Divide In The Southern District Over When Cryptocurrency Is A … – Mondaq News Alerts

On July 31, 2023, and only a few weeks after the Ripple
decision, another judge in the U.S. District Court for the Southern
District of New York held that the case against Terraform Labs
(Terraform) and its CEO may proceed because the Security and
Exchange Commission (SEC) adequately pled that Terraform’s
crypto assets (a stablecoin and the Luna reserve asset
cryptocurrency) may qualify as securities.

Howey Test and Ripple

The Securities Act regulates the offer and sale of securities
and grants broad enforcement authority to the SEC. Under Section 5
of the Securities Act, it is unlawful to sell, offer to buy or
purchase a security, including investment contracts, without a
registration statement.

In 1947, the U.S. Supreme Court articulated a three part test
for determining whether or not a transaction constitutes an
investment contract. In SEC v. W.J. Howey Co., the Supreme
Court held that an investment contract is “a contract,
transaction, or scheme whereby a person (1) invests his money (2)
in a common enterprise and (3) is led to expect profits solely from
the efforts of the promoter or a third party.”

In recent years, judges have used the Howey Test to
find that specific crypto assets are securities or investment
contracts. In these rulings, developer statements tying the value
of digital assets or profits depending on the “efforts of
others” or pooling funds was sufficient to find participation
in a “common enterprise” satisfying the Howey Test.

The SEC has brought more than 100 enforcement actions involving
crypto assets by asserting that tokens constitute securities.

In the Ripple decision published earlier in July, Judge Torres
walked through the Howey Test and ultimately determined that the
decision depended on the third prong of the Howey Test, investor
knowledge and expectation. In holding the crypto tokens may
constitute a security in the context of sales to institutional
buyers but not in programmatic sales, Judge Torres found that the
sophisticated institutional buyers have experience, expertise, and
understand the speculative nature of their investments and had an
expectation of profits from their investments where the
programmatic sales to retail investors did not involve such
considerations.

Terraform

Terraform is a Singapore-based company that develops, markets,
and sells crypto assets including the Terra/UST and LUNA tokens and
is known for developing the Terraform blockchain. In 2021, the
value of the UST became unstable and ultimately crashed resulting
in the loss of over $40 billion to investors leading the SEC to
bring an enforcement action.

In denying Terraform’s motion to dismiss, the court held
that some of Terraform’s crypto assets, such as stablecoins,
may not qualify as securities but the promotion of its digital
assets did constitute securities. In the ruling, the court
expressly and directly rejected the application of the Howey
Test analysis in Ripple, particularly the differentiation of
purchasers. Accordingly the court stated that “Howey makes no
such distinction between purchasers” and if the SEC’s
allegations are true, “the defendants’ embarked on a
public campaign to encourage both retail and institutional
investors to buy their crypto-assets by touting the profitability
of the crypto-assets and the managerial and technical skills that
would allow the defendants to maximize returns on the
investors’ coins.”

Terraform advertised and stated that purchases of all its crypto
assets would directly feed into the Terraform blockchain and
generate profits for all asset holders. These statements presumably
reached purchasers of all kinds and made investors belief that
their contributions would be used to generate profits.

Takeaways

The SEC will almost certainly appeal the Ripple decision to
solidify its position on crypto assets. The SEC will likely
leverage the Terraform opinion to assert in other enforcement
actions, that crypto assets are securities.

It is important to note that the Ripple and Terraform decisions
were at different procedural stages in litigation. The Ripple
decision was at summary judgment where a well-developed factual
record was available while Terraform was on a motion to dismiss. It
still remains to be seen if the SEC can prove its allegations and
survive summary judgment.

Disclaimer: This Alert has been
prepared and published for informational purposes only and is not
offered, nor should be construed, as legal advice. For more
information, please see the firm’s
full disclaimer.