A US regulator has filed charges against Terraform, the company behind the TerraUSD stablecoin and its former CEO Do Kwon, accusing them of orchestrating a $40bn securities fraud.
In the complaint filed by the Securities and Exchange Commission (SEC), Do Kwon and Singapore-based Terraform Labs are accused of perpetrating a fraudulent scheme that led to “devastating losses” for US investors.
From its founding in 2018 to its collapse in May last year, Terraform is alleged to have misled investors into purchasing a range of crypto-asset securities, including TerraUSD and its collateral token, LUNA.
The complaint notes that Terraform’s crypto-asset securities offerings involved an array of inter-related tokens that were created, developed, offered and sold by the defendants as profit-seeking investments.
Both Terraform and Do Kwon marketed these crypto-assets to investors in the US and abroad, repeatedly claiming that the tokens would increase in value.
The SEC notes that, up until April 2022, the defendants’ efforts to lure money into the Terraform “ecosystem” had been extremely successful.
At that time, LUNA was among the ten highest valued crypto-assets in the world, and TerraUSD had a market value of $17bn.
But even prior to TerraUSD’s unravelling in May 2022, Terraform is accused of fraudulently papering over the cracks in its “algorithmic stablecoin” experiment, by arranging third parties to artificially prop up TerraUSD and the wider ecosystem.
In May 2021, the price of TerraUSD fell below $1 and was not quickly restored by the underlying algorithm. The defendants allegedly arranged for an unnamed third party to buy “massive amounts” of TerraUSD to restore its peg to $1.
After the episode, Terraform and Do Kwon publicly celebrated the restoration of the peg as a triumph for decentralisation and the “automatic self-healing” that was supposedly inherent to the TerraUSD algorithm.
In one instance, the defendants described the episode as a “black swan” that was “as intense of a stress test in live conditions as can ever be expected”.
Over the following year, investors poured billions into LUNA and TerraUSD, but the ecosystem collapsed abruptly in May 2022 when TerraUSD lost its peg once again and Terraform was unable to find outside help to restore it.
"As alleged in our complaint, the Terraform ecosystem was neither decentralised, nor finance,” said Gurbir Grewal, director of the SEC’s Division of Enforcement.
“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."
As the Terraform ecosystem was collapsing, the SEC also alleges that the defendants withdrew more than 10,000 bitcoin for themselves to an unhosted wallet address.
Since June last year, the defendants have allegedly converted $100m of that bitcoin to cash using a Swiss financial institution.
When stablecoins become securities
The SEC has charged Terraform and Do Kwon with violating the registration and anti-fraud provisions of both the 1933 Securities Act and the 1934 Exchange Act.
On the first page of the complaint, the SEC makes clear that, under federal law, the term “security” includes any “investment contract”, “security-based swap” or “receipt for a security”.
“Investment contracts are instruments through which a person invests money in a common enterprise and reasonably expects profits or returns derived from the managerial or entrepreneurial efforts of others,” the complaint notes.
In the 1946 case of SEC v Howey, Congress defined “security” broadly to embody a “flexible rather than static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits”.
In its complaint, the SEC has characterised all of Terraform’s crypto-asset offerings as securities, including TerraUSD.
Due to Terraform's clear marketing of these products as for-profit investments, the SEC sees little cause for opposition to this characterisation.
In September 2020, for example, Terraform and Do Kwon began publicly marketing TerraUSD as a “yield-bearing” stablecoin, encouraging investors to purchase TerraUSD and deposit it in the Anchor Protocol.
The Anchor Protocol is a decentralised finance (defi) platform created by Terraform, where users could earn 19-20 percent APR by loaning out their TerraUSD to others on the platform.
By May 2022, the complaint notes that almost three quarters of the entire supply of TerraUSD was deposited in the Anchor Protocol.
Registration violation claims
Although Terraform marketed TerraUSD and other crypto-assets as profit-making investments, it failed to register the offer or sale of these crypto-assets as securities in compliance with federal law.
According to the SEC, these violations were exacerbated by the defendants’ use of US communications and banking systems to reach new investors, some of whom lost their “life savings” in Terraform products.
Do Kwon and other Terraform executives also travelled to the US to solicit investors, and Terraform had a sponsorship deal with the Washington Nationals baseball team, allowing it to have the word "Terra" printed on every seat in certain areas of the stadium.
The SEC’s wide-ranging complaint against Terraform and TerraUSD offers a strong indication that US regulators plan to regulate all stablecoins as securities going forward.
As reported by VIXIO PaymentsCompliance this week, the SEC has also signalled that it intends to sue Paxos, issuer of the Binance USD stablecoin, for the offer and sale of unregistered securities.
This would likely have a profound effect on other stablecoin issuers who have, likewise, failed to register their product as a security and make disclosures of the same to investors.