By: Julie Chung
The rise in cryptocurrency usage and sales confused the traditional securities and financial space. The Securities and Exchange Commission (“SEC”) typically exercised regulatory oversight to protect investors in the capital markets.[1]Cryptocurrencies have notably dodged financial regulators like the SEC with virtual currencies and sophisticated payment systems structured to avoid financial regulation.[2] Cryptocurrencies are incredibly volatile and lack investor protection and regulatory oversight.[3] Therefore, the SEC has sued crypto companies, like Terraform, in an attempt to enforce financial regulation in the crypto industry to protect investors and the capital markets.[4]
Terraform is a blockchain that allows users to “build, change, and version cloud and on-prem resources safely and efficiently.”[5] The SEC filed suit against Terraform in the United States District Court for the Southern District of New York in violation of Section 5 of the Securities Act of 1933,[6] which requires that “securities be registered with the SEC before any person may sell or offer to sell such securities.”[7] The SEC argued that Terraform cryptocurrencies are securities because they are investment contracts under the Securities Act.[8] On December 28, 2023, the court found that Terraform offered and sold unregistered securities under Sections 5(a) and 5(c) of the Securities Act in its Howey Test analysis.[9] The Supreme Court created a three-prong test (“Howey Test”) in Securities and Exchange Commission v. W.J. Howey Co.[10] to determine whether an instrument qualified as an investment contract under the Securities Act.[11] The three-prongs are: 1) investment of money, 2) in a common enterprise, and 3) with profits to come solely from the efforts of others.[12] If all prongs of the test are satisfied, then the instrument is an investment contract and qualified as a security under the securities law.[13]
Terraform easily satisfied the first prong as buyers invested money in Terraform’s cryptocurrencies, such as TerraUSD and LUNA.[14] Secondly, the court easily found that Terraform satisfied prong two’s common enterprise element as Terraform pooled the profits of LUNA purchases together with promising LUNA investors that increased investments through LUNA would benefit all LUNA investors in the end.[15]
The third prong requires that the profits come solely from the efforts of others; therefore, a court would need to find that the investors must have invested in Terraform with “reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”[16] The third prong is an objective analysis focusing on the economic realities of the transaction and the purchaser’s reliance on the efforts of others.[17] The court decided that Terraform satisfied the third prong because Terraform and its Chief Executive Officer and co-founder, Do Kwon, repeatedly told investors to expect a profit in relying on Terraform’s efforts to develop the Terraform blockchain.[18] Terraform’s management gave interviews to the public, stating that purchasing Terraform’s cryptocurrencies and becoming a Terraform crypto holder will distribute profits in fees to the Terraform crypto holder, which satisfies the third prong of the Howey Test.[19] Further, offering an instrument for sale to the public has the characteristic of selling a security in a public offering.[20] Thus, by successfully demonstrating that Terraform met all three prongs of the Howey Test, the SEC moves a step closer to its mission to regulate the crypto industry.
The SEC has repeatedly tried to use the Howey Test to regulate cryptocurrencies and crypto exchanges by categorizing cryptocurrencies as an investment contract to have enforcement actions.[21] Some of their lawsuits are successful, like Terraform; however, some are unsuccessful.[22] The court in SEC v. Ripple[23] determined that Ripple’s cryptocurrencies are not securities in its analysis of the Howey Test conflicts with Terraform’s decision. In Ripple, the court found that Ripple did not meet the third prong of the Howey Test because buyers were unaware that they were purchasing Ripple’s virtual currency and profiting from Ripple.[24] In opposition, Terraform’s court clearly rejected Ripple’s decision.[25] Terraform and Ripple’s cryptocurrency contradictory decisions lead to confused faces among the business, cryptocurrency, and securities law communities.[26] Perhaps the SEC will expand its operations in crypto regulation, and congressional authority may step in and create new laws governing cryptocurrencies. Nonetheless, these decisions have long-term implications, and it will be interesting to see the next moves from the crypto industry and financial regulators in crypto regulation.
[1] See U.S. Sec. & Exch. Comm’n, https://www.sec.gov (last visited Feb. 16, 2024) (explaining their powers include informing and protecting investors, facilitating capital formation, and enforcing securities law).
[2] Rakesh Sharma, Bitcoin Has a Regulation Problem, Investopedia (Nov. 5, 2023), https://www.investopedia.com/news/bitcoin-has-regulation-problem/#:~:text=In%20the%20U.S.%2C%20the%20IRS,tokens%20instead%20of%20security%20tokens.
[3] TJ Porter, Talking to Clients About Crypto Risks: A Guide for Financial Professionals, Investopedia (Jan. 15, 2024), https://www.investopedia.com/risks-of-cryptocurrencies-8401477 (explaining the currency’s asset fluctuates heavily with cybersecurity, liquidity, and security risks).
[4] Adam Hayes, How SEC Regs Will Change Cryptocurrency Markets, Investopedia (Jan. 20, 2024), https://www.investopedia.com/news/how-sec-regs-will-change-cryptocurrency-markets/ (noting SEC proceeded with 26 enforcement actions in 2023).
[5] What is Terraform?, Hashicorp, https://developer.hashicorp.com/terraform/intro (last visited Feb. 16, 2024).
[6] SEC v. Terraform Labs, No. 23-cv-1346, 2023 U.S. Dist. LEXIS 230518, at *1, *2 (S.D.N.Y. Dec. 28, 2023).
[7] SEC v. Cavanagh, 445 F.3d. 105, 111 (2d Cir. 2006) (citing 15 U.S.C. § 77e).
[8] 15 U.S.C. § 77b(a)(1) (stating securities includes notes, bonds, stocks, investment contracts, etc…).
[9] Terraform Labs, 2023 U.S. Dist. LEXIS 230518, at *50.
[10] 328 U.S. 293, 298-99 (1946).
[11] Id.
[12] Id.
[13] Id.
[14] Terraform Labs, No. 23-cv-1346, 2023 U.S. Dist. LEXIS 230518, at *43.
[15] See id. at *36.
[16] United Hous. Found., Inc. v. Forman, 421 U.S. 837, 852 (1975).
[17] Framework for “Investment Contract” Analysis of Digital Assets, U.S. Sec. & Exch. Comm’n, https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets#_edn11 (last modified Mar. 10, 2023).
[18] Terraform Labs, 2023 U.S. Dist. LEXIS 230518, at *47.
[19] See id.
[20] James Chen, Public Offering: Definition, Types, SEC Rules, Investopedia (Apr. 25, 2022), https://www.investopedia.com/terms/p/publicoffering.asp.
[21] See Framework for “Investment Contract” Analysis of Digital Assets, supra note 17 (stating SEC’s published guide in using the Howey Test to have enforcement actions for virtual currencies).
[22] Stuart D. Levi, et al., Two sides of the same coin: analyzing the recent Ripple and Terraform decisions, Reuters L. News (Aug. 31, 2023), https://www.skadden.com/insights/publications/2023/08/two-sides-of-the-same-coin-analyzing-the-recent-ripple-and-terraform-decisions.
[23] See Levi, supra note 22.
[24] See id.
[25] See id.
[26] David L. Axelrod, et al.,Terraform Versus Ripple – Courts Split on Whether Cryptocurrency Is a Security, Ballard Spahr (Aug. 3, 2023), https://www.ballardspahr.com/insights/alerts-and-articles/2023/08/terraform-versus-ripple-courts-split-on-whether-cryptocurrency-is-a-security.
