The end of 2023 ushered in a flurry of new developments in key crypto cases. In August of last year, we wrote about conflicting decisions in two Southern District of New York (“SDNY”) cases testing the authority of the U.S. Securities and Exchange Commission (“SEC”) to regulate the crypto asset industry. In SEC v. Ripple Labs (“Ripple Labs”), which was generally considered a victory for Ripple, Judge Analisa Torres granted partial summary judgment in favor of Ripple on the issue of whether certain sales of Ripple’s XRP digital tokens were “investment contracts” and thus “securities” under securities laws. As discussed further below, Judge Torres found, in part, that purchasers who acquired XRP directly from Ripple enjoyed protections not shared by those who purchased XRP on crypto trading platforms in programmatic sales. Weeks later, Judge Jed Rakoff delivered a decision generally viewed as an SEC victory in SEC v. Terraform Labs Pte. Ltd. and Do Hyeong Kwon (“Terraform Labs”). Judge Rakoff rejected the approach of Judge Torres and ruled that the manner of sale of crypto asset securities—including whether to direct purchasers or via crypto trading platforms—has no impact on whether an asset is a security.

Analytical Divergence in the SDNY

The current divergence in SDNY precedent focuses on application of the so-called Howey test to determine the existence of an “investment contract.” An investment contract is a type of “security” regulated by the SEC. In short, an investment contract exists under the Howey test where there is: (1) an investment of money; (2) in a common enterprise; (3) with reasonable expectation of profits; (4) to be derived from the efforts of others. We discussed this test and the implications of a crypto asset being a “security” in this prior article.

Judge Torres and Judge Rakoff agree that the first two prongs of the Howey test are met in their respective cases. Their views appear to diverge on whether one or both of the following groups of people can establish a reasonable expectation of profits derived from the efforts of others:

1. Investors who purchase crypto assets on a platform and do not know the identity of the seller, who do not possess a direct relationship with the asset issuer, and who must rely primarily on non-specific statements promoting a crypto asset made by the issuer and its representatives to the general public. 
2. Investors who obtain assets directly from the issuer as part of a private placement of securities, who possess a direct relationship with the issuer, and may be able to rely on promotional statements made by the issuer and its representatives directly to them in addition to any made to the general public. 

As discussed further below, Judge Torres’ decisions have essentially found, based on the factual record in Ripple Labs, that public statements by Ripple and its representatives regarding future proceeds did not create a reasonable expectation of profits for investors who acquired XRP on crypto exchanges. Judge Rakoff’s decisions, based on the very limited facts in Terraform Labs, arguably reject this reasoning and find that an investment contract can exist based on public statements by an issuer and its representatives regarding future proceeds—whether made directly to investors or not and regardless of the manner in which the crypto assets are acquired. 

Ripple Labs Updates

Since we last wrote, two significant developments took place in the Ripple Labs case. First, in October 2023, Judge Torres denied the SEC's bid for interlocutory appeal of her decision on summary judgment. The SEC challenged Judge Torres’ decision arguing, among other things, that she misapplied the Howey test and that her summary judgment holdings were “of particular consequence to an issue of programmatic concern to the SEC’s enforcement of the securities laws and potentially a large number of pending litigations.” Accepting the SEC’s argument may have expedited the Second Circuit’s review of the Ripple Labs decision, resulting in earlier consideration of Judge Torres’ decision by one of the nation’s most influential securities law courts.

Perhaps unsurprisingly, Judge Torres rejected the SEC’s argument that she “improperly applied the Howey test.” She also concluded that other cases brought by the SEC involved different circumstances (e.g., different assets, companies, and legal postures), and that because of this, her decision in Ripple Labs did not have precedential value for “a large number of cases” and thus did not involve “controlling questions of law.” 

Judge Torres also rejected the SEC’s argument that Judge Rakoff’s decision in Terraform conflicted with her decision in Ripple Labs. She concluded that the Terraform decision “did not engage with the Court’s reasoning” in Ripple Labs because of the different procedural postures in each case. For example, Judge Rakoff’s decision in Terraform Labs came at the motion to dismiss stage. Thus, he accepted as true the SEC’s argument that promotional statements by Terraform “would have reached individuals who purchased their crypto asset assets on secondary markets” due to the lack of a factual record. Judge Torres, on the other hand, found that the SEC failed to prove that Ripple distributed certain promotional materials to the general public at the summary judgment phase and after the development of an extensive factual record.

Second, and shortly after Judge Torres denied the SEC’s petition for interlocutory appeal, the SEC voluntarily dismissed its claims against two Ripple executives alleging that they aided and abetted Ripple’s securities law violations with respect to the direct institutional sales of Ripple’s XRP tokens that did not occur on a crypto exchange (i.e., the sales of XRP that Judge Torres did deem to be sales of “unregistered securities” in her earlier decision). 

The Ripple case is currently set for resolution in 2024 on the issue of the remedy and/or damages from the sales of XRP tokens to institutional buyers that the Court determined violated the securities laws. Briefing on these matters appears likely to close in mid-spring, and we will be tracking the case closely to provide further updates.

Terraform Updates 

Over two months after Judge Torres characterized Judge Rakoff’s decision in Terraform Labs as “not engag[ing] with the Court’s reasoning” in Ripple Labs, Judge Rakoff issued a highly anticipated decision on cross-motions for summary judgment in Terraform Labs. Perhaps unsurprisingly, his decision largely upheld his earlier reasoning in the motion to dismiss, in determining that Terraform (and its founder, Do Kwon) violated the federal securities laws by failing to register Terraform’s UST, LUNA, wLUNA and MIR crypto asset tokens.

The SEC argued that four of Terraform’s crypto assets (UST, LUNA, wLUNA, and MIRA) are securities, as defined in Section 2(a)(1) of the Securities Act for the purposes of the federal securities laws, because they are investment contracts under Howey. In response, Terraform and Do Kwon argued that: 1) the assets are not investment contracts as a matter of law; and 2) the undisputed facts do not demonstrate that the crypto assets at issue are investment contracts. 

Many observers wondered how Judge Rakoff might respond to Judge Torres’ October ruling in Ripple Labs, and he responded by doubling down on his earlier decision not to apply her reasoning. Judge Rakoff emphatically rejected both of defendants’ arguments. Among other things, he found that a myriad of evidence put forth by the SEC showed Terraform and its executives trumpeting how sales of the various tokens would be used to generate shared profits amongst the purchasers. While the facts and circumstances of each token varied, Judge Rakoff determined that Terraform marketed each of the four tokens in specific ways that clearly met each prong of the Howey test. Given this, Judge Rakoff determined that each of the four tokens at issue were securities under Section 2(a)(1) of the Securities Act, and that the offerings of UST, LUNA, wLUNA, and MIRA should have been registered.

In addition, Judge Rakoff found that Terraform and Do Kwon violated Section 5 of the Securities Act by selling unregistered securities. The defendants argued the securities were otherwise exempt from registration because they were only sold directly to sophisticated investors, an argument Judge Rakoff found unpersuasive. For some tokens, Judge Rakoff determined that even though Terraform sold them directly to institutional investors through sales agreements, the terms of these agreements expressly contemplated Terraform’s development of a secondary market to help incentivize secondary resales. Many initial investors also received the tokens at a substantial discount, which would have allowed them to sell the tokens at higher prices after a lockup period. Sales of other tokens were made pursuant to agreements that did not restrict the resale of those tokens to secondary investors. Judge Rakoff also found no indication that Terraform sought to restrict the resale of its tokens to U.S. customers and investors. 

While Judge Rakoff ruled in favor of the SEC on the two critical legal issues above, his decision was not a complete win for the SEC:

1. Judge Rakoff ruled that as a matter of law, the defendants did not offer unregistered security-based swaps (a product known as mAssets, which the SEC did not allege were securities) in violation of either Section 5(e) of the Securities Act or Section 6(1) of the Exchange Act.
2. Judge Rakoff denied the parties’ cross-motions for summary judgment on the SEC’s claims that defendants intended to defraud investors in statements regarding Terraform’s business in violation of Section 10(b) and Rule 10b-5, determining that reasonable jurors could differ on the questions of whether: (a) a reasonable investor would have found specific statements made by Terraform to be materially misleading; and (b) the SEC had proven defendants acted with the requisite scienter in making the statements at issue, given that much of the SEC’s evidence to support scienter came from whistleblowers whose credibility and scope of testimony needed to be determined at trial.

Notably, Judge Rakoff’s decision did not mention Judge Torres’ earlier decision in Ripple Labs, or specifically grapple with the differing outcomes on key legal issues.

Judge Rakoff’s partial summary judgment decision in favor of the SEC leaves the remaining claims for a liability phase of trial recently rescheduled to start on March 25, 2024. The trial was postponed from January to March by Judge Rakoff’s Order in an effort to provide more time for Do Kwon to work through his extradition. Judge Rakoff noted that any remedies for the defendants’ sale of unregistered securities would be determined after the liability questions had been resolved at trial for all remaining claims.

Final Thoughts

Looking ahead to 2024, we expect further significant legal decisions in Ripple Labs and Terraform Labs. We also expect the SEC to leverage what it views as favorable rulings in cases like Terraform Labs in other pending actions, and to downplay decisions that it considers less favorable. For example, the SEC has already made the court aware of Judge Rakoff’s decisions in its ongoing case against Coinbase. The SEC is also seeking to limit the reach of Judge Torres’s decisions. During over four hours of argument regarding Coinbase’s motion for judgment on the pleadings on January 17, 2024, Coinbase argued, among other things, that unlike the crypto assets at issue in the case, a stock reflects an interest in the permanent capital of a corporation. When it trades, that interest in the permanent capital of the corporation, which is a participation in its capital structure, transfers in entirety from one holder to another holder. The SEC countered that purchasers of crypto assets on an exchange are also investing in the network or ecosystem behind it, indicating there is a value proposition behind the crypto purchase that makes it a security. Judge Failla articulated concern that the SEC’s argument was too broad and risked impacting existing markets for collectibles and commodities, among other non-securities, but she did not clearly indicate which way she intended to rule. Should Judge Failla deny Coinbase’s motion, the case will proceed into discovery and potentially summary judgment in 2024 or later. 

Despite recent advancements in the Ripple Labs and Terraform cases, the industry likely remains many years away from judicial resolutions of which crypto assets are “securities” under applicable law. Legislative action clarifying the SEC’s jurisdiction over crypto assets remains highly sought after by the industry, but Congressional action remains unlikely in 2024 due to the current political environment.