SEC Charges Do Kwon in Violation of Federal Securities Laws
Yesterday, the Securities and Exchange Commission the Securities (the “SEC”) brought charges against Terraform Labs PTE Ltd and Do Hyeong Kwon (the “Defendants”), both based in Singapore, for orchestrating a multi-billion dollar crypto asset securities fraud. The scheme involved an “algorithmic” stablecoin and other crypto asset securities.
The SEC’s complaint charges Terraform, Kwon, and Chai with violating the antifraud provisions of the federal securities lawsmand charges Terraform and Kwon with violating the registration provisions of the federal securities laws. The Complaint seeks a permanent injunction, disgorgement plus prejudgment interest, civil penalties, and other relief.
According to the SEC’s complaint, between April 2018 and May 2022, Terraform and Kwon sold unregistered crypto asset securities and engaged in a fraudulent scheme that caused a $40 billion market value loss, including devastating losses for US retail and institutional investors. They marketed tokens as profit-seeking investments and misled investors about the stability of their stablecoin, UST. Terraform and Kwon also falsely claimed that a Korean mobile payment app used their blockchain technology to process and settle transactions. The SEC alleges they violated securities offering registration provisions and antifraud provisions of federal securities laws.
Summary of the Violations Alleged by the SEC
The defendants are accused of violating federal securities laws by selling crypto asset securities without registering them with the SEC, which was required under Section 5(a) and 5(c) of the Securities Act of 1933. Additionally, they violated Section 5(e) of the Securities Act and Section 6(1) of the Securities Exchange Act of 1934, which governs security-based swap provisions. They offered, sold, and executed transactions in securities-based swaps, known as "mAssets," without an effective registration statement filed with the Commission, to non-eligible contract participants in transactions that were not executed on a national securities exchange. Defendants' conduct also violated Section l 7(a) of the Securities Act, Section l0(b) of the Exchange Act, and Rule lOb-5 thereunder, along with Section 20(a) of the Exchange Act, which governs antifraud provisions of federal securities laws.
SEC Authority & Sought Relief
The Commission filed this lawsuit under the authority of Section 20(b) of the Securities Act and Section 21(d)(l) of the Exchange Act, seeking a final judgment. The judgment aims to order the Defendants to permanently stop violating the federal securities laws and pay disgorgement with prejudgment interest. It also orders Defendants to pay civil money penalties and prohibits them from participating, directly or indirectly, in the purchase, offer, or sale of any crypto asset security. Additionally, it prohibits them from engaging in activities that induce or attempt to induce the purchase, offer, or sale of any crypto asset security by others. The Court may also impose other relief deemed just and appropriate.
Summary of the SEC’s Statutory and Legal Framework
Congress made the Securities Act to control the offer and sale of securities, requiring full and fair disclosure to let investors make informed decisions. Sections 5(a) and 5(c) of the Securities Act oblige issuers like Terraform to register offers and sales of securities with the SEC. These registration statements provide investors with vital information such as financial and managerial information, how the issuer will use proceeds, and the risks involved. The definition of a "security" is broad and includes investment contracts, through which investors expect profits or returns from the managerial or entrepreneurial efforts of others. Security-based swaps are securities themselves, including any agreement, contract, or transaction based on the value of a single security. Securities Act Section 5(e) and Exchange Act Section 6(1) forbid the offer or sale of security-based swaps to non-eligible contract participants without an effective registration statement or without being executed on a registered national securities exchange. Eligible contract participants include high-net-worth individuals and certain sophisticated and/or regulated entities.
The SEC’s Background on Crypto Assets (summarized from the complaint)
The Securities Act is a testament to the regulation of securities and the responsibility of those offering and selling such investments to provide complete and accurate information to potential investors. It is a departure from the common commercial practice of caveat emptor and aims to provide a regime of full and fair disclosure. To ensure that the public can make informed decisions before investing, those who offer and sell securities must provide sufficient and precise information, and failure to do so can result in severe consequences.
The term "crypto asset" has become increasingly prevalent in recent years and refers to assets issued and/or transferred using blockchain or distributed ledger technology. While the definition of crypto asset may vary, it generally includes assets such as "cryptocurrencies," "digital assets," "virtual currencies," "digital coins," and "digital tokens." These investments have been made possible by distributed ledgers or blockchains, peer-to-peer databases that record transactions across a network of computers. The system relies on cryptographic techniques for secure recording of transactions and can record "smart contracts," computer programs that execute the terms of a contract when specific conditions are met.
Consensus mechanisms validate transactions in blockchains, aiming to achieve agreement on the data value or the state of the ledger. Crypto assets can be traded on crypto asset trading platforms in exchange for other crypto assets or fiat currency issued by a country.
Terraform's crypto assets include LUNA tokens, wrapped LUNA, UST, MIR tokens, and security-based swaps or mAssets, and they were promoted as profit opportunities for investors. Terraform and Kwon touted their professional expertise, promoting Terraform's team as one led by serial entrepreneurs with deep relevant expertise. They also advertised their considerable efforts to ensure that UST maintained its $1.00 peg.
Terraform's aggressive marketing strategy included posting promotional materials on publicly accessible social media platforms, giving interviews to media promoting its crypto assets, traveling to the US to meet with investors, and partnering with the Washington Nationals baseball team. Several of Terraform's crypto assets were also listed on major crypto asset trading platforms, including a prominent US-based platform.
Overview of the SEC’s Howey Test on LUNA
Investing in LUNA was a complex process. Investors were required to tender fiat currency or crypto assets in exchange for LUNA. Institutional investors had the privilege of purchasing LUNA directly from Terraform after meeting with Kwon in person or via videoconference. On the other hand, non-institutional investors purchased LUNA from crypto asset trading platforms, including at least one trading platform in the U.S.
However, purchasing LUNA was not simply a transaction, it involved investing in a common enterprise with other LUNA purchasers as well as with Terraform and Kwon. The funds received from investors were pooled by Terraform and Kwon to develop the Terraform ecosystem and increase the value of LUNA. The investors shared equally in LUNA price increases or suffered LUNA price decreases equally. This meant that if one investor profited, all investors did so as well. As LUNA is fungible, the fortunes of LUNA purchasers were tied to one another, and each depended on the success of Defendants' efforts and strategy and the Terraform ecosystem.
Given the common enterprise and the involvement of Terraform and Kwon in the development of the Terraform ecosystem, investors in LUNA had a reasonable expectation of profits from Defendants' managerial efforts. Defendants publicly pitched LUNA as an investment that would increase in value with the increased usage of the Terraform blockchain, which could result from their continued development and maintenance. They publicly stated that as the Terraform ecosystem grew based on their efforts, the value of LUNA would go up as well. Terraform described purchases of LUNA as "investments" and LUNA buyers as "investors" in marketing materials distributed to potential investors in January 2019. The same materials noted that "top global exchanges and funds" had already "invested in" Terraform (referring to their purchase of LUNA), and that Terraform had raised $32 million in July 2018 from an "elite group of VCs," referring to venture capital firms.
The agreements between Terraform and LUNA investors also incentivized buyers to seek to sell their LUNA into public markets in order to realize a profit. By selling at a discount to market prices, Defendants incentivized buyers to sell their LUNA into public markets. Moreover, for some buyers who purchased LUNA prior to the public launch of the token, Defendants provided in some of the agreements for a gradated token distribution schedule that would control the flow of LUNA tokens being sold into the market, such that early investors would receive their LUNA continuously over a period of 12-18 months. These provisions controlled the release of LUNA over a longer period of time in smaller quantities, to control for potential negative effects on LUNA's price that could occur with large distributions of LUNA into the market.
What has the SEC said about the complaint?
"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 SEC Chair Gary Gensler. "We also allege that they committed fraud by repeating false and misleading statements to build trust before causing devastating losses for investors."
"I commend the SEC’s hard-working staff who remained vigilant in such an important investigation, even when the defendants attempted to prevent us from obtaining important information about their business," Chair Gensler added. "This case demonstrates the lengths to which some crypto firms will go to avoid complying with the securities laws, but it also demonstrates the strength and commitment of the SEC’s dedicated public servants."
"Today’s action not only holds the defendants accountable for their roles in Terra’s collapse, which devastated both retail and institutional investors and sent shock waves through the crypto markets, but once again highlights that we look to the economic realities of an offering, not the labels put on it," said Gurbir S. Grewal, Director of the SEC’s Division of Enforcement. "As alleged in our complaint, the Terraform ecosystem was neither decentralized, nor finance. It was simply a fraud propped up by a so-called algorithmic “stablecoin” – the price of which was controlled by the defendants, not any code."
In summary, Terraform's crypto assets fall under the purview of the Securities Act, and the company and its CEO, Kwon, may face severe consequences for failure to register with the SEC and provide complete and accurate information to potential investors. The economic realities underlying the transactions will determine whether these assets are deemed securities, and it is the responsibility of the SEC to ensure compliance with federal securities laws.
1https://www.sec.gov/news/press-release/2023-32
2 https://www.sec.gov/news/press-release/2023-32
3 https://www.sec.gov/news/press-release/2023-32
4https://www.sec.gov/news/press-release/2023-32
By John Montague