The legal battle between Terraform Labs, the company behind the Terra blockchain and its native token LUNA, and the U.S. Securities and Exchange Commission (SEC) is heating up. The SEC has accused Terraform Labs and its co-founder and CEO Do Kwon of conducting an unregistered securities offering of LUNA tokens worth over $150 million in 2019 and 2020. The SEC also claims that Kwon and his company misled investors about the nature and profitability of the Terra project, which aims to create a decentralized and stable global payment system.
Terraform Labs and Kwon have denied the SEC’s allegations and challenged the SEC’s expert testimony in a recent court filing. They argue that the SEC’s expert, Professor John Griffin, has failed to provide a reliable and relevant analysis of the LUNA token and its economic functions. They also contend that the SEC’s complaint is based on a flawed and outdated understanding of the Terra ecosystem and its innovative features.
What are Terra and LUNA?
Before we dive into the legal dispute, let us briefly explain what Terra and LUNA are and how they work. Terra is a blockchain platform that supports various applications, such as e-commerce, gaming, and social media. The main goal of Terra is to create a stable and scalable global payment system that can compete with traditional fiat currencies and payment networks.
To achieve this goal, Terra uses a dual-token model that consists of LUNA and Terra stablecoins. LUNA is the native token of the Terra blockchain and serves as a governance and staking token. LUNA holders can vote on the network’s parameters and upgrades, as well as stake their tokens to secure the network and earn rewards. LUNA also acts as collateral for the Terra stablecoins, which are pegged to various fiat currencies, such as the U.S. dollar (UST), the Korean won (KRT), and the euro (EUT).
Terra stablecoins are algorithmic and decentralized, meaning that they are not backed by any physical assets or centralized entities. Instead, they rely on a smart contract mechanism that adjusts the supply and demand of the stablecoins to maintain their pegs. The mechanism works as follows: when the demand for a stablecoin increases, the smart contract mints new stablecoins and sells them for LUNA, increasing the supply of LUNA and decreasing its price. Conversely, when the demand for a stablecoin decreases, the smart contract burns the excess stablecoins and buys back LUNA, decreasing the supply of LUNA and increasing its price. This way, the stablecoins can maintain their pegs while LUNA absorbs the price volatility.
Terra stablecoins can be used for various purposes, such as payments, remittances, savings, lending, and trading. Terra has partnered with several platforms and merchants, such as Chai, Mirror, Anchor, and MemePay, to facilitate the adoption and usage of its stablecoins. According to Terraform Labs, Terra processed over $10 billion in transaction volume and had over 2.5 million users in 2020.
What are the SEC’s allegations?
The SEC filed a complaint against Terraform Labs and Kwon in December 2020, alleging that they violated the federal securities laws by conducting an unregistered securities offering of LUNA tokens. The SEC claims that LUNA tokens are securities under the Howey test, which is a four-pronged test that determines whether an asset is a security based on whether it involves:
- An investment of money
- In a common enterprise
- With a reasonable expectation of profits
- Derived from the efforts of others
The SEC argues that LUNA tokens meet all four prongs of the Howey test, because:
- Terraform Labs and Kwon raised over $150 million from investors in exchange for LUNA tokens in 2019 and 2020, through various sales and distributions, such as initial exchange offerings (IEOs), private placements, and airdrops.
- Terraform Labs and Kwon created a common enterprise with the LUNA investors, as they pooled the funds raised from the sales and distributions to develop and operate the Terra network and its applications.
- Terraform Labs and Kwon led the LUNA investors to reasonably expect profits from their investment, as they made various statements and representations about the potential growth and profitability of the Terra project, such as the increasing adoption and usage of the Terra stablecoins, the increasing demand and value of LUNA tokens, and the increasing rewards and dividends for LUNA holders.
- Terraform Labs and Kwon were the primary drivers of the success of the Terra project, as they controlled the development, governance, and marketing of the Terra network and its applications, and exerted significant influence over the LUNA token and its price.
The SEC also alleges that Terraform Labs and Kwon misled the LUNA investors by making false or misleading statements about the nature and profitability of the Terra project, such as:
- Claiming that the Terra network was fully decentralized and autonomous, while Terraform Labs and Kwon could intervene and manipulate the network and its parameters, such as the supply and demand of the stablecoins and the rewards and dividends for LUNA holders.
- Claiming that the Terra stablecoins were fully backed by LUNA tokens, while in fact, the collateralization ratio of LUNA to stablecoins was often below 100%, exposing the stablecoins to the risk of debugging and insolvency.
- Claiming that the Terra project was compliant with the relevant laws and regulations, while Terraform Labs and Kwon failed to register LUNA tokens as securities or obtain any exemptions or licenses from the SEC or other regulators.
The SEC seeks to enjoin Terraform Labs and Kwon from further violating the securities laws and to impose civil penalties and disgorgement of ill-gotten gains on them.
What are Terraform Labs and Kwon’s defenses?
Terraform Labs and Kwon have denied the SEC’s allegations and filed a motion to dismiss the complaint in February 2021. They argue that the SEC’s complaint is based on a flawed and outdated understanding of the Terra ecosystem and its innovative features. They also challenge the SEC’s expert testimony, which they claim is unreliable and irrelevant.
Terraform Labs and Kwon contend that LUNA tokens are not securities under the Howey test, because:
- Terraform Labs and Kwon did not raise any funds from the public in exchange for LUNA tokens, but rather distributed LUNA tokens to various participants and contributors of the Terra network, such as validators, developers, and users, as a reward for their services and activities.
- Terraform Labs and Kwon did not create a common enterprise with the LUNA holders, as they did not pool any funds or share any profits or losses with them. Rather, each LUNA holder acted independently and assumed the full risk and reward of their own investment.
- Terraform Labs and Kwon did not lead the LUNA holders to reasonably expect profits from their investment, as they did not make any promises or guarantees about the future performance or value of the Terra project or the LUNA token. Rather, they provided factual and transparent information about the Terra network and its applications and encouraged the LUNA holders to conduct their own research and due diligence.
- Terraform Labs and Kwon were not the primary drivers of the success of the Terra project, as they did not control or influence the Terra network and its applications, or the LUNA token and its price. Rather, they delegated the development, governance, and marketing of the Terra network and its applications to the community of validators, developers, and users, who collectively determined the direction and outcome of the Terra project.
Terraform Labs and Kwon also assert that they did not mislead the LUNA holders by making false or misleading statements about the nature and profitability of the Terra project, as they did not conceal or misrepresent any material facts or risks about the Terra network and its applications, or the LUNA token and its price. Rather, they disclosed and explained the technical and economic aspects and challenges of the Terra project, and complied with the applicable laws and regulations.