18 US states jointly sued the SEC. What are the chances of both parties winning?

Author:TaxDAO

For the first half of this article, please refer to "18 US states jointly sued the SEC. What are the chances of both parties winning (Part 1)"

3. Two iconic US crypto 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 angles, which triggered a strong reaction from the crypto industry. The focus of the dispute in the two cases is highly similar to that of this case. Both cases discussed the qualitative and regulatory issues of crypto assets, which has an important reference role in the direction of future judgments in this case. 3.1 Ripple Case 3.1.1 Basic Facts Ripple Labs, the holder of Ripple and its native cryptocurrency token XRP (Ripple), was established in 2012 and is one of the earliest pioneers in the blockchain field. XRP is designed to facilitate financial transactions as a bridge tool, and its customer base is mainly financial institutions. In December 2020, the SEC filed a lawsuit against Ripple Labs and its CEO Brad Garlinghouse and co-founder Chris Larsen, accusing them of illegally issuing securities through the sale of cryptocurrency XRP, with a total financing of more than US$1.3 billion. The SEC believes that XRP is essentially an investment contract, similar in nature to stocks or bonds, and should therefore strictly comply with the relevant provisions of the securities law, including registration with the SEC and providing investors with adequate information disclosure. However, Ripple failed to fulfill these obligations and violated securities laws. Ripple argued that XRP is a digital currency that functions more like Bitcoin or Ethereum. At the same time, XRP does not meet the standards set by the Howey test and cannot be classified as a security. The SEC's lawsuit has set off a huge wave in the crypto industry. This is the first time that the SEC has filed a lawsuit against a mainstream cryptocurrency that has already been in circulation, symbolizing the broader conflict between digital asset innovation and regulation. 3.1.2 Judgment In July 2023, the court ruled that XRP (and all cryptocurrencies) were not securities when sold to the public on exchanges, but were securities when sold to institutional investors. The ruling triggered a strong market reaction, directly leading to a 70% increase in the price of XRP. In August 2024, the case was finally decided. As to whether XRP should be identified as a "security", the court used sales scenarios to distinguish. On the one hand, there are direct sales by institutions. The judge believed that such sales met the Howey test. Institutions purchased XRP directly from Ripple with the purpose of expecting to profit from the increase in the value of XRP. This was a typical investment contract behavior and belonged to securities issuance. On the other hand, XRP sold programmatically in the open market was not a security. The judge pointed out that the open market buyers did not know who the seller was and did not establish profit expectations with Ripple. This programmatic sales did not meet the criteria for determining an investment contract and therefore did not belong to securities issuance. In the end, the court ruled that Ripple pay a civil penalty of approximately $125 million, which was far lower than the nearly $2 billion fine initially requested by the SEC and higher than Ripple's original intention to limit the fine to $10 million.

From the results, both Ripple and the SEC have achieved certain victories in the case. For Ripple, it does not have to pay the huge fine required by the SEC, and the SEC is not without gain. But it is obvious that the SEC's expectations were greatly disappointed, which led the SEC to file a notice of appeal in October 2024 and appeal to the Federal Second Circuit Court, intending to overturn part of the district court's ruling. According to the response of the Federal Second Circuit Court, the SEC must submit an opening statement of the appeal before January 15, 2025. Therefore, there is a certain possibility that the judgment in this case will be overturned. 3.1.3 Subsequent impact In terms of the subsequent impact of the case, on the one hand, the Ripple case clarified the important role of the transaction method in the characterization of crypto assets. In the Ripple case, the court held that the sale of XRP to the public through the secondary market did not constitute securities trading, indicating that the way in which crypto assets are sold or traded will affect the characterization of crypto assets. On the other hand, this case will limit the expansion of the SEC's regulatory scope on crypto assets to a certain extent. Unless the SEC succeeds in the Court of Appeal, the ruling of this case will be binding in the United States, which follows case law, preventing the SEC from treating a large number of crypto assets as securities and bringing them under regulatory jurisdiction. Overall, the Ripple case marks an important victory for the crypto industry in its battle against the strong regulatory model. This ruling not only boosted the confidence of crypto practitioners and led to a rebound in market sentiment, but may also become an important turning point in the future regulatory landscape. 3.2 Terraform Case 3.2.1 Brief Introduction Terraform Labs is a platform that provides blockchain technology and crypto assets. Its founder Do Kwon attracted investors in the secondary market by designing and selling a variety of crypto assets, including its native stablecoin UST and token LUNA. The UST coin is pegged to the U.S. dollar, while its stability is "algorithmically" dependent on the support of its sister token, LUNA. However, Terraform's stabilization mechanism has serious problems in actual operation. In May 2021, the price of UST de-pegged, but Terraform was able to briefly restore UST's peg through a secret arrangement with a third-party company. In 2022, UST fell below $1 again, and without external intervention to support it, its value quickly plummeted, causing LUNA to lose value as well. The crash triggered a loss of more than $40 billion in market value and also dragged down other crypto assets, including Bitcoin, further impacting the entire crypto market and causing multiple companies to file for bankruptcy in 2022. In February 2023, the U.S. Securities and Exchange Commission (SEC) charged Terraform Labs and its founder Do Kwon with a multi-billion dollar unregistered crypto asset securities fraud. The SEC believes that Terraform has violated the registration and anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934 by attracting investors through multiple misleading statements and fraudulent acts. In June 2024, the U.S. District Court approved the $4.5 billion settlement agreement 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 prejudgment interest. Do Kwon must pay $110 million in illegal gains and $14.3 million in prejudgment interest together with Terraform, and pay an independent civil penalty of $80 million. However, since Terraform filed for bankruptcy in January 2024, these fines may be difficult to pay in full and can only be handled as unsecured claims in bankruptcy liquidation.  

3.2.2 Decision

The core of the decision in the Terraform case lies in the determination of the legal attributes of UST and LUNA. The court held that the purchasers of these crypto assets reasonably expected their tokens to generate profits and viewed these tokens as a profitable investment, and these assets met the definition of investment contracts in the Howey Test. The court further ruled that all relevant crypto assets created by Terraform, including UST and LUNA, met the definition of investment contracts under the Securities Act of 1933 and should be classified as securities.  

It is worth noting that in connection with the case in which 18 states sued the SEC, the court responded to Terraform's defense of the Major Questions Doctrine. The Major Questions Doctrine requires that: "In exceptional circumstances, an agency claiming the power to regulate a large portion of the U.S. economy of great economic and political significance must point to a clear congressional authorization of that power." The court held that: (1) there is little comparability between Terra Labs and cases to which the Major Questions Doctrine applies (such as those involving the U.S. tobacco and energy industries). (2) The SEC's regulation of certain crypto assets when it determines that they are securities hardly constitutes a transformative expansion of its regulatory power. At the same time, similar to the 18 states' grounds for prosecution, Terraform argued that the SEC violated the Administrative Procedure Act. The court rejected this argument: the SEC's determination that Terraform's digital assets were investment contracts could not be denied solely on the basis of the Administrative Procedure Act. The SEC did not promulgate a new policy in this case, but merely implemented its previously established policy. At the same time, the court confirmed that the SEC's indictment fully accused Terraform of offering and selling LUNA and other tokens, which amounted to an illegal public offering of unregistered securities, and of making false or misleading statements and benefiting from them during the offering process. 3.2.3 Subsequent Impact The verdict in the Terraform case supported the SEC's regulatory stance and attracted widespread attention in the crypto asset industry. Specifically: First, the qualitative method of crypto assets was proposed again. The Terraform case showed that crypto assets traded in the secondary market can be identified as securities as long as they pass the Howey test, especially if investors have reasonable expectations of profit from the efforts of the issuer. Second, the SEC's regulatory power over the crypto market is strengthened. In the process of law enforcement, the Terraform case ruling has been cited by the SEC in lawsuits against other crypto asset exchanges, such as the Binance and Coinbase cases, which may further promote the SEC's comprehensive regulation of the digital asset market. Third, it has issued a warning to the crypto industry, requiring crypto industry practitioners to pay attention to the legal risks in the design and marketing of crypto assets. 3.3 Summary Although both Terraform and Ripple cases revolve around the characterization of crypto assets, there are significant differences in the rulings of the two cases. In the Ripple case, the court held that the secondary market sales of XRP did not constitute securities transactions, while the Terraform case ruled that UST and LUNA met the definition of investment contracts. This difference first exacerbated legal uncertainty in the field of digital assets. The ruling in the Ripple case emphasized the importance of the transaction method, pointing out that anonymous transactions in the secondary market may not meet the requirements of "common enterprise" or "dependence on the efforts of others for profit" in the Howey test. The Terraform case, on the other hand, focuses more on investors' profit expectations and the behavior of issuers, indicating that even in secondary market transactions, as long as the efforts of issuers play a key role in investors' returns, they can still be identified as securities transactions. This difference in the application of laws has added uncertainty to the digital asset industry.  

Secondly, it affects the SEC's regulatory strategy, which may lead to repeated changes in the SEC's regulatory stance. In the Terraform case, the SEC's claims were supported by the court, which strengthened its regulatory power over secondary market crypto asset transactions. 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 field of digital assets needs to be adjusted according to individual cases, and it is possible that in the future, restrictions can be compensated by more detailed regulation of the issuer's behavior.  

At the same time, it triggers market fluctuations and affects the direction of industry development. The Terraform case and the Ripple case send completely different signals to the market. The Terraform case is seen as support for the SEC's regulatory power, which has increased the market's expectations for strict regulation and may have a certain inhibitory effect on the innovation of crypto assets. The Ripple case is seen as a victory for the crypto industry, which has boosted market sentiment and boosted the price of digital assets in the short term. This dual impact may cause the market to show more obvious volatility in the future. In addition, such repeated judicial decisions may provide impetus for legislative clarification. The difference in the rulings of the two cases shows that the existing securities laws are insufficient in dealing with the complexity of digital assets. The results of the Ripple case and the Terraform case may prompt the U.S. Congress to further promote special legislation for digital assets to clarify their legal attributes and regulatory scope. Only through systematic legislation can the current regulatory ambiguity caused by differences in judicial interpretation be resolved. In this regard, FIT21, which is yet to be voted on by the Senate, may be able to improve this situation. 4. Litigation motives and chances of success of the 18 states 4.1 Analysis of litigation motives The 18 states jointly sued the SEC for violating the Constitution in its regulation of the crypto industry. In essence, they are restricting the expansion of the SEC's regulation of the crypto industry through judicial means, while striving for more autonomy for state power within the constitutional framework. The possible motives for the 18 states to file a lawsuit are: First, to form legal rules with universal validity through constitutional rulings. In recent years, the SEC has expanded the scope of application of the Howey test and imposed securities regulatory requirements on a large number of digital assets. This law enforcement behavior has caused widespread controversy inside and outside the industry. The 18 states chose to file unconstitutional claims based on the First Amendment and the Tenth Amendment of the U.S. Constitution, intending to deny the SEC's law enforcement behavior from a constitutional perspective through a federal court ruling. If the Supreme Court ultimately supports the claims of the 18 states, this ruling will have universal binding force across the United States, provide a legal precedent for similar disputes in the future, and force the SEC to adjust its regulatory strategy. Second, it will contain administrative power and prevent policy continuation. Under the leadership of Gary Gensler, the SEC has adopted a strict encryption policy, including intensive law enforcement actions against encryption companies such as Ripple and Terraform, and imposed high fines. This regulatory model has severely inhibited the development of the industry and infringed on the autonomy of state governments. Through this lawsuit, the 18 states not only attempted to curb the strong regulatory behavior of the current SEC chairman, but also intended to set legal boundaries for future governments to prevent the continuation of similar policies. Third, it will fill legislative gaps and promote industry development. The federal legislation in the field of digital assets in the United States is still imperfect, and disputes over the attributes of digital assets and their regulation have long existed. By promoting judicial rulings, the crypto industry can establish rules with precedent effect under the existing legal framework, provide a clearer compliance path for the digital asset industry, and create a more favorable environment for innovation and development. 4.2 Advantages and disadvantages Overall, the 18 states chose to file a lawsuit after the Republican Party represented by Trump won the election, which created many favorable conditions for winning the case, but also faced many uncertainties. From the perspective of favorable conditions: First, the policy propositions of the Trump administration. President-elect Trump has clearly expressed his support for the crypto industry and has announced the replacement of the SEC chairman. The new chairman nominated by Trump may adopt a more relaxed regulatory policy, which may reduce the SEC's confrontation in the future in this case and make the court's ruling more inclined to protect the crypto industry. Second, the conservative tendency of the Supreme Court. This case involves the Constitution, and the Federal Supreme Court has the final say in constitutional cases. Currently, conservatives hold the majority of seats in the Federal Supreme Court, and justices such as Thomas and Alito tend to support state rights on the relationship between federal and state rights. This political tendency may allow the 18 states to gain more support in their claims that the SEC is unconstitutional. At the same time, conservative judges are more receptive to the claims that the power of federal administrative agencies should be restricted, which provides favorable conditions for winning the case. Finally, broad support from the industry. There is widespread criticism of the current regulatory policy of the SEC within and outside the crypto industry. Many companies believe that strict regulatory requirements have suppressed technological innovation and increased compliance costs, and there is a strong demand to break the strict regulatory model.  

However, unfavorable factors also exist in reality: First, judicial uncertainty. There is no unified standard for the identification of digital assets in the US judicial system. In the Terraform case, the court rejected similar "major issues principle" and "Administrative Procedure Act" defenses, which may become an unfavorable reference for the trial of this case. In addition, the differences in the characterization of digital assets among state courts have increased the difficulty for the 18 states to win the case. Second, the time and resource costs are high. This case was filed in a local district court and may go through multiple appeal stages in the future, all the way to the Federal Supreme Court. The lengthy judicial process consumes a lot of time and resources, and the regulatory uncertainty during the case advancement may have a short-term negative impact on the development of the industry. In addition, the 18 states need to continue to deal with the SEC's defense during the judicial process, and their policies and litigation resources may face great pressure. Third, the legislative progress is slow. As mentioned earlier, although the House of Representatives passed the FIT21 bill, attempting to clarify the regulatory framework for digital assets, it failed to make substantial progress in the Senate. Therefore, there may still be obstacles to the passage of future bills. This legislative gap may lead the court to prefer to maintain the status quo rather than impose substantial restrictions on executive power through rulings.  

Overall, considering the current control of the Republican Party represented by Trump over executive and judicial power, as well as the industry's protest against the strong regulatory model, the 18 states have a certain chance of winning this lawsuit. The government's friendly policy towards the crypto industry will provide a potential positive trend for winning the case, and the conservative tendency of the Supreme Court may support the unconstitutional claim. However, this case also faces the problems of slow legislative progress and uncertainty in judicial discretion. Especially when the qualitative characterization of digital assets is still controversial, how to convince the court to impose substantial restrictions on SEC policies will be the key to determining the success or failure of the case.

5. Summary and Outlook The case in which 18 states sued the SEC is a major game involving constitutional principles and the future of digital asset regulation. Although it has a certain chance of winning, the case still needs to face 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 US crypto industry.  

If the court ultimately rules that the SEC's regulatory policy is unconstitutional, it will directly limit its regulatory scope for digital assets, which may prompt more decentralization of regulatory power to the CFTC or state governments, thereby forming a more decentralized and diversified regulatory system. This change will help ease the current SEC's overly strict regulatory style, create a more friendly development environment for the crypto industry, and may make the classification of crypto assets clearer, reduce industry disputes over the application of the Howey test, and enhance compliance certainty. This case will also play an important role in rebalancing state-federal relations. State governments may design regulatory policies that are more in line with local needs, form a competitive regulatory landscape, and promote the United States' leading position in the field of digital assets. In addition, the reduction of regulatory pressure may greatly stimulate industry innovation. Companies can experiment with new technologies and business models in a more relaxed environment, promote the widespread application of digital assets, and decentralized finance (DeFi) and cross-border payments may benefit significantly. However, the ruling of the case may also bring new risks and challenges. Policy changes may trigger market fluctuations, especially during the trial of the case, when investors are more sensitive to regulatory uncertainty. In addition, if regulatory power is delegated to state governments, policy differences between states may increase the compliance complexity of companies operating across states. In addition, international competitive pressure may also intensify. Countries and regions such as the European Union and Singapore have made some progress in digital asset regulation. If the US regulatory framework is too fragmented, it may weaken its competitiveness in the global market. Overall, the case filed by 18 states against the SEC is an important milestone in the development of the US crypto industry. The case provides an opportunity to strive for more friendly regulatory policies. In the future, the healthy development of the US crypto industry requires a balance between regulation and innovation. With reasonable judicial decisions, the United States has the opportunity to continue to lead innovation and growth in the global digital asset field.