One US federal district court judge affirmatively challenged the analysis of another district court judge sitting in the same courthouse in denying defendants’ motion to dismiss in the Securities and Exchange Commission’s enforcement action against Terraform Labs Pte. Ltd. and Do Kwon.

In an Opinion and Order issued on July 31, 2023, the Hon. Jed S. Rakoff said he “rejects” the approach taken by the Hon. Analisa Torres when she ruled in connection with motions for summary judgment by both the SEC and Ripple Labs, Inc. (as well as two principals) that, while initial institutional sales of XRP (the native token of the Ripple blockchain) involved investment contracts (and thus securities), programmatic sales in blind bid and offer scenarios on trading platforms did not. This is because, said Judge Torres, 

“…[T]he vast majority of individuals who purchased XRP from digital asset exchanges did not invest their money in Ripple at all. An Institutional Buyer knowingly purchased XRP directly from Ripple pursuant to a contract but the economic reality is that a Programmatic Buyer stood in the same shoes as a secondary market purchaser who did not know to whom or what it was paying money.”

However, in his Terraform Labs Opinion, Judge Rakoff takes a different view:

“Simply put, 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.”

This statement, however, does not address why purchasers of various crypto assets issued by Terraform Labs could reasonably have believed that, by purchasing such tokens from sellers on a trading platform through blind bid and offer scenarios, they were making capital contributions directly to Terraform, let alone how they were making such contributions in fact. However, for purposes of a motion to dismiss, the Court was obligated generally to consider all allegations in the SEC’s complaint as true, and the Court very well could have solely deferred to the SEC’s pleading at this stage.

Both Judge Rakoff and Judge Torres preside in the Southern District Court in New York City.

In his opinion, Judge Rakoff reached a number of other conclusions:

• The Major Questions Doctrine did not preclude the SEC from bringing its enforcement action against the defendants. According to Judge Rakoff, application of this doctrine is limited “for the most extraordinary cases where the agency claims broad regulatory authority and the area to be regulated is one invested with particular economic and political significance” – as evidenced by the very few decisions (five) of the Supreme Court applying this doctrine. Judge Rakoff concludes that “there is very little comparison between the instant case and the ones in which the Major Questions Doctrine was decisive.”

However, this position does not acknowledge the size of the overall crypto asset industry – which recently had a market capitalization of approximately US $3 Trillion – in the context of the US economy as a whole, and two comprehensive proposals for legislation pending in Congress related to the crypto asset industry that endeavor to formally address what the bills’ sponsors consider the non-clarity as to when a crypto asset may be an investment contract or not under existing law.

(The Major Questions Doctrine provides that where a federal agency asserts “power to regulate a significant portion of the American economy,” it must have clear authorization to do so from Congress.” According to Judge Rakoff, “the crypto-currency industry – though certainly important – falls far short of being a ‘portion of the American economy’ bearing ‘vast economic and political significance’.”)

• Defendants were not denied due process by the SEC commencing its enforcement action against them. This is because, said Judge Rakoff, “rather than state that all cryptocurrencies are securities or that none of them are, the SEC insists that it has broadcast the same positions on this issue all along: that some crypto-currencies, depending on their particular characteristics, may qualify as securities.” (Emphases in the original quotation.)

However, this summary of the SEC’s view is not precise. The SEC has claimed that most crypto assets other than bitcoin are likely securities. This is despite the Commodity Futures Trading Commission taking a different view as evidenced by its allowance of futures on ether to be actively traded on various CFTC-supervised exchanges and its commencement of enforcement actions against various defendants in connection with numerous crypto assets. Thus, persons trading crypto assets as well as one sister federal agency to the SEC, are not clear (or even disagree) on when a crypto asset may fairly be regarded as a security.

• Crypto assets that may not have constituted a security at one time, may “…as circumstances change, become an investment contract that is subject to SEC regulation,” said Judge Rakoff in his Opinion. This is an interesting twist on former Director of the SEC’s Division of Corporate Finance William Hinman’s observation in 2018, that “If the network on which [a] token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract.”

In other words, the nature of crypto assets, depending on a transaction, is not static and could morph over time. However, the SEC has not, to date, provided practical guidance on when it believes a crypto asset is sufficiently decentralized to warrant it not being considered an investment contract. Although SEC staff (not the Commission) provided some guidance in its 2019 “Framework for “Investment Contract” Analysis of Digital Assets,” the guidance set forth numerous subjective standards and nothing like the precise numerical standards in the Commodity Exchange Act and Securities Exchange Act that exactly define when a futures contract on a security index (which often changes its composition based on the component securities and their weighting) will be a security futures contract subject to the joint oversight of the SEC and CFTC) as opposed to solely a futures contract (subject to the exclusive oversight of the CFTC).

Again, Judge Rakoff’s Opinion must be considered in the context of Defendants’ motion to dismiss, and the Court’s obligation in determining such a motion, generally, to consider all allegations of the SEC as true.  The Ripple decision, by contrast, came on cross-motions for summary judgment after extensive fact and expert discovery had occurred.  

The SEC commenced an enforcement action against Terraform Labs and its former chief executive officer, director and majority owner, Mr. Kwon, earlier this year. It claimed, among other things, that the defendants had committed fraud in offerings of an algorithmic stablecoin and what the SEC termed “other crypto asset securities.”

Click here to access the Judge Rakoff’s Opinion and Order in Response to Defendants’ Motion to Dismiss in SEC v. Terraform Labs et al.

Click here to access Judge Torres’ Order in Response to the parties’ Motions for Summary Judgment in SEC v. Ripple Labs et al.

"...[T]he Court declines 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." -- Hon. Jed. S. Rakoff, USDJ, SDNY