The Securities and Exchange Commission filed a civil fraud lawsuit against Singapore-based Terraform Labs and its CEO Do Kwon in Manhattan federal court on Thursday. The suit accused them of misleading investors on a number of issues, including a partnership with the Korean mobile payment app Chai and the stability of the UST dollar peg.
"We allege that Terraform and Do Kwon failed to provide the public with full, fair, and truthful disclosure as required for a host of crypto asset securities, most notably for LUNA and Terra USD," SEC Chair Gary Gensler said in a press release. "We also allege that they committed fraud by repeating false and misleading statements to build trust before causing devastating losses for investors."
Unlike fiat-collateralized stablecoins, which are issued by centralized entities that hold 1:1 cash and bonds reserves to back their tokens, UST’s peg was maintained algorithmically, where $1 worth of Luna was burnt to mint one UST, and vice versa. When May 2022 market panic spurred a UST sell-off and most stablecoin pools were already drained, holders rushed to exit the toxic asset by burning UST in exchange for Luna, hyperinflating the token as its supply entered trillions and the price crashed to a fraction of a penny.
Terra’s swift demise wiped around $60 billion off the crypto market, devastating both retail and institutional investors and setting off a domino chain of failures and liquidations across the industry. Terra founder, Do Kwon, has since been on the run and is subject to an active Interpol Red Notice. According to the latest investigation by a South Korean intelligence department, the fugitive crypto CEO now resides in Serbia.
The SEC claims that virtually all assets within the Terra ecosystem were unregistered securities, including yield-bearing Anchor Protocol, UST stablecoin, LUNA, wLUNA (wrapped Luna), MIR token, and Mirror Protocol’s synthetic mAssets.
According to Gabriel Shapiro, a general counsel at Delphi Labs and a member of the LeXpunK group of crypto lawyers, the SEC’s rationale for declaring UST security lays the ground for further enforcement action against other stablecoin issuers. And given the regulator's recent crackdown on Binance’s BUSD stablecoin, this is a particularly worrying trend when considering how stablecoins are essentially a backbone of DeFi.
"You can expect the argument for UST being a security to be a roadmap for how the SEC goes after other stablecoins. They will allege that integration, promotion, marketing, commercial deals, etc. building the stablecoin ecosystems are 'efforts of others' that are 'reasonably expected' and can lead to profits in connection with the stables," Shapiro wrote in his Twitter thread. "This is why I've been saying that stables might even pass the Howey test (never mind other types of securities tests like Reves), despite them being ‘stable’."
The SEC also alleges that Terraform Labs misleadingly touted to investors its partnership with Chai, a Seoul-based fintech startup founded by Terraform Labs co-founder Daniel Shin.
"Specifically, Terraform and Kwon repeatedly claimed that a Korean company, Chai Corporation, used the Terraform blockchain to process and settle millions of transactions for Korean consumers at retail establishments, such as online stores, movie theaters, and convenience stores," the lawsuit reads.
In reality, Chai transactions were never settled on Terra — but Do Kwon engaged in an elaborate hoax to create an impression that they were.
"To further deceive investors, Terraform and Kwon recorded completed Chai transactions onto the Terraform blockchain to make it appear as if they were processed on the blockchain when, in fact, they were not. The purported ‘real-world use’ of the Terraform blockchain was a literal fabrication," the regulator says.
In a press release, SEC’s Division of Enforcement Director Gurbir S. Grewal said that Terraform ecosystem "was neither decentralized, nor finance."
"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," he added.