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Crypto tokens considered “securities” by law, in a big win for the SEC | United States | Global law firm
On December 28, 2023, New York federal district judge Jed Rakoff found as a matter of law that various cryptographic tokens sold by Terraform were “securities” under U.S. securities laws. SEC v. Terraform Labs Pte. Ltd.2023 WL8944860 (SDNY, December 28, 2023). The court then granted the SEC’s summary judgment on its 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 UST, LUNA, wLUNA and MIR tokens sold by Terraform. The court’s decision was blunt: “There is no real dispute as to whether UST, LUNA, wLUNA, and MIR are securities because they are investment contracts.”
The court based its ruling squarely on the “Howey test” of the US Supreme Court SEC vs. WJ Howey Co.328 USA 293, 298-99 (1946), to identify the types of “investment contracts” that Section 2(a)(1) of the Securities Act, 15 USC § 77b(a)(1), defines as constituting “securities”. Under this criterion, the Court explained, “the Supreme Court held in no uncertain terms that “an investment contract for purposes of the Securities Act means a contract, transaction, or scheme under which a person invests his or her own money in a joint venture and is led to expect profits solely from the efforts of the promoter or third parties.’”
Judge Rakoff stated in his ruling that “[t]There is no real dispute that the elements of the Howey test – “(i) investment of money (ii) in a common enterprise (iii) with profits arising solely from the efforts of others” (id.) – have been satisfied for UST, LUNA, wLUNA and MIR.” He rejected the defendants’ various arguments as to why these tokens did not fit the Howey test.
UST is not exempt as it is a stablecoin
The defendants argued that the UST token, as a stablecoin whose value has not changed, could not meet the Howey test because there could be no expectation of profit from purchasing such a coin. But the court highlighted the fact that Terraform also developed and offered its so-called “Anchoring Protocol”, under which USTs deposited into the protocol would generate, according to Terraform’s marketing materials, a fixed and stable return of 20% . The court further noted that such payments were indeed made.
Therefore, the court said, “the UST in combination with the Anchor Protocol constitutes an investment contract.” While not all UST holders deposited tokens into the Anchor Protocol, the court cited Howey to conclude that there was “no legal consequence” that “some holders ‘ch[o]if we do not accept the full offer of an investment contract.’” The court’s ruling did not address what the UST’s status might be in the absence of the Anchoring Protocol or a similar program.
Token sales were 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 have ‘pooled’ together the proceeds of the LUNA purchases and have promised that further investments through these purchases would benefit all LUNA holders.” .” This charge, as the court had previously held, “adequately demonstrated that the defendants and investors were united in a joint venture for profit.”
Now, in summary judgment, the court cited evidence that the defendants themselves had characterized the purchase of LUNA as equivalent to purchasing “stake” in their company and that owning LUNA “essentially means owning a stake in the network” which would not other than increasing in value. as the Terraform ecosystem grows. “In other words,” the court said, Terraform was arguing that “a person could invest his or her own ‘money in a joint venture’ and be ‘led to expect profits solely from the efforts of the promoter or third parties,’ i.e. Terraform E [its president].” The court rejected the defendants’ attempts to rebut the force of this “evidence that LUNA and wLUNA were securities” as “misplaced.”
The claims of decentralization fail
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 transactions” on the “Mirror Protocol” launched by Terraform, claiming in a press release that “[b]By adding the Mirror governance token, MIR, to liquidity pools, MIR holders can earn 0.25% from trading fees.
Although Terraform had claimed that MIR was decentralized (i.e., so as not to depend solely on the efforts of the initiators as required by Howey), the court noted that Terraform had actually explained that “the team behind Terra contributed the majority of the work of main development behind the mirror [Protocol].” The court also pointed out 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 overall proceeds of MIR sales. The Court concluded as follows:
“In light of all this, Defendants cannot meaningfully dispute that they induced MIR owners 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 color flight.”
Unrecorded sales of LUNA and MIR
The court therefore found that there was “no real dispute as to whether the defendants offered and sold unregistered securities, in violation of Sections 5(a) and 5(c) of the Securities Act,” given clear evidence that “the 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 the development of a secondary market by Terraform,” including through agreements whose discounts “provided a built-in incentive for secondary resale.” The court also cited evidence that Terraform recognized that “token listing is a prerequisite for [the] The Earth/Luna Ecosystem Can Work” and discussed his plans to “enhance LUNA’s liquidity in secondary trading markets.”
Similarly, regarding MIR, the court cited evidence that MIR tokens were sold through agreements that “did not prevent purchasers from reselling their MIR tokens in secondary trading markets or to U.S. investors.” Terraform had agreements requiring others to “trade MIR tokens on cryptocurrency trading platforms” and “sold both LUNA and MIR tokens to secondary market buyers 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 were sold only directly to sophisticated investors,” the court found that “to avail of this exemption, the defendants would also have to demonstrate that they “intended” the tokens LUNA and MIR “rest with” those sophisticated investors.” However, it states, “the securities are not deposited with investors intending further distribution.”
Therefore, Terraform’s repeated statements about developing a liquid secondary market for LUNA, and its explicit requirements that others trade MIR on exchanges and provide reports to Terraform on such secondary trading, “make it clear that neither Terraform nor its institutional investors had any intention to simply hold LUNA or MIR without further trading.” This prevented the defendants from relying on any exemption under Section 5 for selling securities only to sophisticated investors.
The court also found that there was no evidence to support the defendants’ contention that such secondary market trading occurred exclusively outside the United States, so as to be exempt from Section 5 of Regulation S.
SEC Other Securities Claims Status
Although the court thus granted the SEC summary judgment on its Section 5 allegations for the offer and sale of unregistered securities, it found that “genuine disputes of material fact persist which preclude summary judgment for any party on the “fraud charges” that the SEC had also brought against the defendants in connection with these sales. The Court noted, for example, that “[m]much of the evidence the SEC provided to Scienter in its two fraud charges. . . comes from third-party informants whose credibility is paramount and whose testimony is subject to numerous challenges that are best resolved at trial.”
Trial on the case is now scheduled to begin on January 29, 2024.
Conclusion
A legal battle has raged for years over whether sales of cryptographic tokens can properly be considered, in appropriate circumstances, to be sales of securities subject to the requirements of U.S. federal securities laws, and indeed whether the tokens themselves can be considered securities. Judge Rakoff’s summary ruling in the Terraform case goes far beyond simply demonstrating that such outcomes are possible.
Rather, Judge Rakoff’s ruling shows that certain facts about how such tokens are sold and marketed — which are unlikely to be unique to Terraform and which may indeed be undeniable — may be sufficient to establish as a matter of law the applicability of securities laws to sales of such tokens. Furthermore, Judge Rakoff had no difficulty defining the tokens themselves as “investment contracts” and “securities,” even though their profit potential stemmed from a separate “protocol” by which perhaps not all token purchasers were involved.
Judge Rakoff’s decision in the Terraform case is of course only the decision of a single judge at the district court level, with which other district court judges may disagree and which may ultimately be challenged on appeal. There will likely be other litigants who will seek to challenge and test his broad and strong conclusions in other cases. However, Judge Rakoff’s Terraform ruling will likely strengthen the SEC’s role in numerous future cases where token sales occurred under similar circumstances.