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 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.
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.