Are Crypto Tokens Securities? Terraform Court Says ‘Yes’ in Extensive Decision

Key Points

• In SEC v. Terraform, the court has granted summary judgment for the SEC on its claim that the defendants offered and sold unregistered securities in the form of “crypto assets.” This comes amidst the SEC authorizing 11 ETFs in spot Bitcoin to begin trading this week.
• The court held that certain of Terraform’s crypto tokens were “investment contracts” under the Supreme Court’s Howey test, and that other tokens, while not themselves securities, rose to the level of investment contracts under Howey because they were bundled with Terraform’s efforts to lend the tokens to borrowers.
• In doing so, the court offered a different approach from a prior opinion from the same judicial district—SEC v. Ripple—which determined if digital assets were securities based on whether they were sold in offerings to institutional investors or in secondary market transactions.

The Litigation

On December 28, 2023, less than a year after the commencement of a lawsuit by the U.S. Securities and Exchange Commission (SEC), Judge Jed S. Rakoff of the Southern District of New York granted summary judgment for the SEC in its case against Terraform Labs and one of its co-founders, Do Hyeong Kwon, on its claim that defendants offered and sold securities in unregistered offerings involving Terraform’s crypto tokens.

In its decision, the court ruled that the transactions in question, which concerned crypto tokens created by Terraform, were investment contracts under SEC v. Howey, and therefore securities under the Securities Act of 1933. The court’s decision comes amidst the SEC’s continued push to bring more crypto-based transactions under its purview. The decision is consistent with the SEC’s stated view that pooling crypto assets in transactions designed to generate returns based on the crypto issuer’s efforts brings those assets within the SEC’s jurisdiction. The SEC has already referenced Judge Rakoff’s decision in ongoing litigation against crypto exchanges Binance and Coinbase.¹

Judge Rakoff reached his decision even though the SEC did not contest that certain of the tokens, standing on their own, were not securities under U.S. law. The court further held that defendants were entitled to summary judgment on the SEC’s swap-based claims because sellers of the swaps did not transfer risk to their counterparties, and denied cross-motions for summary judgment on the SEC’s fraud claims, finding unresolved issues of material fact to preclude judgment for either side. In doing so, the court emphasized certain strengths of the SEC’s case, comments which could affect the parties’ positioning ahead of trial, which is currently scheduled for later this month.

Factual Background

Terraform involves several digital assets, issued over a multiyear period, and a complex series of facts. The SEC’s litigation also runs parallel to the U.S. Department of Justice’s and Korean criminal authority’s prosecution of Kwon. It is perhaps no surprise that the court’s summary judgment opinion spanned 71 pages.

Kwon co-founded Terraform in April 2018. In 2019, the Terraform blockchain launched, and Terraform minted one billion tokens of a crypto asset called LUNA, which it sold to buyers in exchange for fiat currency and other crypto assets. In December 2020, Terraform issued a substantially identical token called wLUNA for trading on non-Terraform blockchain platforms. In public marketing and purchase agreements for LUNA tokens, Terraform described LUNA as a means of investing in the success of Terraform’s blockchain business, proposed to offer LUNA to the general public in the future and promised to take steps to create a secondary market for trading the tokens. Terraform later signed agreements concerning LUNA with a global high-frequency trading firm.

In parallel to its development and sales of LUNA, in December 2019, Terraform created another crypto token, UST, which it marketed as a “stablecoin” permanently and algorithmically pegged to the value of one U.S. dollar. Starting in March 2021 with the “Anchor Protocol,” Terraform allowed UST holders to deposit the tokens into a shared pool from which others could borrow UST in return for interest payments. Terraform offered UST depositors a share of the interest payments in proportion to the amount they deposited into the pool, with a target yield of 20% APR. By May 2022, approximately 14 billion UST tokens were deposited with the Anchor Protocol, of approximately 18.5 billion outstanding. For at least a time, Terraform paid returns from the Anchor Protocol to depositors in proportion to the amounts deposited.

In December of 2020, Terraform launched the “Mirror Protocol,” which allowed users to obtain tokens called “mAssets” whose value was designed to “mirror” the price of a preexisting non-crypto asset, such as a publicly traded security. A Mirror Protocol user could mint an mAsset by depositing collateral worth 150% or more of the underlying security’s value, and the buyer of an mAsset could obtain exposure to the underlying security without holding it directly. Whenever the price of the underlying security rose above the minter’s initial buy-in, Terraform required the minter to deposit additional collateral to maintain the mAsset. A Terraform subsidiary sold a governance token for the Mirror Protocol called MIR, which derived its value from the Mirror Protocol’s usage, with greater usage creating greater value for MIR’s purchasers. There were no restrictions on reselling MIR tokens in secondary markets.

Terraform’s crypto assets had value for some time—indeed, LUNA’s value ballooned to over $40 billion before its May 2022 collapse.² When the SEC sued, it alleged multiple violations of the federal securities laws associated with the offer and sale of unregistered securities and security-based swaps, including strict liability and fraud-based offenses.

The Court’s Ruling that Certain of Terraform’s Crypto Transactions Involved Securities

Applying Howey, the court ruled that transactions involving UST, LUNA, wLUNA and MIR constituted investments of money in a common enterprise with profits to be derived solely from the efforts of others. The court reached this conclusion with respect to UST even though the SEC did not dispute that UST, on its own, is not a security because buyers understood it to have a stable value rather than generating a profit. The court agreed with the SEC that because the Anchor Protocol permitted UST holders to pool their tokens with other depositors with the goal of generating returns based on interest charged by Terraform to the Anchor Protocol’s borrowers, transactions involving UST in combination with the Anchor Protocol constituted investment contracts.

The court held that the transactions involving LUNA, wLUNA and MIR were investment contracts under Howey for similar reasons. Based on defendants’ public statements and agreements to increase LUNA’s market liquidity, purchasers of LUNA and wLUNA expected to profit from defendants’ efforts to build Terraform into a successful blockchain and to create trading opportunities in its tokens. Purchasers of MIR tokens similarly expected to profit from Terraform’s efforts to develop, maintain and grow the Mirror Protocol, with the tokens increasing in value based on the protocol’s success, including through the generation of trading fees.

Notably, in granting summary judgment for the SEC, the court also rejected defendants’ argument that their distributions of LUNA and MIR were not public offerings because they sold the tokens only to sophisticated investors.

The Court’s Ruling that Terraform’s Security-Based Swaps Are Not Securities

The court granted summary judgment to defendants on counts alleging that they offered unregistered security-based swaps to non-eligible contract participants in violation of the Securities Act. The SEC asserted that by creating and maintaining the Mirror Protocol through which others could mint mAssets, defendants offered and effected transactions in security-based swaps. The court disagreed, finding that “an mAsset does not meet the statutory definition of a security-based swap” because “there is no transfer of financial risk.”³ The court concluded there was no transfer of risk from the purchaser of an mAsset to the minter of the asset because the requirement that a minter deposit additional collateral in the event the price of the underlying security increased prevented the minter from making a profit on the change in value.

The Court’s Denial of Both Parties’ Cross-Motions for Summary Judgment on Fraud Claims

Finally, the court found that genuine disputes of material fact “linger” that preclude summary judgment for any party on the fraud claims. A jury trial on the fraud claims is set to begin on January 29, 2024. Assuming that date sticks, this case will have moved from complaint to opening statements in less than one year’s time.

Takeaways

• Despite granting summary judgment to both sides in part, Judge Rakoff’s ruling that certain of Terraform’s digital assets are securities can be viewed as a significant victory for the SEC, and will likely prove pivotal to future litigation.
• This opinion stands in contrast to a recent opinion in SEC v. Ripple.⁴ Applying the Howey test, the Ripple court held that “XRP, as a digital token, is not in and of itself a ‘contract, transaction, or scheme’ that embodies the Howey requirements of an investment contract. Rather, the court examines the totality of circumstances surrounding [d]efendants’ different transactions and schemes involving the sale and distribution of XRP.” Judge Rakoff did not apply a “totality of the circumstances” test here, nor did he cite Ripple, despite the overlapping issues.
• We expect the SEC will seize upon this outcome in Terraform in arguing that more digital assets are securities. The SEC has already referenced Judge Rakoff’s decision in ongoing litigation against crypto exchanges Binance and Coinbase. In each of these cases, the SEC alleged not only that the platforms offered unregistered crypto asset securities on their platforms, but also that the platforms operated as unregistered exchanges, broker-dealers and clearing agencies. 

^{1 The SEC’s letter to the Coinbase court invoking the Terraform decision is available here, and a Notice of Supplemental Authority in the Binance litigation alerting the court of Terraform is available here.}

^{2 David Yaffe-Ballany & Erin Griffith, How a Trash-Talking Crypto Founder Caused a $40 Billion Crash, N.Y. Times, May 18, 2022, https://www.nytimes.com/2022/05/18/technology/terra-luna-cryptocurrency-do-kwon.html}

^{3 Order at 48-49.}

^{4 Akin’s alert contrasting the ruling on the motion to dismiss in Terraform with the outcome in Ripple on summary judgment is available here.}