Written by: TaxDAO
For details of the previous article, please see: (18 US states jointly sued the SEC, what are the chances of both parties winning (Part 1))
3. Two iconic 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, established in 2012, and is one of the earliest pioneers in the blockchain field. XRP aims to serve as a bridge tool to facilitate financial transactions, primarily targeting financial institutions.
In December 2020, the SEC sued 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, akin to stocks or bonds, and therefore must strictly comply with relevant provisions of securities laws, including registration with the SEC and providing sufficient information disclosure to investors. However, Ripple did not fulfill these obligations, violating securities laws. Ripple defended itself by claiming that XRP is a digital currency, functioning more like Bitcoin or Ethereum. At the same time, XRP does not meet the standards outlined in the Howey Test and cannot be classified as securities.
The SEC's lawsuit has caused a huge wave in the cryptocurrency industry. This is the first time the SEC has filed a lawsuit against mainstream cryptocurrencies that are already in circulation, symbolizing a broader conflict between digital asset innovation and regulation.
3.1.2 Ruling Results
In July 2023, the court ruled that XRP (and all cryptocurrencies) are not securities when sold to the public on exchanges, but are considered securities when sold to institutional investors. This ruling triggered a strong market reaction, directly leading to a 70% increase in XRP's price.
In August 2024, the case reached its final ruling. Regarding whether XRP should be classified as 'securities,' the court distinguished between sales scenarios. On one hand, there are institutional direct sales. The judge believed these sales meet the Howey Test, as institutions purchase Ripple's tokens with the expectation of profit from the increase in value, constituting a typical investment contract and 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 seller is and have no established profit expectation with Ripple. Such programmatic sales do not meet the standards for determining investment contracts and therefore do not constitute securities issuance. Ultimately, the court ordered Ripple to pay a civil fine of approximately $125 million, far less than the nearly $2 billion initially requested by the SEC but higher than Ripple's intention to set a cap on the fine at $10 million.
In terms of results, both Ripple and the SEC achieved certain victories in this case. For Ripple, it does not have to pay the huge fines 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 to the SEC filing a Notice of Appeal in October 2024, intending to appeal certain rulings of the district court to the federal Second Circuit Court. According to the response from the federal Second Circuit Court, the SEC must submit its appellate opening statement by January 15, 2025, hence the ruling results of this case also have a certain potential to be overturned.
3.1.3 Subsequent Impact
Regarding the subsequent impact of the case, on one hand, the Ripple case clarified the importance of transaction methods in the classification of crypto assets. In the Ripple case, the court ruled that the act of selling XRP to the public through the secondary market does not constitute a securities transaction, indicating that the manner of selling or trading crypto assets will affect their classification. On the other hand, this case will, to some extent, limit the SEC's regulatory scope over crypto assets. Unless the SEC succeeds in the appellate court, otherwise, in the precedent-following U.S., the ruling results of this case will be binding, preventing the SEC from classifying a large number of crypto assets as securities and bringing them under regulatory supervision.
Overall, the Ripple case marks an important victory for the cryptocurrency industry in its battle against strong regulatory models. This ruling not only boosts the confidence of cryptocurrency practitioners and warms market sentiment but may also become a significant 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 crypto assets, and its founder Do Kwon attracted investors in the secondary market by designing and selling various crypto assets, including its native stablecoin UST and token LUNA. The UST coin is pegged to the U.S. dollar, while its stability 'algorithmically' relies on the support of its sister token LUNA. However, Terraform's stabilization mechanism encountered severe problems 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, its value plummeted rapidly, causing LUNA to also lose value. This collapse resulted in over $40 billion in market capitalization losses and also affected other cryptocurrencies, including Bitcoin, leading to multiple companies filing for bankruptcy in 2022.
In February 2023, the U.S. Securities and Exchange Commission (SEC) accused Terraform Labs and its founder Do Kwon of engaging in a fraudulent scheme involving billions of dollars in unregistered crypto asset securities. The SEC believes that Terraform attracted investors through multiple misleading 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, the 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 approximately $467 million in pre-judgment interest. Do Kwon must pay $110 million in illegal gains and $14.3 million in pre-judgment interest jointly 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 process.
3.2.2 Ruling Results
The core of the Terraform case's ruling lies in the recognition of the legal attributes of UST and LUNA. The court held that purchasers of these crypto assets reasonably expect their tokens to generate profits and view these tokens as a profitable investment, thus meeting the definition of an investment contract in the Howey Test. The court further ruled that all related crypto assets created by Terraform, including UST and LUNA, meet the definition of investment contracts under the Securities Act of 1933 and should be classified as securities.
It is noteworthy that regarding the situation of the eighteen states suing the SEC, the court responded to the defense presented by Terraform concerning the Major Questions Doctrine. The Major Questions Doctrine requires: 'In special cases, when an agency claims to have the authority to regulate a significant portion of the U.S. economy with great economic and political significance, it must point to a clear authorization from Congress for that power.' The court found that: (1) there is almost no comparability between Terra Labs and cases applicable to the Major Questions Doctrine (e.g., cases involving the U.S. tobacco and energy industries). (2) The SEC's implementation of regulation in determining that certain crypto assets are securities does not constitute a transformative expansion of its regulatory power.
At the same time, similar to the reasons cited by eighteen states, Terraform has claimed that the SEC violated the Administrative Procedure Act. The court rejected 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 new policies in this case but simply enforced its previously established policies. The court also confirmed that the SEC's complaint sufficiently accused Terraform of providing and selling tokens like LUNA as equivalent to the illegal public offering of unregistered securities, making false or misleading statements during the issuance process and profiting from it.
3.2.3 Subsequent Impact
The ruling results of the Terraform case supported the SEC's regulatory stance, drawing widespread attention in the crypto asset industry. Specifically: Firstly, it again proposed a method for classifying crypto assets. The Terraform case indicates that crypto assets traded in the secondary market can be recognized as securities as long as they pass the Howey Test, especially if they meet investors' reasonable profit expectations based on the issuer's efforts. Secondly, it reinforced the SEC's regulatory power over the crypto market. In enforcement processes, the ruling of the Terraform case has been cited by the SEC in lawsuits against other crypto asset exchanges, such as Binance and Coinbase, which may further promote comprehensive regulation of the digital asset market by the SEC. Thirdly, it issued a warning to the crypto industry, urging practitioners to pay attention to the legal risks in the design and marketing processes of crypto assets.
3.3 Summary
While both the Terraform case and the Ripple case revolve around the classification of crypto assets, there are significant differences in their ruling outcomes. In the Ripple case, the court concluded 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 the legal uncertainty in the digital asset space. The ruling in the Ripple case emphasized the importance of transaction methods, stating that anonymous transactions in the secondary market do not necessarily meet the requirements of a 'common enterprise' or 'profit relying on the efforts of others' as defined in the Howey Test. In contrast, the Terraform case focused more on the profit expectations of investors 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 the investor's returns, it can still be classified as securities trading. This difference in legal application adds uncertainty to the digital asset industry.
Secondly, the impact on the SEC's regulatory strategy could lead to fluctuations in the SEC's regulatory stance. In the Terraform case, the SEC's claims were supported by the court, strengthening its regulatory power over secondary market crypto asset 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 compensate for these limitations by implementing more detailed regulations targeting the issuer's behavior.
At the same time, it has triggered market fluctuations and affected the direction of industry development. The Terraform case and the Ripple case send entirely different signals to the market. The Terraform case is viewed as a support for the SEC's regulatory power, increasing market expectations for strict regulation, potentially suppressing innovation in crypto assets. Conversely, the Ripple case is seen as a victory for the cryptocurrency industry, uplifting market sentiment and temporarily boosting the prices of digital assets. This dual impact may lead to more pronounced market volatility in the near future.
Furthermore, such repeated judicial rulings may provide momentum for legislative clarification. The differences in the rulings of the two cases indicate that existing securities laws are inadequate in addressing the complexities of digital assets. The outcomes of the Ripple and Terraform cases may prompt the U.S. Congress to further push for specialized legislation on digital assets to clarify their legal attributes and regulatory scope. Only through systematic legislation can the current regulatory ambiguities caused by judicial interpretation differences be resolved. In this regard, the FIT21 bill, pending a Senate vote, may improve the situation.
4. The Litigation Motives and Chances of Winning for Eighteen States
4.1 Analysis of Litigation Motives
The joint lawsuit by eighteen states against the SEC for its regulation of the cryptocurrency industry violates the constitution, essentially attempting to limit the SEC's regulatory expansion over the cryptocurrency industry through judicial means, while also vying for more autonomy for state rights within the constitutional framework. The possible motivations for the eighteen states to file the lawsuit include: firstly, forming universally applicable legal rules through constitutional rulings. In recent years, the SEC has imposed securities regulatory requirements on a large number of digital assets by expanding the application of the Howey Test, leading to widespread controversy both within and outside the industry. The eighteen states chose to raise constitutional challenges based on the First and Tenth Amendments of the U.S. Constitution, intending to negate the SEC's enforcement actions from a constitutional level through a federal court ruling. If the U.S. Supreme Court ultimately supports the claims of the eighteen states, this ruling will have nationwide binding force, providing a legal precedent for future similar disputes and forcing the SEC to adjust its regulatory strategy.
Secondly, to restrain administrative power and prevent policy continuity. Currently, the SEC, under the leadership of Gary Gensler, has adopted stringent crypto policies, including intensive enforcement actions against crypto companies like Ripple and Terraform, along with hefty fines. This regulatory model has severely suppressed industry development and infringed upon state governments' autonomy. Through this lawsuit, the eighteen states aim not only to curb the current SEC chairman's strong regulatory actions but also to establish legal boundaries for future governments to prevent the continuation of similar policies.
Thirdly, filling the legislative gap and promoting industry development. Federal legislation in the United States regarding digital assets is still incomplete, and disputes over the attributes of digital assets and their regulation have long existed. By promoting judicial rulings, the cryptocurrency industry can establish case law under the existing legal framework, providing a clearer compliance path for the digital asset industry while creating a more favorable environment for innovation and development.
4.2 Favorable Conditions and Adverse Factors
In summary, the choice of the eighteen states to file a lawsuit after the Republican Party, represented by Trump, won the election creates many favorable conditions for victory, while also facing numerous uncertainties.
From favorable conditions: firstly, the policy stance of the Trump administration. Incoming President Trump has clearly expressed support for the cryptocurrency industry and announced changes to the SEC chairmanship. The new chair nominated by Trump may adopt a more relaxed regulatory policy, potentially reducing the SEC's confrontational stance in this case, making the court's ruling more likely to protect the cryptocurrency industry. Secondly, the conservative inclination of the Supreme Court. This case involves constitutional issues, and the U.S. Supreme Court has final authority over cases related to the Constitution. Currently, the conservative justices hold a majority, and justices like Thomas and Alito tend to support state rights in matters of federal versus state authority. This political inclination may give the eighteen states more support in their assertion of the SEC's unconstitutionality. At the same time, conservative judges are more receptive to claims that limit the power of federal administrative agencies, providing favorable conditions for winning the case. Finally, there is widespread support from the industry. There is broad criticism of current SEC regulatory policies within and outside the cryptocurrency industry, with many companies believing that strict regulatory requirements stifle technological innovation and increase compliance costs, leading to a strong desire to break the strict regulatory model.
However, there are also real adverse factors: firstly, judicial uncertainty. The U.S. judicial system lacks a unified standard for identifying digital assets. In the Terraform case, the court rejected similar defenses based on the 'Major Questions Doctrine' and the 'Administrative Procedure Act,' which may serve as an unfavorable reference in this case. Additionally, the differences in how state courts define digital assets increase the difficulty for the eighteen states to win the case. Secondly, the time and resource costs are high. The case was initiated in a local district court and may go through multiple appeal stages until it reaches the Supreme Court. The lengthy judicial process requires substantial time and resources, and the regulatory uncertainty during the case's progression may negatively impact industry development in the short term. Moreover, the eighteen states will need to continuously respond to the SEC's defenses during the judicial process, putting significant pressure on their policies and litigation resources. Thirdly, legislative progress is slow. As mentioned earlier, although the House of Representatives has passed the FIT21 bill in an attempt to clarify the regulatory framework for digital assets, there has been no substantial progress in the Senate. Therefore, the future passage of the bill may still face obstacles. This legislative gap may lead to courts being more inclined to maintain the status quo rather than making substantive limitations on administrative power through rulings.
Overall, considering the current control of administrative and judicial power by the Republican Party represented by Trump, as well as the industry's protests against strong regulatory models, the eighteen states have a certain chance of winning in this lawsuit. A friendly government policy towards the cryptocurrency industry will provide potential positive momentum for winning the case, and the conservative inclination of the Supreme Court may support claims of unconstitutionality. However, this case also faces issues of slow legislative progress and judicial discretion uncertainty, especially regarding how to persuade the court to impose substantive limitations on SEC policies will be key to the case's success or failure.
5. Summary and Outlook
The lawsuit filed by eighteen states against the SEC is a significant game involving constitutional principles and the future of digital asset regulation. Although it has some chance of success, the case still faces multiple challenges at the judicial and policy levels. Regardless of the final outcome, this case will have a profound impact on the legal and policy landscape of the U.S. cryptocurrency industry.
If the court ultimately rules that the SEC's regulatory policy is unconstitutional, it will directly limit its regulatory scope over digital assets, potentially leading to a greater decentralization of regulatory authority to the CFTC or state governments, thereby forming a more decentralized and diverse regulatory system. Such changes would help alleviate the current overly strict regulatory style of the SEC, create a more friendly development environment for the cryptocurrency industry, and potentially clarify the classification of crypto assets, reducing the industry's disputes over the applicability of the Howey Test and enhancing compliance certainty. This case will also have significant implications for the rebalancing of state and federal relations. State governments may devise regulatory policies that better meet local needs, forming a competitive regulatory landscape and promoting the U.S. leading position in the digital asset field. Furthermore, the reduction of regulatory pressure may greatly stimulate industry innovation. Companies will be able to experiment with new technologies and business models in a more relaxed environment, promoting the widespread application of digital assets, especially in the decentralized finance (DeFi) and cross-border payment sectors, which may benefit significantly.
However, the case rulings may also bring new risks and challenges. Policy changes may trigger market volatility, especially during the trial period when investors are sensitive to regulatory uncertainties. Furthermore, if regulatory authority is decentralized to state governments, policy differences among states may increase compliance complexity for businesses operating across state lines. Additionally, international competitive pressure may also intensify. Regions such as the EU and Singapore have made certain progress in digital asset regulation, and if the U.S. regulatory framework becomes too fragmented, it may weaken its competitiveness in the global market.
Overall, the lawsuit filed by eighteen states against the SEC is an important milestone in the development of the U.S. cryptocurrency industry, providing an opportunity to fight for more favorable regulatory policies. In the future, the healthy development of the U.S. cryptocurrency industry will require a balance between regulation and innovation, and with reasonable judicial rulings, the U.S. has the opportunity to continue leading global innovation and growth in the digital asset field.
