After a recent ruling from a federal judge in the XRP/Ripple case, many thought that some clarity had been reached in the crypto-regulation world. U.S. District Judge Analisa Torres ruled that Ripple's XRP sales on public cryptocurrency exchanges were not offers of securities, in part because certain purchasers did not know if their funds went to Ripple or a third party. This decision turned on the identity of the investor. Even at that time, I disagreed because I saw a mixed decision with a muddled approach to the "Howey Test" and to the underlying "tokenomics" of the digital assets. We now have even less certainty because of Do Kwon and TerraSD.

TerraUSD, an algorithmic stablecoin that was supposed to maintain a 1:1 value connection to the U.S. dollar, was paired with another token called Luna. Both tokens lost nearly all their value when TerraUSD, also known as UST, slipped below its 1:1 dollar peg in May 2022. Prior to its collapse, TerraUSD had a market cap of more than $18.5 billion and was the 10th largest cryptocurrency. 

The Securities and Exchange Commission (SEC) followed with a complaint alleging that Terraform Labs and Kwon misled investors about the stability of UST. Among other allegations, the complaint stated that Kwon and Terraform made representations that the firm's crypto tokens would increase in value. Kwon and Terraform made a motion to presiding judge Jed Rakoff to the dismiss the allegations.

In a new decision on July 31, 2023, Judge Rakoff, out of the Southern District of New York along with judge Torres, denied the motion to dismiss. In denying the motion, Judge Rakoff held that the identity of the seller "has no impact" on whether a reasonable investor would interpret statements by Kwon and his company as a "promise of profits based on their efforts." Stated differently, Rakoff rejected the approach used to partially resolve the Ripple/XRP test. 

Why did he do this and who is correct? A definitive answer to either question would be difficult to articulate in this context. However, we can get a feel for the issue quickly.

Both judges applied the "Howey Test," which is based on a ruling from a 1946 Supreme Court ruling in SEC v. W.J. Howey Co.. In that case, the Howey Company sold tracts of citrus groves to buyers in Florida, who would then lease back the land to Howey so that its staff could tend to the groves and sell the fruit for the ultimate benefit of the owners. Most buyers had no experience in agriculture and were did not maintain the land themselves. These Howey offerings were not registered as securities with the SEC and a lawsuit followed. While this is certainly a complex way to get orange juice, the complexity still gives us meaning today in the digital asset world.

The opinion of the Supreme Court created the four criteria now used as the "Howey Test":

An investment of money

In a common enterprise

With the expectation of profit

To be derived from the efforts of others

According to the SEC, the "investment of money" test is satisfied with the sale of TerraSD and XRP because fiat money or other digital assets are being exchanged with the expectation of profits or gains. Likewise, the "common enterprise" test is also easily met.

Judge Torres found that the test was not met because the context of exchange customers, the investors did not know who was selling them the securities. Judge Rakoff responded with a resounding "who cares?" From his order, what mattered is that the statements were made in connection of a common enterprise to communicate the expectation of profit to be derived from the work of others. I need to spend more time with these issues, but Judge Rakoff's approach does appear to be closer to the traditional interpretation of the securities laws. We will see....