Securities and Exchange Commission v. Terraform Labs Pte Ltd.

Background

The Securities and Exchange Commission (SEC) alleged that Terraform Labs Pte. Ltd. and Do Hyeong Kwon orchestrated a multibillion-dollar fraud involving the development, marketing, and sale of several crypto-assets. The products included the UST stablecoin, LUNA, wLUNA, MIR tokens, and mAssets. The SEC alleged that the defendants promoted these products as profitable investments, sold them in unregistered transactions, and made misleading statements about their stability and their supposed use in transactions through the Chai payment application.

The SEC alleged that the defendants promoted the Anchor Protocol as offering returns of about 19% to 20% on UST deposits. It also alleged that the defendants represented that the Terraform ecosystem would expand through their efforts and increase the value of the crypto-assets. According to the SEC, when UST lost its dollar peg in May 2021, the defendants arranged for a U.S. trading firm to buy UST and then described the restoration of the peg as the result of the UST/LUNA algorithm rather than disclosing the third-party intervention. The SEC also alleged that the defendants falsely represented that Chai transactions used Terraform’s blockchain and stablecoins, when the transactions actually took place on Chai’s platform using Korean currency.

The SEC asserted five claims for relief as described in the opinion: fraud under Section 17(a) of the Securities Act; fraud under Section 10(b) of the Exchange Act and Rule 10b-5; control-person liability for Kwon; failure to register offers and sales of the crypto-assets; and unlawful offers, sales, or transactions involving mAssets to people who were not eligible contract participants.

Arguments and legal standards

The defendants moved to dismiss under Federal Rule of Civil Procedure 12(b)(2), arguing that the court lacked personal jurisdiction, and Rule 12(b)(6), arguing that the SEC had failed to state legally sufficient claims. At this stage, the court treated well-pleaded allegations as true, drew reasonable inferences for the SEC, and asked whether the allegations plausibly supported relief.

Personal jurisdiction

The court denied the personal-jurisdiction portion of the motion. It held that the SEC adequately alleged that the defendants purposefully directed activities toward the United States and that the alleged injuries related to those activities. The allegations included marketing to U.S. investors, meetings and conferences in the United States, U.S.-based employees, contracts with U.S. entities, and sales or loans of LUNA and UST to U.S. firms.

The court also concluded that the SEC adequately alleged a basis for treating a British Virgin Islands subsidiary’s contacts as contacts of Terraform. The opinion described allegations that the subsidiary shared Terraform’s name, was connected to Terraform’s founders, and was controlled by Terraform. The court emphasized that discovery could later show that the companies had separate ownership or operated independently, but the allegations were sufficient at the motion-to-dismiss stage.

Whether the crypto-assets could be treated as securities

The defendants argued that the major-questions doctrine, due process, and the Administrative Procedure Act barred the SEC from alleging that the crypto-assets were securities. The court rejected those arguments. It held that the major-questions doctrine did not apply because the SEC was not claiming transformative authority over an industry of the kind involved in the Supreme Court cases applying that doctrine. Instead, the SEC was asserting its ordinary authority to require truthful disclosure and regulate products that qualify as securities.

The court also rejected the defendants’ fair-notice argument. It concluded that prior SEC enforcement actions, written guidance, and other statements had given a reasonable person in the crypto-currency industry notice that some digital assets could qualify as securities depending on their characteristics. The court further held that the SEC was applying an existing statutory standard to particular facts, rather than adopting a new industry-wide policy that required notice-and-comment rulemaking.

Investment-contract allegations

The court held that the SEC plausibly alleged that the crypto-assets were investment contracts under the test from SEC v. W.J. Howey Co. That test asks whether there was an investment of money in a common enterprise with a reasonable expectation of profits from the efforts of the promoter or a third party.

The court stated that the analysis must consider the substance and totality of the economic arrangement, including related protocols and the expectations surrounding the tokens, rather than examining the tokens in isolation. It concluded that the SEC plausibly alleged common enterprises because the defendants allegedly pooled purchasers’ assets or used sales proceeds to develop the Terraform blockchain or Mirror Protocol, with the expected result of increasing investors’ returns.

The court also found plausible allegations of reasonable expectations of profits. The SEC alleged that the defendants promoted Anchor Protocol returns, represented that LUNA’s value would increase as the Terraform ecosystem grew, tied MIR’s value to the Mirror Protocol, and promoted mAssets as reflecting the value of traditional securities. The court declined to distinguish between tokens sold directly to institutional investors and tokens purchased in secondary-market transactions, reasoning that the defendants’ public statements about their efforts and the expected profits could affect both groups’ expectations.

Registration claims

The court declined to dismiss the claims concerning LUNA and MIR. It held that the SEC plausibly alleged that the defendants’ sales and loans of LUNA were steps necessary to unregistered public distributions, particularly because the alleged purpose of the loans was to improve liquidity and the tokens were allegedly resold on a U.S. trading platform. The court also held that the SEC plausibly alleged that Terraform and its subsidiaries could not avoid registration requirements through the structure of the transactions or through a trading platform that generated MIR tokens automatically.

The court likewise declined to dismiss the mAssets claims. It concluded that the alleged purchase of an mAsset could qualify as a security-based swap because the transaction transferred financial risk tied to a traditional security’s future value without transferring ownership of that security. The court also found that the SEC plausibly alleged that the defendants were necessary participants in the distribution because they created, maintained, promoted, and allegedly received fees from the Mirror Protocol.

Fraud claims

The court held that the SEC adequately pleaded its fraud claims. It found sufficient the allegations that the defendants falsely represented that Chai transactions used Terraform’s blockchain and crypto-assets, and that the defendants benefited from those statements through a substantial investment in the company. The court also concluded that the SEC adequately alleged a duty to disclose the third-party intervention that restored UST’s dollar peg because the defendants’ public account of the event allegedly became materially misleading when combined with that secret information.

The court further found sufficient allegations supporting fraudulent intent or recklessness. The SEC alleged that the defendants had a motive to mislead investors because disclosure of the truth about Chai could reduce the value of the tokens, and that Kwon had direct access to information about Chai and the de-pegging event. The opinion also stated that securities-law violations by Terraform could be imputed to Kwon at this stage because of his alleged control of the company and involvement in the central events.

Disposition

Judge Jed S. Rakoff denied the defendants’ motion to dismiss in its entirety. Because this was a motion to dismiss, the ruling determined only that the SEC’s claims were sufficiently pleaded to continue; it did not finally determine whether the alleged fraud, securities violations, or other misconduct occurred.