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Crypto Tokens Considered ‘Securities’ by Law, a Big Win for SEC | Germany | Global Law Firm
On December 28, 2023, New York Federal District Judge Jed Rakoff ruled as a matter of law that various cryptocurrency tokens sold by Terraform were “securities” under U.S. securities laws. SEC v. Terraform Labs Pte. Ltd.2023 WL 8944860 (SDNY December 28, 2023). The court then granted summary judgment on the SEC’s claim that Terraform offered and sold unregistered securities in violation of Sections 5(a) and 5(c) of the Securities Act of 1933, 15 USC §§ 77e(a), 77e(c).
A basic application of the “Howey test”
The case involved the UST, LUNA, wLUNA, and MIR tokens sold by Terraform. The court’s ruling was clear: “There is no real dispute that UST, LUNA, wLUNA, and MIR are securities because they are investment contracts.”
The court based its ruling directly on the U.S. Supreme Court’s “Howey test,” from SEC v. W.J. Howey Co.328 United States 293, 298-99 (1946)to identify the types of “investment contracts” that Section 2(a)(1) of the Securities Act, 15 U.S.C. § 77b(a)(1), defines as constituting “securities.” Under that test, the court explained, “the Supreme Court has established in unequivocal terms that ‘an investment contract for purposes of the Securities Act means a contract, transaction, or scheme by which a person invests his own money in a joint venture and is led to expect profits solely from the efforts of the promoter or a third party.’”
Judge Rakoff argued in his ruling that “[t]There is no real dispute that the elements of the Howey test — “(i) investment of money (ii) in a joint venture (iii) with profits derived solely from the efforts of others” (id.) — were satisfied for UST, LUNA, wLUNA, and MIR.” He rejected defendants’ various arguments as to why these tokens did not fall under the Howey test.
UST is not exempt as it is a stablecoin
The defendants argued that the UST token, as a stablecoin whose value did not change, could not satisfy the Howey test because there could be no expectation of profit in purchasing such a coin. But the court pointed to the fact that Terraform had also developed and offered its so-called “Anchor Protocol,” under which UST deposited into the protocol would, according to Terraform’s marketing materials, generate a fixed and stable return of 20 percent. The court also noted that such payments had actually been made.
Therefore, the court said, “UST in combination with the Anchor Protocol constituted an investment contract.” While not all UST holders deposited tokens into the Anchor Protocol, the court cited Howey in concluding that it was “of no legal consequence” that “certain holders ‘ch[o]not to accept the full offer of an investment contract.” The court’s ruling did not address what the status of the UST might be in the absence of the Anchor Protocol or a similar program.
Token sales were hedged when tokens were marketed as buying a stake in the growth of the network
The SEC’s claim regarding the LUNA token (and by extension the wLUNA token) was that “Defendants ‘pooled’ the proceeds of LUNA purchases and promised that further investments through these purchases would benefit all LUNA holders.” This claim, the court previously held, “adequately demonstrated that Defendants and Investors were in a joint venture for profit.”
Now, in the summary judgment, the court cited evidence that the defendants themselves characterized their purchases of LUNA as equivalent to purchasing “the stock” of their company and that owning LUNA “is essentially owning a stake in the network” that would only grow in value as the Terraform “ecosystem” grew. “In other words,” the court said, Terraform was arguing that “a person could invest his or her ‘money in a joint venture’ and be ‘led to expect profits solely from the efforts of the promoter or a third party,’ namely, Terraform and [its president].” The court rejected defendants’ attempts to rebut the strength of this “evidence that LUNA and wLUNA were securities” as “misplaced.”
Claims about decentralization are weakened
A similar analysis showed that Terraform’s MIR token is also a “security,” the court said. The defendants had described MIR as a “governance token that earns fees from asset trades” on the “Mirror Protocol” that Terraform had launched, arguing in a press release that “[b]By adding the Mirror governance token (MIR) to liquidity pools, MIR holders can earn 0.25 percent in trading fees.”
Although Terraform had claimed that MIR was decentralized (i.e., not solely dependent on the efforts of promoters as Howey claimed), the court noted that Terraform had in fact explained that “the team behind Terra contributed the majority of the core development work behind Mirror.” [Protocol].” The court also pointed to evidence that Terraform advertised to buyers its efforts to strengthen and increase the visibility of the Mirror Protocol, expand its markets, and provide it with a product manager and software updates that were paid for with the joint proceeds of MIR sales. The court then concluded:
“In light of all of the foregoing, Defendants cannot meaningfully dispute that they induced MIR holders to expect profits from a joint venture based on Terraform’s efforts to develop, maintain, and grow the Mirror Protocol—in other words, that MIR passes the Howey test with flying colors.”
Unregistered sales of LUNA and MIR
The court therefore found that there was “no genuine dispute that defendants offered and sold unregistered securities in violation of Sections 5(a) and 5(c) of the Securities Act,” given the clear evidence that “defendants offered and sold LUNA and MIR in unregistered transactions.”
Specifically, “Terraform sold LUNA tokens directly to institutional investors through sales agreements that expressly contemplated Terraform’s development of a secondary market,” including through agreements whose discounts “provided a built-in incentive for secondary resale.” The court also cited evidence that Terraform recognized that “the token listing is a precondition for [the] The Terra/Luna ecosystem will operate” and discussed its plans to “improve LUNA’s liquidity in secondary trading markets.”
Similarly, with respect to MIR, the court cited evidence that MIR tokens were sold under agreements that “did not restrict purchasers from reselling their MIR tokens on secondary trading markets or to U.S. investors.” Terraform had agreements that required others “to trade MIR tokens on cryptocurrency trading platforms” and “sold both LUNA and MIR tokens to secondary market purchasers on Binance and other cryptocurrency exchanges.”
No exemptions available
While the defendants argued “that their distributions of LUNA and MIR were not public offerings because they sold directly only to sophisticated investors,” the court held that “to avail themselves of this exemption, the defendants would also have to demonstrate that they ‘intended’ that the LUNA and MIR tokens ‘go into the hands’ of those sophisticated investors.” However, it said, “the securities do not go into the hands of investors intending further distribution.”
Thus, Terraform’s repeated statements about the development of a liquid secondary market for LUNA, and its explicit requirements that others trade MIR on exchanges and report to Terraform on such secondary trading, “make it clear that neither Terraform nor its institutional investors had any intention of simply holding LUNA or MIR without further trading.” This precluded defendants from relying on any exemption under Section 5 for sales of securities only to sophisticated investors.
The court further found that there was no evidence to support the defendants’ contention that such secondary market trading took place exclusively outside the United States and was therefore exempt from Section 5 under Regulation S.
Status of Other SEC Securities Applications
While the court thus granted summary judgment on the SEC’s Section 5 claims for the offering and sale of unregistered securities, it held that “genuine disputes of material fact remain that preclude summary judgment for any party on the fraud claims” that the SEC had also asserted against the defendants in connection with those sales. The court noted, for example, that “[m]Much of the SEC’s scientific evidence for its two fraud charges… comes from third-party whistleblowers whose credibility is paramount and whose testimony is subject to numerous challenges that are best resolved in court.”
The trial is now scheduled to begin on January 29, 2024.
Conclusion
A legal battle has raged for years over whether crypto token sales can properly be considered, under appropriate circumstances, as sales of securities subject to the requirements of the U.S. federal securities laws, and whether the tokens themselves can be considered securities. Judge Rakoff’s summary judgment in Terraform goes far beyond simply showing that such outcomes are possible.
Rather, Judge Rakoff’s ruling demonstrates that certain facts about how such tokens are sold and marketed, which may hardly be unique to Terraform and may indeed be undeniable, may be sufficient to establish as a matter of law the applicability of securities laws to the sales of such tokens. Moreover, Judge Rakoff had little difficulty defining the tokens themselves as “investment contracts” and “securities,” even though their profit potential arose under a separate “protocol” with which perhaps not all token purchasers were involved.
Judge Rakoff’s decision in Terraform is of course only a single judge’s ruling at the district court level, which other district court judges may disagree with and which may ultimately be challenged on appeal. There will likely be other litigants seeking to challenge and test his broad and strong findings in other cases. However, Judge Rakoff’s Terraform ruling will likely strengthen the SEC’s position in numerous future cases where token sales have occurred under similar circumstances.