SEC charges Terraform Labs, Do Kwon with fraud

The U.S. Securities and Exchange Commission has charged Terraform Labs and its CEO, Do Kwon, with securities fraud.

The Terra network collapsed in a span of a few days in May 2022 after its stablecoin, Terra USD, experienced a bank run — a situation where too many investors withdraw their investments at once — that led the coin to lose its critical $1 price peg.

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Stablecoins typically use cash to maintain a $1 price peg. However, Terra maintained the price peg with an algorithm linked to the supply of its sister token, LUNA. Terra's failing price eventually brought LUNA to its demise as well. Terra ecosystem's collapse caused a total loss of $60 billion in investor funds.

The SEC said Terraform had raised billions of dollars from investors, promising "inter-connected suite crypto asset securities, many in unregistered transactions" from April 2018 to May 2022. The agency also accused Kwon and his company of committing fraud by repeating misleading information to investors before the ecosystem collapsed.

"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 chairman Gary Gensler said.

Kwon, who co-founded Terraform Labs, is known to make "outrageous" comments on Twitter, such as ridiculing his critics. Shortly before Terra's collapse, he tried to assure investors that the team was "deploying more capital" to prop the failing token.

SEC director of the division of enforcement Gubir Grewal said the agency's move to charge Terra and Kwon goes beyond holding the defendants accountable for their contribution to the network's collapse because it also highlights that the SEC looks "to the economic realities of an offering, not the labels put on it."

"As alleged in our complaint, the Terra ecosystem was neither decentralized, nor finance. It was simply fraud propped up by a so-called algorithmic 'stablecoin' — the price of which was controlled by the defendants, not the code," Grewal added.

Authorities in Kwon's home country, South Korea, have also issued an arrest warrant for the Terra co-founder, who was last reported to be in Serbia.

Contagion effect

The collapse of Terra triggered a contagion effect across the entire crypto industry. Singaporean-based crypto hedge fund Three Arrows Capital (3AC) was the first major firm to get hit by the impact of the implosion because it incurred exponential losses due to its staked Luna position.

3AC defaulted on loan payments to several crypto lenders. Voyager Digital, for instance, reported that 3AC had defaulted on a crypto loan worth around $670 million, comprising 15,250 BTC and $350 million in USDC. Voyager had to file for Chapter 11 on July 5, 2022, partially due to 3AC's loan default.

By late June, 3AC filed for bankruptcy in a British Virgin Islands court, which immediately ordered the company to begin liquidation proceedings. On July 1, 2022, 3AC filed for Chapter 15 bankruptcy in a Southern District of New York court to secure its U.S. assets from creditors.

Genesis Trading and BlockFi, which provided loans to the defunct 3AC, sold some of their crypto assets to cover the loss. Reports suggested that BlockFi liquidated $1 billion in Bitcoin after 3AC failed to pay its loan. BlockFi also received a $250 million bailout from crypto exchange FTX.

BlockFi later filed for bankruptcy at the end of November 2022 after FTX collapsed following a "liquidity crunch." FTX and its founder, Samuel Bankman-Fried, are currently under scrutiny for allegedly misusing customer funds to bet on crypto.

The contagion effect also prompted regulators in many countries to call for stricter regulation of the nascent industry, with regulators demanding that crypto companies be treated like traditional financial institutions.