Summary

Just when it looked like a victory for the crypto industry in SEC v. Ripple, a mere two weeks later, a different judge in the Southern District of New York disagreed with Ripple’s holding, introducing greater uncertainty in the crypto space. In SEC v. Terraform, Judge Jed Rakoff, in denying a motion to dismiss, held that the cryptocurrencies at issue may be securities, and noted that it is insignificant whether securities are sold directly to institutional investors or on the secondary market. Terraform shows the continuing lack of clarity in the law regarding whether a particular crypto-asset is or is not a security.

The Upshot

• The debate over whether cryptocurrencies are securities continues.
• The crypto-assets at issue in Terraform may be securities subject to SEC regulation.
• Ripple may not have established the standard for crypto regulation, and the SEC’s aggressive stance against entities and individuals in the crypto arena will likely continue unabated following this decision.

The Bottom Line

This lack of clarity means that companies in the crypto industry should be prepared for potential SEC enforcement actions, and they should engage experienced counsel to advise on litigation and compliance risks.

On July 31, 2023, the Court in SEC v. Terraform Labs Pte. Ltd., 2023 U.S. Dist. LEXIS 132046 (S.D.N.Y. Jul. 31, 2023) denied defendants’ motion to dismiss the SEC’s Amended Complaint. Defendants argued that the SEC was barred from asserting that the defendants’ crypto-assets were securities because (1) the SEC did not have the authority to regulate the crypto-assets in question, and (2) the crypto-assets did not qualify as “securities” subject to SEC regulation. The crypto-assets in question were the Terra USD cryptocurrency (UST), its companion coin, LUNA, and three other related crypto-assets. UST was supposed to be a “stablecoin,” a type of crypto-asset whose price was algorithmically pegged on a 1:1 ratio with US dollars. At any point, a holder of either UST or LUNA could swap their coins for the other on a 1:1 ratio.

Preliminary Questions Regarding SEC’s Ability to Regulate Crypto-Assets

In arguing that the SEC could not regulate the crypto-assets in question, the defendants relied on: (1) the Major Questions Doctrine; (2) the Due Process Clause; and (3) the Administrative Procedure Act (APA). Judge Rakoff rejected all three of these arguments. First, under the Major Questions Doctrine, the Supreme Court has held that, in cases where an agency claims “the power to regulate a significant portion of the American economy” that has “vast economic and political significance,” the agency must point to “clear congressional authorization” for that power. Util. Air Regul. Grp. v. EPA, 573 U.S. 302, 324 (2014). Judge Rakoff found that this doctrine did not apply because “the crypto-currency industry – though certainly important – falls far short of being a portion of the American economy bearing vast economic and political significance.” Additionally, Judge Rakoff noted that the SEC was not exercising “vast economic power over the securities markets,” but rather was simply assuring “that they provide adequate disclosure to investors.” Id. at 22.

Second, in rejecting the defendants’ argument that the SEC violated their due process rights by bringing this enforcement action without first providing “fair notice” that their crypto-assets would be treated as securities, Judge Rakoff determined that the SEC has provided sufficient notice through its regulations, written guidance, litigation, and other actions, such that a reasonable person operating within the crypto industry would have fair notice that their conduct might prompt an SEC enforcement action.

Similarly, Judge Rakoff found that the APA was also not a bar to the SEC’s claims. Defendants argued that the APA required the SEC to announce a new policy on crypto-assets prior to bringing this action. Judge Rakoff held that the SEC was merely enforcing its previously stated views that certain crypto-assets are securities if they meet the Howey test.

The Howey Test

Defendants also alleged in their motion to dismiss that the crypto-assets in question were not “securities” subject to SEC regulation. The Supreme Court in 1946 established the standard for determining whether a particular economic arrangement can be classified as an “investment contract,” in other words, a security, and thus regulated by the SEC. See SEC v. W.J. Howey Co.., 328 U.S. 293 (1946) (Howey). Under the Howey test, an “investment contract” under federal securities law is any “contract, transaction, or scheme whereby a person (1) invests his money (2) in a common enterprise and (3) is led to expect profits solely from the efforts of the promoter or a third party.” Id. at 298-99. In Terraform, the court considered whether each of the defendants’ crypto-assets amounted to a transaction or scheme that met the three prongs of the Howey test.

At the outset, Judge Rakoff noted that there is no requirement for a formal contract between parties for Howey to apply – instead, there only needs to be a scheme where one party will make an investment of money in the other party’s profit-seeking endeavor. Furthermore, a product may become a security once circumstances change and thus become subject to SEC regulation. Therefore, Judge Rakoff declined to distinguish between the tokens in this action and their related investment protocols. Tokens, by themselves, might not qualify as investment contracts, but once they confer the right to purchase another security (as was the case here), or were considered “yield-bearing investments whose value would grow in line with” defendants’ business, then they crossed the line into “investment contracts” under Howey. Additionally, the fact that certain of the coins owned by investors in this case were deposited into an investment pool that advertised profits also qualified these tokens as “investment contracts” under Howey.

Judge Rakoff then proceeded to analyze the five crypto-assets in this case under the three prongs of Howey. First, Judge Rakoff noted that there was no dispute on Howey’s first prong that investors invested money in exchange for crypto-assets. For Howey’s second prong, Judge Rakoff held that there was a common enterprise given that (a) defendants had marketed one of the crypto-assets as generating returns in return for deposit; (b) defendants used proceeds from the sales of other crypto-assets to develop their blockchain and represented that these improvements would increase the value of the crypto-assets themselves; or (c) the crypto-assets could be exchanged for the other tokens that qualified as “investment contracts.” Finally, for Howey’s third prong, Judge Rakoff held that the SEC satisfied the standard of whether an objective investor would have perceived the defendants’ statements and actions as promising the possibility of returns in exchange for investments. In support of its claims, the SEC relied on the defendants’ repeated statements that investors would profit in exchange for their purchases of defendants’ crypto-assets.

Rejecting Ripple

Notably, Judge Rakoff’s decision in Terraform "rejected" the recent crypto decision by Judge Torres in the same courthouse, SEC v. Ripple Labs Inc., 2023 U.S. Dist. LEXIS 120486 (S.D.N.Y. July 13, 2023). In Ripple, Judge Torres drew a line between crypto-assets that were sold directly to institutional investors, finding those to be securities, with those sold through the secondary market, which she held were not securities. According to Judge Torres, re-sale purchasers could not have known if their payments went to the defendant as opposed to a third party, and therefore there was no expectation of profit that could be ascribed to the defendant. Judge Rakoff forcefully disagreed with Ripple’s holding, and stated that “Howey makes no such distinction between purchasers . . . [a]nd it makes good sense it did not. That a purchaser bought coins directly from the defendants or, instead, in a secondary re-sale 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.”

Conclusion

The decision in Terraform makes it clear that Ripple did not spell the end of SEC Enforcement efforts in the crypto arena, and Terraform will spur renewed efforts by the SEC to pursue companies engaged in crypto-related investments and offerings. Cryptocurrency firms should engage experienced legal counsel to help mitigate litigation and compliance risks in the aftermath of Terraform.