SEC secures victory against Terraform Labs and founder Do Kwon: key takeaways

In late December, Judge Jed Rakoff of the federal district court for the Southern District of New York issued an opinion and order on cross-motions for summary judgment in an SEC enforcement action against blockchain and cryptocurrency creator Terraform Labs and founder Do Hyeong Kwon.

The SEC had alleged that, in developing, marketing, and selling various cryptocurrencies, the defendants had offered and sold securities without registration, offered and effected transactions in security-based swaps without registration, and engaged in fraud.

The court granted summary judgment for the SEC on its claims for unregistered offer and sale of securities, granted summary judgment for the defendants on the SEC’s claims for unregistered transactions in security-based swaps, and denied the cross-motions on the fraud claims.

Although the case involves issues similar to other SEC enforcement actions involving digital assets, the SEC’s focus on the defendants’ stablecoin and its role within the ecosystem represents another front in the SEC’s ongoing oversight of the US cryptocurrency industry.

Terraform developed and sold cryptocurrencies LUNA, MIR, and UST, with various supporting DeFi protocols

According to the opinion, in 2019 Terraform Labs (and its founders Do Kwon and Daniel Shin) created the Terraform blockchain and its native token, LUNA. As is typical, prior to launch, Terraform entered into agreements to sell LUNA to various institutional investors. In the agreements, Terraform sold LUNA at a discount from expected market prices and stated that Terraform would undertake efforts to generate a secondary trading market, which Terraform did by working with exchanges and with market maker Jump Crypto.

Terraform also created UST, which was designed to be “algorithmically” pegged to the US dollar, as well as a UST borrowing and lending protocol called Anchor Protocol. Terraform announced that “Anchor will target 20% fixed APR.” By May 2022, 18.5 billion UST were in circulation, 14 billion of which had been deposited in Anchor.

Additionally, Terraform created a DeFi protocol called Mirror, which allowed users to create and trade tokens called mAssets,” designed to mirror the value of an associated non blockchain security, such as stock listed on a public stock exchange. Terraform issued a governance token for Mirror Protocol called MIR, which a Terraform subsidiary sold through SAFTs, without resale restrictions. As with LUNA, Terraform worked with Jump Crypto and exchanges to support secondary markets for MIR. Terraform also sold LUNA and MIR directly on secondary markets, such as Binance. According to the ruling, there was no evidence that Terraform took steps to determine whether those trading platforms were available to US investors.

Finally, Terraform founder Daniel Shin created Chai, a Korea-based mobile payment application. Terraform and Kwon allegedly made public representations that Chai would leverage Terraform (eg, that payments would be settled in KRT, another Terraform asset), but Chai never actually used Terraform to process transactions.

In May 2021, UST lost its peg to the US dollar, prompting Terraform to work with Jump Crypto to take various trading actions (including UST buys) to restore the peg in exchange for the release of Jump’s vesting conditions on receipt of additional LUNA. During these manual attempts to re-peg UST, Terraform tweeted positively about the reliability of UST’s “algorithmic” peg.

While UST regained its peg, roughly a year later the prices of LUNA and UST crashed. The SEC sued, alleging that the defendants engaged in the unregistered offer and sale of securities and security-based swaps and committed fraud by (1) misrepresenting the manual efforts to repeg UST and (2) misrepresenting the role of Terra in the Chair product.

The Court rules that LUNA, MIR, and UST constitute securities

After resolving cross-motions to exclude various experts, the court granted summary judgment for the SEC on its claims that defendants offered and sold unregistered securities, holding that each of LUNA and MIR are investment contracts under United States v. Howey.

Agreeing with the SEC, the court summarily found that MIR and LUNA constituted investment contracts because Terraform promised profits on purchases of those tokens from its continued efforts, including facilitating a secondary market and continuing to develop the underlying technology. The court also noted that while Mirror Protocol was advertised as decentralized, the Terraform team contributed core development and other work towards Mirror’s maintenance.

The court further held that UST constituted a security because a key purpose for holding UST, the court reasoned, was to deposit it in Anchor Protocol, where it would generate returns. The opinion acknowledged that not all UST holders used the Anchor Protocol but, quoting Howey, held that it was “of no legal consequence that “some holders chose not to accept the full offer of an investment contract.” The court’s holding with respect to UST is particularly troubling if it is read to suggest that any asset can constitute a security if used to generate profit, a material, unwarranted expansion of prior cases in the space, such as Kik or Telegram.

The defendants argued that the token sales were exempt from registration under Section 4(a)(2) or Rule 506(b) because they were either sold in private offerings only to sophisticated investors with resale restrictions or were sold overseas in compliance with the registration safe harbor provided under Regulation S. Though these are common strategies for token issuers, the court rejected these arguments. The court concluded that the defendants did not satisfy the requirements of the private offering exemption because they failed to show that they intended the tokens to “come to rest” with the private investors and as a result the sales were, in reality, part of a public distribution. The court reached this conclusion even though some private investors were subject to resale restrictions that would prevent their tokens from being immediately tradeable on secondary markets. These investors, in the court’s view, had no “intent to simply hold onto LUNA or MIR without further trades.”

The court similarly rejected Terraform’s arguments that certain sales of LUNA were exempt under Regulation S, reasoning that the defendants failed to show the absence of a substantial US market interest or steps taken to prevent resale to US persons.

Court holds mAssets did not constitute security-based swaps

In contrast, the court held that mAssets did not constitute security-based swaps. Under the Commodity Exchange Act, a swap requires parties to transfer financial risk associated with the underlying security. According to the court – though its analysis was brief – mAssets offered no way to profit when the price of the underlying security increased; thus, no financial risk was “swapped.”

Cross-motions for summary judgment on securities fraud denied

The court denied the parties’ cross-motions for summary judgment on securities fraud. After a more detailed analysis of the evidence, the court reasoned that despite some “compelling” facts presented by the SEC, a reasonable jury could find for the defendants on various elements of the two allegedly fraudulent schemes, particularly given the fact-specific nature of the charges.

Key takeaways

Even with this latest ruling, many crucial legal issues on the application of securities law to blockchain-based assets remain unresolved. This case offers the SEC additional ammunition in its ongoing efforts to reign in the activities of those involved in the offer and sale of digital assets in the US. Market participants should expect that:

• The SEC will use the Terraform decision expansively in support of its arguments that various cryptocurrencies constitute securities. The court’s holding with respect to UST is particularly troubling and may embolden the SEC to pursue other stablecoin issuers.
• The court’s cursory rejection of both the private sale exemption and the foreign sale safe harbor may also signal future regulatory challenges for issuers who have relied on the exemption or safe harbor in their compliance efforts
• Federal district courts, for the most part, continue to agree with the SEC’s view of the Howey test as applied to digital assets. The battle between industry and the regulator will move to the appellate courts which have yet to weigh in on many of these issues.

DLA Piper boasts award-winning and nationally recognized blockchain and cryptocurrency and white-collar defense and global investigations practices with former federal prosecutors and regulators. Please reach out to any of the authors or your DLA Piper contact with any questions.