SEC Secures Victory as US Judge Rules Terra ‘Stablecoin,’ Other Tokens are Securities

Jimmy Aki
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A United States federal judge has ruled that Terraform Labs and its former CEO, Do Kwon, violated the law by not registering two digital currencies that collapsed in 2022.

Howey Test Remains Relevant in Investment Contract Ruling

U.S. Federal Judge Jed Rakoff issued a significant ruling in the closely-watched SEC v. Terraform crypto case. The judgment declared that four crypto tokens, including UST and LUNA, offered by the now-defunct Terraform Labs, were considered unregistered securities.

In a 71-page filing on December 28, Judge Rakoff stated that there was “no genuine dispute” over the securities status of the four crypto tokens from Terraform Labs, classifying them as “investment contracts.”

The court argued that the defendants aimed to dismiss established legal precedents, citing the pivotal 1946 U.S. Supreme Court case, SEC v. WJ Howey Co, which introduced the Howey test for defining investment contracts.

According to the ruling, an investment of money in a common enterprise, with profits derived solely from others’ efforts, is an investment contract.

Judge Rakoff’s ruling also supported the argument that the sale of Terraform’s crypto assets constituted an unregistered security. Notably, even UST, designed to be pegged to $1, faced scrutiny as the judge argued that token holders could deposit tokens in Terraform’s proprietary protocol to earn a yield.

This distinction suggested that stablecoins lacking a yield component might not be classified as securities.

Despite this stance, the judge acknowledged potential differences of opinion among reasonable jurors regarding whether the defendants intended to defraud investors.

This uncertainty extended to various aspects of Terraform’s business, including the temporary failure of TerraUSD to maintain its $1 peg in May 2021. Additionally, it extends to the utilization of the Terraform blockchain by a popular Korean mobile payment app, which played a role in supporting the value of Luna.

Furthermore, the judge noted that the SEC’s remedies for selling unregistered securities would be determined after resolving the defendants’ liability on the fraud claims.

Judge Leaves SEC’s Claim Allegations Unsettled

Judge Rakoff left a crucial aspect of the case unresolved, specifically the fraud allegations tied to the depegging of UST as asserted by the SEC.

According to the SEC, Kwon and Terraform Labs engaged in transactions characterized as security-based swaps by creating and maintaining the Mirror Protocol, which facilitated the minting of “mAssets.”

These M-Assets function as blockchain assets, replicating real-world assets by reflecting on-chain exchange prices.

In his ruling, Rakoff emphasized that the SEC’s evidence relies on information from external whistleblowers, and their testimony should be presented before a jury.

Furthermore, he argued that the defendants had raised a dispute over whether prudent investors would interpret statements about UST’s depeg as potentially misleading.

However, the resolution of fraud claims is slated for a jury trial commencing soon, with the jury selection scheduled for January 24, 2024.

Brief Overview of Terraform Labs and Do Kwon’s Setbacks and Trials

During the crypto surge of 2021, Terraform Labs stood out as a notable project, attracting substantial investments from industry luminaries.

As the UST algorithmic stablecoin scaled, Kwon promised a crypto token that could sustain a $1 peg through a complex system involving the distribution of a secondary cryptocurrency named LUNA.

However, UST faced a controversial collapse in May 2022, losing its $1 peg and causing significant financial setbacks for global investors, including retail traders. Both UST and LUNA prices plummeted, triggering a crisis.

Subsequently, Kwon’s arrest in Montenegro triggered an extradition battle between the U.S. and South Korea, with the U.S. Department of Justice filing fraud charges.

On February 16, 2023, the SEC filed a lawsuit against Terraform Labs and Kwon, alleging a multibillion-dollar securities fraud involving unregistered securities, including UST and LUNA, along with two other crypto tokens, MIR and wLUNA, linked to the ecosystem.

In response, the defendants’ lawyers, echoing sentiments from other crypto firms under SEC scrutiny, argued that U.S. securities laws are outdated and crypto tokens don’t fit the traditional Howey test definition. They asserted that UST, designed for a $1 peg, didn’t represent an investment with an expectation of profit from others’ efforts.

After a separate case where U.S. District Judge Analisa Torres ruled that Ripple’s XRP was not a security, Terra’s lawyers sought dismissal. However, Judge Rakoff, overseeing the Terra case, deviated from Torres’s decision, rejecting the motion and the approach used to differentiate how various digital assets are sold.

About Jimmy Aki PRO INVESTOR

Based in the UK, Jimmy is an economic researcher with outstanding hands-on and heads-on experience in Macroeconomic finance analysis, forecasting and planning. He has honed his skills having worked cross-continental as a finance analyst, which gives him inter-cultural experience. He currently has a strong passion for regulation and macroeconomic trends as it allows him peek under the global bonnet to see how the world works.