On April 5, 2024, a jury in the Southern District of New York found cryptocurrency startup Terraform Labs PTE Ltd. (the “Company”) and its co-founder, Do Kwon, liable for securities fraud. The jury sided with the SEC in determining that the Company lied to investors about the stability of their digital assets to raise billions of dollars by selling digital securities, many of which were unregistered. The verdict was delivered following a two-week long trial, providing a significant win to the SEC in its campaign to regulate the cryptocurrency sector and continuing a split among judges related to how to evaluate whether a cryptocurrency is a security.
In a complaint filed in February 2023, the SEC alleged that the Company and its co-founder sold crypto asset securities in unregistered transactions and perpetuated a fraud, from April 2018 through May 2022, that led to at least $40 billion in lost market value, including losses for U.S. retail and institutional investors. Specifically, the SEC alleged that defendants led two schemes of deception. The first scheme involved falsely conveying to investors that the Company’s cryptocurrency, UST, was stable and carefully programmed to maintain its value in relation to the U.S. dollar. In May 2021, when the value of UST became “unpegged” from the U.S. dollar, the SEC alleged that the Company discussed secret plans with Jump Trading, a Chicago‑headquartered trading firm and major stakeholder of the Company at the time, to buy large amounts of UST to restore its value. When UST’s price was restored, the SEC claims the Company lied to the public and misled investors by stating that the cryptocurrency algorithm successfully re-pegged UST to the dollar while failing to disclose the trading firm’s intervention. The second scheme alleged involved defendants falsely claiming that Korean e-commerce application, Chai, used the Company’s blockchain to process millions of transactions for Korean consumers at retail establishments. The Company and its co-founder fabricated completed Chai transactions on the Company’s blockchain to create an appearance of the “real-world use” of the blockchain and further deceive investors.
Ultimately, as alleged by the SEC, the Company made billions of dollars in profit from investors and defrauded crypto investors out of $40 billion, while the co-founder deceived and misled investors on the Company’s stability and business prospects. The schemes took place amidst a crash in cryptocurrency exchange and came before the Company declared bankruptcy. In May 2022, UST was de-pegged from the U.S. dollar again, but UST’s price never recovered. This led to large sales of UST, which fell in price to “near zero,” along with the prices of the Company’s other crypto assets. The SEC alleged this collapse led to domestic international investors suffering billions of dollars in losses in market valuations and numerous retail investors falling into debt and losing their life savings.
The SEC brought fraud claims against the co-founder and the Company for their conduct. Specifically, the SEC charged the Company and its co-founder with violating the registration and anti-fraud provisions of the Securities Act of 1933 (the “Securities Act”) and the Exchange Act of 1934 (the “Exchange Act”). The SEC also brought an additional claim of control person liability under the Exchange Act related to the 10b-5 claim against the Company. In their motion to dismiss filing, defendants argued that their stablecoins were investment contracts instead of securities, relying on the decision in SEC v. Ripple Labs, Inc. See “In Denying Motion To Dismiss In Terraform Cryptocurrency Case, New York Federal Judge Rejects Key Aspects Of Ripple Ruling, Continuing Uncertainty On How Securities Law Applies To Cryptocurrencies”. In Ripple, Judge Analisa Torres of the Southern District of New York held that Ripple Labs, Inc.’s (“Ripple”) cryptocurrency token, XRP, was not a security under the Securities Act when Ripple sold it on digital asset exchanges. Judge Torres utilized a transaction-focused framework, which factored in the different circumstances and expectations of buyers in the relevant transactions, to determine that XRP was not a security. The Company and its co-founder relied on the Ripple decision in an attempt to argue that UST and its other tokens were sold as investment contracts and were likewise not securities.
Judge Jed Rakoff rejected Ripple’s transaction-based approach and “declined[ed] to draw a distinction between these coins based on their manner of sale, such that coins sold directly to institutional investors are considered securities and those sold through secondary market transactions to retail investors are not.” Terraform Labs, 2023 WL 4858299, at *15. Judge Rakoff instead adopted an asset approach in assessing the Company’s stablecoin and considered the nature of the token and its use in deciding whether it was a security. Judge Rakoff noted that the co-founder’s representations about the Company’s cryptocurrencies and expected profits, ultimately found to be deceptive, would “presumably have reached individuals who purchased their crypto-assets on secondary markets – and indeed motivated those purchasers – as much as it did institutional investors.” Id.
The seven-person jury found defendants liable for all three claims. Judge Rakoff has yet to decide the civil penalties that defendants must face, as well as the disgorgement of illicit gains and prejudgment interest. The co-founder is facing a parallel criminal case and is currently being held in Montenegro, where he was arrested last year, while the U.S. and South Korea both seek his extradition.
Following the verdict, SEC Division of Enforcement Director Gurbir S. Grewal spoke to the “devastating losses for investors” caused by the co-founder’s fraudulent schemes and shared that the SEC intends to “continue to use the tools at our disposal to protect the investing public, but it is high time for the crypto markets to come into compliance.” The SEC’s win in this high-profile trial signifies an important counterpoint to its loss in Ripple and suggests, at least until the Second Circuit weighs in, that the agency will continue its crypto enforcement efforts.
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SEC v. Terraform Labs Pte Ltd. et al
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