On July 31, 2023, Judge Jed Rakoff of the Southern District of New York (“SDNY”) sided with the Securities Exchange Commission in SEC v. Terraform Labs Pte. Ltd. by holding that sales of crypto assets to retail investors on public marketplaces amounted to a sale of “securities” subject to the SEC’s registration requirements.1 In doing so, he is the first judge to disagree with fellow SDNY Judge Analisa Torres’s recent decision in SEC v. Ripple Labs, Inc., where she held that the sale of certain crypto tokens on public exchanges was not a sale of securities subject to SEC regulation.2
Terraform’s Crypto Asset Sales to Retail Investors Were Investment Contracts
The SEC filed its enforcement action against Terraform Labs Pte. Ltd. and its founder, CEO, and majority shareholder Do Hyeong Kwon on February 16, 2023. Among other allegations, the SEC claimed that Terraform and Kwon raised billions of dollars from investors by selling a number of crypto assets in unregistered transactions in violation of the federal securities laws. When the defendants moved to dismiss the suit, one of the questions before the court was whether Terraform’s sales of its crypto assets—both to institutional investors in private sales and to retail investors on the secondary public market—were investment contracts and thus securities subject to the SEC’s registration requirements. The court sided with the SEC, concluding that the crypto assets at issue were securities and thus denied the defendants’ motion to dismiss.
In analyzing the SEC’s allegations, the Court applied the test from SEC v. W.J. Howey Co. to the sales of Terraform’s crypto assets, asking whether these assets were sold as investment contracts where a purchaser “(1) invest[ed] his money (2) in a common enterprise and (3) [was] led to expect profits solely from the efforts of the promoter or a third party.”3
According to Judge Rakoff, while the first two elements of the Howey test were met, the third element was not. In so holding, he broke with Judge Torres’s reasoning in Ripple. Judge Torres held that, although the sale of certain crypto tokens to institutional investors was a sale of securities, the sale of those same tokens to retail investors on public exchanges was not. She reasoned that Ripple’s sales on public exchanges were “blind bid/ask transactions,” and thus the purchasers would not have known if their money went to Ripple or any other seller of the token. Judge Rakoff, however, “decline[d] to draw a distinction between these coins based on their manner of sale,” holding that “Howey makes no such distinction between purchasers.” According to the Court, whether the crypto assets were sold directly to a purchaser or in a secondary resale transaction does not affect whether a buyer might view Terraform’s various public statements as promising profits based on Terraform’s own efforts. In fact, Terraform and Kwon had “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto assets by touting their profitability and the managerial and technical skills that would allow defendants to maximize returns.” As the Court put it, “secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf.”
A Still Uncertain Future
Neither Ripple nor Terraform will be the last word on the critical question of when sales of crypto assets constitutes the sale of a “security” subject to regulation under the federal securities laws. Crypto investors and industry participants should continue to monitor this fast evolving area of the law.
1SEC v. Terraform Labs Pte Ltd., No. 23-cv-1346 (JSR), 2023 WL 4858299 (S.D.N.Y. July 31, 2023).
2SEC v. Ripple Labs, Inc., 20 Civ. 10832 (AT), 2023 WL 4507900 (S.D.N.Y. July 13, 2023).
3SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
