SEC Defines 'Interrelated' Terra Tokens as Securities

In a case that appears to broadly define cryptocurrencies as securities, the U.S. Securities and Exchange Commission on Thursday charged Do Kwon and Terraform Labs, the crypto firm he co-founded, with orchestrating a multi-billion fraud.

In a 55-page civil complaint, the SEC said Do Kwon and Terraform offered and sold an “array of interrelated tokens” between April 2018 and May 2022 that led to the loss of $40B in market value and created “devastating” losses for U.S. retail and institutional investors.

Devastating Losses

“We allege that Terraform and Do Kwon failed to provide the public with full, fair, and truthful disclosure as required for a host of crypto asset securities, most notably for LUNA and Terra USD,” said Gary Gensler, the chair of the SEC, in a prepared statement. “We also allege that they committed fraud by repeating false and misleading statements to build trust before causing devastating losses for investors.”

Yet the big news for the crypto industry isn’t Do Kwon — he’s already on the run from South Korean prosecutors and an Interpol red notice — it’s the all-encompassing definition of Terra’s many tokens as securities or investment contracts.

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The Defiant

These include Terra’s governance token, LUNA, its algorithmic stablecoin, UST, and mAssets, security-based swaps designed to pay returns by mirroring the price of stocks of U.S. companies.

In no uncertain terms, the agency said the tokens were unregistered securities subject to federal law. This means such assets must be registered prior to being offered to investors and comply with federal disclosure rules, a requirement the industry has long resisted.

This development could roil the burgeoning tokenization push in decentralized finance, with many protocols racing to offer on-chain versions of bonds, exchange-traded funds, and stocks. It could also spur stablecoin providers to consider registering their tokens to head off possible regulatory action.

“This may have very far reaching implications for many projects,” tweeted Collins Belton, the managing partner at Brookstone P.C., a boutique law firm in San Francisco focusing on emerging technologies like digital assets.

Gabriel Shaprio, general counsel at Delphi Digital, a digital asset research firm, said on Twitter the SEC’s case has “three firsts” — it states a stablecoin is a security, a tokenized or synthetic token is also a security, as are wrapped tokens.

Toxic Debt

Terra’s collapse in May 2022 compounded the bear market in cryptocurrencies and further damaged the industry’s credibility with investors. After UST slipped its dollar peg, it triggered a cascade of losses in linked tokens such as LUNA and became virtually worthless. The failure saddled other crypto giants such as the exchange Celsius and the hedge fund Three Arrows Capital with toxic debt, and eventually caused stress in FTX, the No. 2 crypto exchange worldwide, which went bankrupt in November.

Howey Test

A key precedent for determining whether a financial market instrument is a security was established in a 1946 U.S. Supreme Court ruling. Known as the Howey Test, it determined that a transaction will be deemed an investment contract or a security if a buyer has an expectation of making a profit. For almost two years now, Gensler has said the SEC believes cryptocurrencies meet the Howey Test and the industry better comply with the law.

In its complaint, the SEC said Kwon touted the value of LUNA in an April, 2021, tweet. The agency said Kwon repeatedly told investors Terra’s tokens would appreciate in value.

Tweet included in SEC complaint.

This is just the latest action taken by regulators against crypto companies in recent months. Earlier this month, New York state’s Department of Financial Services ordered Paxos, a financial infrastructure company based in the U.S., to cease issuing the dollar-pegged BUSD token.

Staking-as-a-Service

In a case that further stretched the definition of securities for cryptocurrencies, the SEC this month settled a case with Kraken in which the centralized exchange agreed to shutter its staking-as-service program and pay a $30M penalty. The problem: Kraken had failed to register the staking offering as a security or investment contract.

Do Kwon, who is reputed to be hiding from the authorities in Eastern Europe, did not tweet any comment on the SEC suit.