Courts Continue Grappling With Whether Cryptocurrencies Are Securities and Whether Digital Trading Platforms Are Liable for Securities Violations

The first week of April was a busy one for crypto litigation with key developments in two closely watched cases in the Southern District of New York (SDNY) and the Second Circuit that directly confront two critical questions with respect to digital assets: (i) Is the sale of cryptocurrency tokens on a digital trading platform a securities transaction that is subject to U.S. federal securities laws and regulations? (ii) Can digital trading platforms be held liable for violations of securities laws in connection with cryptocurrency transactions? These recent cases and their tension with other cases show that the interplay of U.S. Securities laws and digital assets is still awash with uncertainty.

On April 5, 2024, in the SDNY case SEC v. Terraform Labs Pte Ltd.,a jury found the cryptocurrency issuer, Terraform Labs, and its creator, Do Kwon, civilly liable for securities fraud.¹ This verdict comes after the presiding judge, Judge Rakoff denied defendants’ motion to dismiss the case on July 31, 2023.² In denying the motion to dismiss and applying the longstanding Howey test to determine whether an asset is a security, Judge Rakoff, ruled that the SEC had adequately pleaded that the defendants had promoted its cryptocurrency token, LUNA, as a profitable investment and was thus offering and selling securities requiring registration under U.S. Securities laws.³ Judge Rakoff’s determination that Terraform’s token was a security resulted in the case going to trial and in a securities fraud verdict. Terraform (which sought bankruptcy protection following Judge Rakoff’s denial of the motion to dismiss),⁴ has stated that it will appeal Judge Rakoff’s determination that it had offered and sold unregistered securities. The critical question on that appeal will be whether Judge Rakoff’s decision that Terraform was engaged in securities transactions was correct.

The likely Terraform appeal sets up a showdown with another cryptocurrency token case in the SDNY, SEC v. Ripple Labs, Inc. In that case, Judge Torres issued a summary judgment ruling—just over two weeks before Judge Rakoff denied the motion to dismiss in Terraform—in which she held that certain of Ripple’s sales of its XRP tokens were not securities transactions subject to securities laws.⁵ While facts and the applicable standards (motion to dismiss vs. summary judgment) in the Terraform and Ripple cases differ in substantial ways, the fact remains that Judge Rakoff considered (and rejected) Judge Torres’ reasoning in the Ripple case in reaching the opposite conclusion in the Terraform case. Given that the SEC has already sought leave to file interlocutory appeal in the Ripple case (which was denied), it is only a matter of time until the Second Circuit has an opportunity to confront and resolve the incongruencies between the Terraform and Ripple rulings. Until then, companies issuing or selling crypto tokens face a substantial possibility that they will be required to comply with all applicable U.S. securities laws or face substantial liability like the defendants in Terraform.

Related to the question of whether cryptocurrency tokens are securities, is the question of who can be held liable for damages resulting from any potential securities violations involving cryptocurrency tokens. The most recent decision on that question is the Second Circuit’s April 5, 2024, unanimous summary order in Underwood v. Coinbase Global Inc. In Underwood, the three-judge panel reversed the district court and brought back to life a putative securities class action against the cryptocurrency trading platform Coinbase on the basis that plaintiffs had adequately pleaded that Coinbase—the digital trading platform, not the token issuer—had held title to the digital assets traded on its platform and was therefore subject to liability for securities violations.⁶

The Underwood ruling represents a significant development because it shows that not only can cryptocurrency issuers (like Terraform) be considered “sellers” of securities subject to securities regulations and liable for securities fraud, so too can secondary trading platforms like Coinbase in certain circumstances. If that conclusion is widely adopted by U.S. courts, legislators, and regulators, it will have serious implications for all secondary trading platforms who will be required to register as broker-dealers with the SEC and comply with securities regulations or risk civil (and potentially criminal) liability for securities violations.

The Underwood case is in tension with a different case from the SDNY that has also been appealed to the Second Circuit: Risley v. Universal Navigation Inc.⁷ In Risley, Plaintiffs filed a putative securities class action against a decentralized cryptocurrency trading platform and various of its investors alleging that they purchased fraudulent crypto tokens on the exchange. The court assumed without deciding (a growing trend in SDNY courts) that the cryptocurrency tokens in question were securities. The Court still dismissed Plaintiffs’ claims, however, because Plaintiffs could not identify who actually defrauded them, given the decentralized nature of the trading platform. In contrast to the Underwood holding, in Risley, the district court drew a stark line and held that the defendant trading platform and its investors cannot be held liable for simply creating or investing a trading platform that traders use to commit fraud.⁸ In this light, the Second Circuit’s forthcoming ruling in the Risley case will be very instructive, because regardless of the conclusion, it will undoubtedly reveal new contours on how courts will determine when a digital cryptocurrency trading platform can be held liable for securities violations.

While the regulation of digital assets in the United States remains a fast-evolving and competing patchwork of state and federal judicial, regulatory, and legislative initiatives, what is becoming very clear is that digital assets will be subject to increasing regulation at the federal level. It is also becoming increasingly clear that under any future regulatory/legislative/judicial regime, some substantial portion of participants in the digital asset ecosystem—whether issuers or exchanges—will be subject to securities regulations.

Stay tuned as we continue monitoring these cases and others and look out for our next article where we will delve more deeply into current legislative and regulatory initiatives and priorities in the digital asset space.

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If you have any questions or would like to further discuss the legal developments in digital assets, please reach out to Natalie Shkolnik at (212) 981 2294, nshkolnik@wilkauslander.com or David Partida at (212) 981 2313, dpartida@wilkauslander.com.

[1] Verdict, SEC v. Terraform Labs Pte. Ltd., No. 1:23-cv-01346 (S.D.N.Y. July 31, 2023), ECF No. 229.

[2] Opinion and Order, SEC v. Terraform Labs Pte. Ltd., No. 1:23-cv-01346 (S.D.N.Y. July 31, 2023), ECF No. 51.

[3] Id. at pp. 40-41.

[4] Form 201, In re Terraform Labs Pte. Ltd., No. 24-10070 (D. Del. January 1, 2024), ECF No. 1.

[5] Opinion and Order, SEC v. Ripple Labs, Inc., No., 20-cv-10832 (S.D.N.Y. July 13, 2023), ECF No. 874.

[6] Summary Order, Underwood v. Coinbase Global Inc., No. 23-184 (2^nd Cir. April 5, 2024), ECF No. 110 at pp. 8-9.

[7] Id. 2023 WL 5609200 (S.D.N.Y August 29, 2023).

[8] Id. 2023 WL 5609200 at *11.