This is another attempt by the U.S. crypto industry to challenge the current strong regulatory model in the United States through judicial means.
Author and source: TaxDAO
3. Two landmark US encryption litigation cases
The Ripple case and the Terraform case are two iconic cases that the US crypto industry cannot avoid. In the judgments of the two cases, the courts defined the legal attributes of crypto assets from different perspectives, triggering a strong reaction from the crypto industry. The focus of the two cases is highly similar to that of this case. Both cases discussed the qualitative and regulatory issues of crypto assets, which will play an important role in the future judgment of this case.
3.1 Ripple Case
3.1.1 Basic Case Facts
Ripple Labs is the holder of Ripple and its native cryptocurrency token XRP (Ripple coin), established in 2012, and is one of the earliest pioneers in the blockchain field. XRP is intended to serve as a bridge tool to facilitate financial transactions, with a client base primarily composed of financial institutions. In December 2020, the SEC filed a lawsuit against Ripple Labs and its CEO Brad Garlinghouse and co-founder Chris Larsen, accusing them of illegally issuing securities through the sale of the cryptocurrency XRP, raising over $1.3 billion. The SEC believes that XRP is essentially an investment contract, similar to stocks or bonds, and therefore must strictly comply with relevant securities laws, including registering with the SEC and providing adequate information disclosure to investors. However, Ripple did not fulfill these obligations and violated securities laws. Ripple contended that XRP is a digital currency, functioning more like Bitcoin or Ethereum. Additionally, XRP does not meet the standards set by the Howey test and cannot be classified as a security. The SEC's lawsuit has stirred significant waves in the cryptocurrency industry as it marks the SEC's first lawsuit against a mainstream cryptocurrency that is already in circulation, symbolizing a broader conflict between digital asset innovation and regulation.
3.1.2 Judgment Results
In July 2023, the court ruled that XRP (and all cryptocurrencies) are not securities when sold to the public on exchanges, but are securities when sold to institutional investors. This ruling triggered a strong market reaction, directly causing XRP's price to increase by 70%. In August 2024, the case reached its final judgment. Regarding whether XRP should be recognized as 'securities,' the court distinguished based on the sales scenario. On one hand, there is direct sales to institutions. The judge found that such sales meet the Howey test, as institutions purchasing XRP directly from Ripple expect the value of XRP to rise for profit, which is typical investment contract behavior, thus classified as a securities issuance. On the other hand, programmatic sales of XRP in the public market do not constitute securities. The judge pointed out that public market buyers do not know who the sellers are and do not have an expectation of profit from Ripple. This programmatic sale does not meet the criteria for determining investment contracts and therefore does not belong to securities issuance. Ultimately, the court ordered Ripple to pay approximately $125 million in civil penalties, significantly lower than the nearly $2 billion penalty initially requested by the SEC but higher than Ripple's initial intention to cap the penalty at $10 million. From the outcome, both Ripple and the SEC achieved some victory in this case. For Ripple, it does not have to pay the huge fine demanded by the SEC, while the SEC also did not leave empty-handed. However, it is evident that the SEC's expectations were greatly unmet, leading the SEC to submit a notice of appeal in October 2024, intending to appeal parts of the district court's ruling to the Second Circuit Court of Appeals. According to the response from the Second Circuit Court of Appeals, the SEC must submit a statement of the appeal's arguments by January 15, 2025. Therefore, there is also a possibility that the judgment result of this case may be overturned.
3.1.3 Subsequent Impacts
Regarding the subsequent impacts of the case, on one hand, the Ripple case clarifies the important role of transaction methods in the qualification of cryptocurrencies. In the Ripple case, the court found that the act of selling XRP to the public through the secondary market does not constitute a securities transaction, indicating that the method of sale or transaction of cryptocurrencies will affect their qualification. On the other hand, this case will, to some extent, limit the SEC's expansion of regulatory scope over cryptocurrencies. Unless the SEC succeeds in the appellate court, the ruling of this case will be binding in the U.S., following case law, preventing the SEC from classifying a large number of cryptocurrencies as securities and incorporating them into the regulatory scope. Overall, the Ripple case marks a significant victory for the cryptocurrency industry in its struggle against a strong regulatory model. This ruling not only boosts the confidence of cryptocurrency practitioners and warms market sentiment but may also become an important turning point in the future regulatory landscape.
3.2 Terraform Case
3.2.1 Case Overview
Terraform Labs is a platform that provides blockchain technology and cryptocurrency, founded by Do Kwon, who attracted investors in the secondary market through the design and sale of various cryptocurrencies, including its native stablecoin UST and token LUNA. The UST coin is pegged to the U.S. dollar, and its stability algorithmically relies on the support of its sister token LUNA. However, Terraform's stabilization mechanism faced serious issues in practice. In May 2021, the UST price depegged, but Terraform managed to briefly restore the UST peg through secret arrangements with third-party companies. In 2022, the UST again fell below $1, and without external intervention to support it, its value plummeted rapidly, causing LUNA to also lose value. This crash triggered a loss of over $40 billion in market capitalization and dragged down other cryptocurrencies, including Bitcoin, further impacting the entire cryptocurrency market, leading to multiple companies filing for bankruptcy in 2022. In February 2023, the U.S. Securities and Exchange Commission (SEC) charged Terraform Labs and its founder Do Kwon with an unregistered securities fraud case involving billions of dollars. The SEC alleges that Terraform misled investors through multiple deceptive statements and fraudulent actions, violating the registration and anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. In June 2024, a U.S. district court approved a $4.5 billion settlement agreement reached between Terraform Labs and the SEC. According to the agreement, Terraform must pay nearly $3.6 billion in illegal gains, $420 million in civil penalties, and about $467 million in pre-judgment interest. Do Kwon must jointly pay $110 million in illegal gains and $14.3 million in pre-judgment interest with Terraform, and independently pay $80 million in civil penalties. However, since Terraform filed for bankruptcy in January 2024, these fines may be difficult to pay in full and will only be treated as unsecured claims in the bankruptcy liquidation.
3.2.2 Ruling Results
The core of the Terraform case ruling lies in the identification of the legal attributes of UST and LUNA. The court found that the purchasers of these cryptocurrencies reasonably expected their tokens to generate profits and regarded these tokens as a profitable investment, thus meeting the definition of investment contracts under the Howey test. The court further ruled that all relevant cryptocurrencies created by Terraform, including UST and LUNA, qualify as securities under the definition of investment contracts in the Securities Act of 1933. Notably, in relation to the situation where eighteen states sued the SEC, the court responded to Terraform's defense regarding the Major Questions Doctrine. The Major Questions Doctrine requires that 'in special circumstances, an agency claiming authority to regulate a substantial portion of the U.S. economy with significant economic and political implications must point to a clear Congressional authorization of that power.' The court noted: (1) There is almost no comparability between Terra Labs and cases applicable to the Major Questions Doctrine (such as those involving the U.S. tobacco and energy industries). (2) The SEC's regulatory actions in determining certain cryptocurrencies as securities do not constitute a transformative expansion of its regulatory authority. At the same time, similar to the reasoning of the eighteen states' lawsuit, Terraform argued that the SEC violated the Administrative Procedure Act. The court dismissed this, stating that the SEC's classification of Terraform's digital assets as investment contracts cannot be negated solely based on the Administrative Procedure Act. The SEC did not issue a new policy in this case but merely enforced its previously established policies. The court also confirmed that the SEC's indictment adequately charged Terraform with providing and selling tokens like LUNA as equivalent to illegal public offerings of unregistered securities, and making false or misleading statements during the issuance process from which it benefited.
3.2.3 Subsequent Impacts
The judgment result of the Terraform case supports the SEC's regulatory stance, attracting widespread attention in the cryptocurrency industry. Specifically: First, it reiterates the qualitative approach to cryptocurrencies. The Terraform case indicates that as long as cryptocurrency traded in the secondary market passes the Howey test, particularly if there is a reasonable expectation of profit from the efforts of the issuer, it can be classified as a security. Second, it strengthens the SEC's regulatory power over the cryptocurrency market. In the enforcement process, the ruling of the Terraform case has been cited by the SEC in lawsuits against other cryptocurrency exchanges, such as the Binance and Coinbase cases, which may further drive the SEC towards comprehensive regulation of the digital asset market. Third, it serves as a warning to the cryptocurrency industry, urging practitioners to be mindful of legal risks in the design and marketing of cryptocurrencies.
3.3 Summary
Although both the Terraform case and the Ripple case revolve around the qualification of cryptocurrencies, there are significant differences in their rulings. In the Ripple case, the court found that the secondary market sale of XRP does not constitute a securities transaction, while the Terraform case ruled that UST and LUNA meet the definition of investment contracts. This difference first exacerbates legal uncertainty in the field of digital assets. The ruling in the Ripple case emphasizes the importance of the method of transaction, indicating that anonymous transactions in the secondary market may not satisfy the 'common enterprise' or 'reliance on the efforts of others to profit' requirements in the Howey test. In contrast, the Terraform case focuses more on investor profit expectations and the actions of the issuer, indicating that even in secondary market transactions, as long as the issuer's efforts play a crucial role in investor returns, it can still be classified as a securities transaction. This difference in legal application adds uncertainty to the digital asset industry. Secondly, it impacts the SEC's regulatory strategy, potentially leading to fluctuations in the SEC's regulatory stance. In the Terraform case, the SEC's claims were supported by the court, reinforcing its regulatory authority over secondary market cryptocurrency transactions. However, in the Ripple case, the court's ruling limited the SEC's regulatory expansion over secondary market transactions. This contradiction reflects that the SEC's regulatory strategy in the digital asset field needs to be adjusted on a case-by-case basis, and in the future, it may seek to compensate for these limitations through more granular regulation of issuer behavior. Additionally, it triggers market volatility and affects the direction of industry development. The signals sent by the Terraform case and the Ripple case to the market are starkly different. The Terraform case is seen as support for the SEC's regulatory power, increasing market expectations for strict regulation, which might suppress innovation in cryptocurrency. In contrast, the Ripple case is viewed as a victory for the cryptocurrency industry, boosting market sentiment and temporarily raising the prices of digital assets. This dual impact may lead the market to exhibit more pronounced volatility in the near future. Furthermore, such repeated judicial rulings may provide impetus for legislative clarification. The differences in the rulings of the two cases indicate that existing securities laws are insufficient to address the complexities of digital assets. The outcomes of the Ripple and Terraform cases may prompt the U.S. Congress to further advance specialized legislation on digital assets to clarify their legal attributes and regulatory scope. Only through systematic legislation can the current regulatory ambiguities caused by divergent judicial interpretations be resolved. In this regard, the FIT21, pending Senate vote, may improve the situation.
