Collapse of stablecoin TerraUSD sparks bold 'scheme liability' suit

Smartphone with Terra logo is placed on displayed U.S. dollars in this illustration taken May 11, 2022. REUTERS/Dado Ruvic

(Reuters) - A new securities fraud class action by an investor in the collapsed stablecoin TerraUSD will test a novel theory of liability against six crypto venture capital firms that pledged to support Terra tokens in the months before they imploded.

Chicago investor Nick Patterson sued Terraform Labs Pte Ltd founder and CEO Do Kwon and California-based research head Nicholas Platias in federal court in San Francisco on Friday, alleging that they lured investors to buy digital assets in the so-called Terra ecosystem with false promises about guaranteed returns and algorithmic stability. Plaintiffs lawyers from Scott + Scott described Terra’s pitch as a “siren song” luring even veteran crypto traders who subsequently lost tens of billions of dollars when the tokens collapsed.

Part of the attraction for stablecoin buyers, according to the complaint, was the backing of six venture capital firms that banded together in February as the Luna Foundation Guard “to support and fund the Terra ecosystem,” including the creation of a billion-dollar reserve pool to serve as collateral for Terra tokens. The complaint alleges that the venture capital firms, including Jump Trading LLC, Tribe Capital and Three Arrows Capital Pte Ltd, knowingly passed along fraudulent information to Terra investors.

That's an intriguing assertion. It's not easy, as you know, to extend securities fraud liability beyond the issuers and underwriters that backed offerings. But plaintiffs' lawyers Sean Masson of Scott + Scott told me the venture capital firms named as defendants in the new Terraform complaint were “agents of Terraform, acting on Terraform’s behalf.”

Executives from some of the firms, Masson said, made public statements touting Terra tokens and the billion-dollar reserve established by the Luna Foundation Guard. “We believe they are prime culpable parties,” Masson said.

I reached out by email or Twitter to Terraform, the Luna Foundation Guard and all six of the venture firms named as defendants. None got back to me.

The key to investors’ federal securities law claims against the venture capital firms is the U.S. Supreme Court’s 2019 ruling in Lorenzo v. Securities and Exchange Commission. In that case, as I've reported, the Supreme Court held that investment banker Francis Lorenzo participated in a fraudulent securities scheme when he knowingly emailed false information about a client’s debt offering to potential investors. The Lorenzo ruling launched a bevy of law firm client alerts about the expansion of “scheme liability” under the Securities and Exchange Act. And although shareholder lawyers told me at the time that the ruling wouldn’t have a big impact on private securities fraud cases, Lorenzo has occasionally popped up in investor class actions.

The new Terra complaint is one of the most ambitious assertions of scheme liability since the Supreme Court issued the Lorenzo decision, said plaintiffs lawyer Kyle Roche of Roche Freedman, who is co-counsel in a recently filed class action accusing the crypto trading platform Binance of violating U.S. securities laws by facilitating the sale of Terra tokens. The new class action, Roche said, also marks the first time that investors have alleged scheme liability against defendants that did not sell digital assets but actively promoted tokens.

If investors' scheme liability theory pans out in the Terraform class action, crypto traders who believe they were defrauded will be able to bring claims against an expanded array of defendants for allegedly helping token issuers deceive the market. The new Terra complaint, moreover, asserts that all of the defendants engaged in a racketeering conspiracy to hoodwink investors. RICO claims, as you know, carry treble damages — so if token buyers can tag the venture capital firms with securities fraud as a predicate for racketeering claims, that’s powerful leverage.

But that’s still a very big if. As a threshold question, plaintiffs will have to show that Terra tokens were, in fact, securities. Terraform Labs did not register any of the digital assets as securities, nor is the Seoul-based company registered with the SEC as a broker-dealer. (The class action, in fact, asserts claims for the sale of unregistered securities.) The SEC has asserted in an array of enforcement actions that digital assets other than Bitcoin and Ether are securities, but you can be sure the Terra defendants will argue otherwise.

Several of the defendants, including Terraform Labs, Terraform CEO Kwon and several of the venture capital firms, are not based in the U.S. and are likely to contest the jurisdiction of California federal courts. The complaint devotes considerable attention to establishing California’s interest in hearing the case. It’s also notable, said Masson of Scott + Scott, that the 2nd U.S. Circuit Court of Appeals ruled just a couple of weeks ago, in Terraform’s challenge to SEC investigative subpoenas, that the company and Kwon are subject to the jurisdiction of U.S. courts. The 2nd Circuit concluded that although Terraform and Kwon are not U.S. entities, they “purposefully availed themselves of the U.S. by promoting the digital assets at issue in the SEC's investigation to U.S.-based consumers and investors.”

Even if investors prevail on California’s jurisdiction, they face an additional obstacle of establishing that Terra token trading took place within U.S. borders.

I’ve been telling you for a while that the Supreme Court’s 2010 ruling in Morrison v. National Australia Bank Ltd, which held that federal securities laws generally don’t apply beyond U.S. borders, has been a boon for crypto defendants based in foreign countries. There’s no doubt that Terraform will claim that its digital assets were not bought and sold in domestic transactions so it cannot be liable under U.S. securities laws.

Investors are anticipating that defense, Masson said, but he added, “We believe that the allegations in the complaint are sufficient to withstand a Morrison challenge.”

To be clear, Terra stablecoin investors have a long, long way to go. Friday’s complaint will probably be amended after U.S. District Judge James Donato of San Francisco picks a lead plaintiff. Defendants will then move for dismissal.

I’ll be watching with interest. Crypto companies like to emphasize decentralization. The conspiracy allegations in this case posit exactly the opposite.

Read more:

New Binance class action likely clears one hurdle but faces plenty of others

Collapsed stablecoin TerraUSD announces recovery plan as token flounders

Will Supreme Court’s Lorenzo ruling spur shareholder class actions?

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Alison Frankel has covered high-stakes commercial litigation as a columnist for Reuters since 2011. A Dartmouth college graduate, she has worked as a journalist in New York covering the legal industry and the law for more than three decades. Before joining Reuters, she was a writer and editor at The American Lawyer. Frankel is the author of Double Eagle: The Epic Story of the World’s Most Valuable Coin.