.” This stood in contrast to Judge Torres’ decision in which she held that “programmatic” sales by Ripple that resembled secondary market transactions did not create a reasonable expectation of profits derived from the entrepreneurial or managerial effort of others, as required under Howey.

Judge Rakoff further rejected the alternative bases for dismissal advanced by Terraform and its CEO, Kwon—most notably that (i) the court lacked personal jurisdiction over defendants; (ii) defendants lacked notice of how the SEC would treat the digital assets in question (thus violating their due process rights); and (iii) the so-called “Major Questions Doctrine” prohibited the SEC from promulgating the regulations it sought to enforce in this case.

In rejecting defendants’ jurisdictional challenge, the court noted the issue had largely been resolved by the Second Circuit Court of Appeals in the context of an SEC subpoena enforcement action seeking information from Terraform as part of the investigation that led to this case. And even if not already decided by the Second Circuit, Judge Rakoff held that the SEC alleged sufficient contact with the United States to support jurisdiction, including allegations regarding a promise to lend 30 million LUNA coins to a U.S.-based company. Even one contract, Judge Rakoff explained, can support jurisdiction.

Addressing defendants’ notice argument, Judge Rakoff pointed to a history of SEC statements he deemed as sufficient to protect their due process rights, explaining that “[it] cannot be that the Due Process Clause requires an agency to detail in advance, in the name of ‘fair notice,’ each and every argument it intends to make in an adjudication proceeding. That the SEC previously expressed its views that crypto-assets could be considered ‘investment contracts’ under Howey suffices.”

Regarding the Major Questions Doctrine, Judge Rakoff emphasized that the doctrine is reserved for “extraordinary cases,” and the SEC’s regulation of crypto assets is not such a case. The cryptocurrency industry, Judge Rakoff explained, “falls far short of being a ‘portion of the American economy’ bearing ‘vast economic and political significance,’” and further explained that “the SEC’s decision to require truthful marketing of certain crypto-assets based on its determination that certain of such assets are securities hardly amounts to a ‘transformative expansion in its regulatory authority.’”

Finally, Judge Rakoff denied defendants’ motion to dismiss the fraud counts against them, pointing to specific statements that the SEC alleged were made by defendants regarding the Terraform blockchain, and rejecting defendants’ arguments that they lacked any duty to disclose certain information because such a duty “arises whenever secret information renders prior public statements material misleading.”

Our View

As we cautioned after the Ripple decision, observers should be careful to avoid drawing broad conclusions from one opinion in a rapidly growing body of precedent—indeed, that is particularly true for Terraform, where Judge Rakoff’s decision speaks only to the sufficiency of the SEC’s allegations, not whether the evidence will ultimately support the SEC’s claims at summary judgment or at trial. Nevertheless, there is still much to learn from Terraform, which highlights the obstacles similarly situated defendants are likely to face in making arguments about personal jurisdiction, due process, the SEC’s authority to regulate the crypto industry in general, and, perhaps most critically, what assets will be deemed securities for purposes of regulation under federal securities laws. If Ripple offered participants in the crypto economy some reason for optimism that courts may find the SEC’s definition of securities to be overbroad, Terraform demonstrates that the pendulum may not have swung that far.

Crypto-market participants and observers should continue to exercise caution when playing any role in offering or selling crypto-assets, knowing the SEC will likely continue to be aggressive in regulating such transactions, buoyed by decisions like Terraform.

[1] Sec. & Exch. Comm’n v. Terraform Labs Pte. Ltd., No. 23-CV-1346 (JSR), 2023 WL 4858299 (S.D.N.Y. July 31, 2023).

[2] Sec. & Exch. Comm’n v. Ripple Labs, Inc. (“Ripple”), No. 20 CIV. 10832 (AT), 2023 WL 4507900, at *1 (S.D.N.Y. July 13, 2023).