The Southern District of New York Splits on Whether a Digital Token is a “Security”

Introduction

In the latest decision evaluating the application of federal securities laws to the digital asset context, Judge Jed S. Rakoff of the United States District Court for the Southern District of New York (“SDNY”) ruled in favor of the Securities and Exchange Commission (“SEC”) on a motion to dismiss in SEC v. Terraform Labs.¹ In doing so he found that the sales of crypto assets to retail investors on public marketplaces do not exempt such tokens from being “securities” subject to the SEC’s registration requirements. Judge Rakoff’s ruling came only weeks after a major ruling by Judge Analisa Torres also of SDNY in SEC v. Ripple Labs, finding that the XRP token was not a security when sold in secondary transactions through digital asset exchanges or through the use of trading algorithms, but was part of an investment contract (and therefore a security) when sold by Ripple Labs directly to investors.² The SEC has already asked Judge Torres to stay her decision while the SEC appeals the court’s ruling to the United States Court for Appeals for the Second Circuit.

Background

Terraform Labs Pte. Ltd. (“Terraform”) is a Singapore-based company that develops, markets, and sells crypto assets, and Do Keyong Kwon (“Kwon”) is the company’s Founder, Chief Executive Officer, and majority shareholder. Terraform and Kwon developed and sold the Terra USD stablecoin (“UST”), as well as a companion digital asset called “LUNA.” A stablecoin is a digital asset designed to have its value pegged to the value of a given reference asset (such as the U.S. dollar). Stablecoins are often used to facilitate digital asset transactions by providing reduced settlement times. Each UST coin was a stablecoin that has its price algorithmically pegged to the U.S. dollar. Owners of a UST coin could swap their coin for $1.00 worth of LUNA coin, which was a native digital asset of the Terraform blockchain. Likewise, any holder of a LUNA coin could exchange that coin for $1.00 of UST coin. Following the collapse of both LUNA and UST in 2022, the SEC charged Terraform and Kwon in February 2023 with orchestrating a multi-billion-dollar crypto asset securities fraud involving an algorithmic stablecoin and other crypto asset securities. The defendants strongly deny the charges.

The “Howey Test”

Courts generally apply the “Howey test”³ to determine whether a digital asset constitutes an “investment contract,” and therefore a security under the U.S. securities laws. The Howey test requires (i) an investment of money (ii) in a common enterprise (iii) with the expectation of profits to be derived from the efforts of others. A given digital asset may be determined to be an investment contract (and therefore a security) if, for example, it is promoted and marketed in a manner that emphasizes the profit-earning potential or secondary market liquidity of the digital asset, such that the purchaser would be acquiring the digital asset for investment-related reasons. A digital asset may also be considered an investment contract (and therefore a security) where promotional and marketing efforts emphasize the managerial expertise of the issuer in the future success of the digital asset project (such as through the development of future use cases for the digital asset).

The Earlier Ripple Decision

On July 13, 2023, Judge Torres ruled in SEC v. Ripple Labs that “programmatic sales” of XRP token on public digital asset exchanges or through the use of trading algorithms did not constitute an impermissible offer and sale of investment contracts, while “institutional sales” did. “Institutional sales” of XRP refer to direct sales of XRP to investors, such as institutional buyers and hedge funds, while “programmatic sales” of XRP refer to selling XRP on public digital asset exchanges or through the use of trading algorithms. In so ruling, Judge Torres determined that the third Howey prong was not satisfied because the programmatic sales were blind bid/ask transactions and investors could not know the seller from which they purchased XRP. Therefore, such sales did not constitute an investment in Ripple at all, and investors could not reasonably expect that Ripple would receive the purchase proceeds and use them to improve XRP.

The Terraform Decision

Judge Rakoff explicitly rejected Judge Torres's distinction in Ripple between a token having been sold directly to an institutional purchaser in a primary issuance and it being sold through secondary transactions with retail investors. Judge Rakoff observed that Howey and its progeny makes no distinction between purchasers, since the manner of sale would not change a purchaser’s reasonable belief in the promise of future profits based on Terraform’s own efforts. Moreover, Judge Rakoff noted that, if the SEC’s allegations are true, Terraform and Kwon “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.” For Judge Rakoff, “secondary-market purchasers had every bit as good a reason to believe that the defendants would take their capital contributions and use it to generate profits on their behalf.”

Judge Rakoff, however, did acknowledge that “the original UST and LUNA coins, as originally created and when considered in isolation, might not then have been, by themselves, investment contracts.” He noted that “[m]uch as the orange groves in Howey would not be considered securities if they were sold apart from the cultivator’s promise to share any profits derived by their cultivation, the term ‘security’ also cannot be used to describe any crypto-assets that were not somehow intermingled with one of the investment ‘protocols,’ did not confer a ‘right to . . . purchase’ another security, or were otherwise not tied to the growth of the Terraform blockchain ecosystem.” On this point, Judge Rakoff appeared to accord with Judge Torres’ contention in Ripple that “XRP, as a digital token, is not in and of itself a ‘contract, transaction[,] or scheme’ that embodies the Howey requirements of an investment contract” and that “[r]ather, the Court examines the totality of circumstances surrounding [the] different transactions and schemes involving the sale and distribution of XRP.”

It is worth noting that the two decisions arrive at different procedural postures, with the Terraform decision by Judge Rakoff ruling on a motion to dismiss, while the Ripple decision arising out of a summary judgement motion predicated on a well-developed factual record. In fact, on August 9, 2023, the SEC filed a notice of appeal in the Ripple case, seeking to certify its challenge to the holding that “Programmatic” offers and sales to XRP buyers over crypto asset trading platforms and Ripple’s “Other Distributions” in exchange for labor and services did not involve the offer or sale of securities under the Howey test. In its appeal letter filed with the court, the SEC cited the Terraform decision as creating an intra-district split.

Takeaways

As Terraform itself emphasizes, neither it nor Ripple will likely be the final say on the dispute of whether and when sales of crypto assets constitutes the sale of a “security.” Nor is either decision binding on other courts. At least for now, whether securities laws apply to digital assets remains a highly fact-sensitive question. Given the rapidly evolving law in this space, stakeholders must continue to closely monitor court and enforcement developments, which can be expected to continue to occur at an accelerated pace.