Digital-asset investors have long faced uncertainty regarding the protections afforded to their investments by United States law. On August 18, 2023, citing an intra-district split in the Southern District of New York, the SEC filed a motion to certify an interlocutory appeal by the Second Circuit seeking clarity on whether sales by crypto issuers on trading platforms qualify as securities transactions.[1] The motion additionally also seeks appeal on the related issue of whether an exchange of services for crypto payments can constitute a securities transaction.[2]
In late July, Judge Jed S. Rakoff of the Southern District of New York issued an opinion in SEC v. Terraform Labs Pte. Ltd, et al., 23-cv-1346 (JSR), 2023 WL 4858299 (S.D.N.Y. July 31. 2023) (“Terraform”), providing a victory for regulators and U.S. investors and supporting that investors do have recourse for losses from investments in digital tokens or currencies that were fraudulently promoted or not properly registered with the SEC. In May of 2022, Terraform’s digital asset ecosystem collapsed, wiping out an estimated half a trillion dollars from crypto markets.[3] In Terraform, Judge Rakoff upheld claims against Terraform Labs and its cofounder Do Kwon under the Securities Act of 1933 and the Securities Exchange Act of 1934. Specifically, the opinion found that the SEC set forth plausible allegations that Defendants violated Section 5 of the Securities Act by distributing unregistered tokens to accredited, institutional investors, knowing that the tokens would be resold, and by selling other assets (mAssets) directly to the public, including to investors who were not “eligible contract participants,” as the law defines them.[4] The Court separately refused to dismiss fraud claims asserting violations of both Acts alleging that Terraform and Kwon: (a) falsely stated that certain transactions were processed on the Terraform blockchain when they were actually processed in Korean Won; and (b) misleadingly omitted that UST was repegged in May 2021 via third party intervention, not by “self-healing” as their prior statements suggested.[5]
The Terraform decision expressly declined to follow an opinion issued in the same District just weeks earlier, SEC v. Ripple Labs Inc., 2023 WL 4507900 (S.D.N.Y. July 13, 2023) (“Ripple”), which had excluded a narrow segment of crypto transactions from the definition of “security.” Because federal law typically only regulates “securities,” the Ripple decision, authored by Judge Analisa Torres, left certain investments unprotected. Like Terraform, Ripple recognized that sales of digital assets can constitute investment contracts and form the basis for securities fraud liability.[6] However, Ripple distinguished between direct sales by issuers to institutional buyers and public sales by issuers on digital exchanges, finding liability only for the former.[7] Applying the Supreme Court’s seminal Howey test,[8] Ripple reasoned that the “Programmatic Buyers” did not purchase Ripple’s digital assets (“XRP”) with the “expectation of profit” to be derived “from Ripple’s efforts,” because (a) the sales were not made pursuant to detailed contracts; (b) Ripple’s promotional materials and brochures may not have been as widely distributed to these buyers as to the institutional buyers; and (c) in the Court’s view, these buyers were “generally less sophisticated as [] investor[s]” and may not have been able to “parse through the multiple documents and statements…across multiple social media platforms and news sites.”[9] Ripple’s reasoning is limited to blind bid/ask transactions, and the opinion expressly declined to rule on secondary market sales.[10] The direct holding in Ripple, therefore, only expressly limited liability for sales by crypto issuers on digital asset exchanges via trading algorithms. Separately, Ripple held that distribution of XRP to employees or third parties as compensation did not involve an “investment of money” and therefore were also not securities transactions under Howey.[11]
In Terraform, Judge Rakoff roundly rejected Ripple’s institutional/retail investor split and its reasoning, observing that the Supreme Court’s seminal Howey opinion “made no such distinction” and “it makes good sense that it did not.”[12] Further, Judge Rakoff found that the SEC had sufficiently alleged that the defendants “embarked on a public campaign to encourage both retail and institutional investors to buy their crypto-assets” and that the misleading “representations would presumably have reached individuals who purchased their crypto-assets on secondary markets –- and, indeed, motivated those purchases -- as much as it did institutional investors.”[13]
By rejecting the Ripple precedent, Terraform created a split within the Southern District of New York on the issue of whether “programmatic” offers and sales by issuers on digital asset trading platforms can be actionable as offers and sales of securities. Generally, appeals courts only hear appeals of “final decisions.” Interlocutory review, however, is warranted where (1) “[an] order involves a controlling question of law,” (2) “as to which there is substantial ground for difference of opinion,” and (3) “an immediate appeal from the order may materially advance the ultimate termination of the litigation.” SEC v. Rio Tinto PLC, 2021 WL 1893165, at *1 (S.D.N.Y. May 11, 2021). Citing the contrary opinion Terraform, the SEC now seeks review in the Second Circuit Court of Appeals of the Ripple decision.
In addition to prompting likely review of the Ripple decision by the Second Circuit, the Terraform decision is separately noteworthy because it identifies several classes of digital assets that can give rise to securities fraud liability, including certain stablecoins and derivative assets. Applying the longstanding Howey test, Terraform found that the SEC had sufficiently alleged fraud liability for assets in the below categories:[14]
Moreover, Terraform confirms that federal courts can have personal jurisdiction over foreign cryptocurrency issuers and related parties.[20] This holding is significant because cryptocurrency companies are often incorporated in foreign jurisdictions and may not have physical headquarters, which complicates personal jurisdiction analysis. To establish personal jurisdiction over a defendant, a plaintiff must show that the defendant “purposefully directed” activities within the forum state and that the allegations “arise out of” that directed activity. Burger King Corp. v. Rudzewicz, 471 U.S. 462, 472-73 (1985). In Terraform, these factors are held to be sufficiently established because of (1) direct sales of the relevant coins or products to United States companies carried out through the United States banking system and (2) that Defendants marketed their products in meetings in the United States.[21] This decision builds on a similar holding by the United States Court of Appeals for the Second Circuit and aligns with notable cases in the Southern District of New York. See U.S. Sec. & Exchange Comm. v. Terraform Labs Pte Ltd., 2022 WL 2066414, at *4 (2d Cir. June 8, 2022); Owens v. Elastos Found., 2021 WL 5868171, at *8 (S.D.N.Y. Dec. 9, 2021).
Accordingly, irrespective of the ultimate resolution of the Terraform-Ripple conflict, Terraform is a positive result for digital-asset investors.
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