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Binance Hit With Investor Suit Over Terra Stablecoin Collapse

August 16, 2022

Law360 (June 13, 2022, 10:02 PM EDT) — Cryptocurrency exchange Binance was hit with a proposed class action in California federal court on Monday claiming the company misrepresented the stability of “algorithmic stablecoin” TerraUSD and that it failed to protect investors by offering the now-collapsed stablecoin on its platform. 

Plaintiff Jeffrey Lockhart brought the suit against Binance, also known as BAM Trading Services Inc., and its CEO, Brian Shroder. The complaint alleges the defendants violated various provisions of federal and state securities laws by offering TerraUSD on the Binance platform. The suit is on behalf of all investors who used Binance to buy and sell TerraUSD from April 13 to the present. 

The complaint alleges that Binance failed to disclose to investors that TerraUSD is a security and that Binance had failed to register with the U.S. Securities and Exchange Commission as either a securities exchange or a registered broker-dealer.

The complaint also alleges that Luna, TerraUSD’s sister cryptocurrency, is a security but not one registered with the SEC or any state regulator. And by failing to disclose this information to investors, Binance deprived the group of traditional disclosures that accompany the issuance of publicly traded securities, according to the complaint.

“Binance U.S.’s failure to comply with the securities laws, and its false advertisements of [TerraUSD], have led to disastrous consequences for Binance U.S.’s customers: in May 2022, in the span of just a few days, [TerraUSD] lost essentially all its value — a loss of approximately $18 billion,” the complaint states. “Investors who purchased [TerraUSD] on Binance U.S. were wiped out, learning quickly that, contrary to Binance U.S.’s advertisements, [TerraUSD] was not ‘safe,’ ‘stable,’ or ‘fiat-backed.'”

TerraUSD is associated with decentralized finance startup Terraform Labs. It’s one of the top stablecoins by market capitalization, according to CoinMarketCap.

Stablecoins are digital assets that are supposed to maintain a steady price, often $1 per coin. But TerraUSD is slightly different from other stablecoins in that instead of being backed by cash or cash equivalents, TerraUSD is a so-called algorithmic stablecoin, which relies on technology and financial engineering to maintain its price.

“The Terra protocol uses the basic market forces of supply and demand to maintain the price” of TerraUSD, Terraform Labs’ website says. The protocol ensures that the supply and demand of TerraUSD are “always balanced, leading to a stable price.”

But the coin’s algorithmic backing proved disastrous for investors in May when TerraUSD’s price, which was supposed to hold consistent at $1, plunged amid a frantic sell-off, hitting a low of 1 cent by the end of May. Likewise, its sister cryptocurrency, Luna, intended to help keep TerraUSD’s price steady, entered a “death spiral” that wiped billions in value from the market in a matter of days.

“An incredible number of investors lost much, if not all, of their life savings … investors were in such despair that they commented in online forums that they were contemplating suicide as a result of the [TerraUSD and Luna] crash,” the complaint states.

Lockhart claims that since the collapse of TerraUSD, Binance has not stopped selling securities created by Terraform Labs.

“Having reaped hundreds of millions — if not billions — of dollars in profits by selling securities without bothering to comply with federal and state laws, Binance U.S.’s parent company blithely added insult to injury when, on May 31, 2022, it began selling Luna 2.0 — a new token which, just like LUNA, is centrally controlled by [Terraform Labs],” the complaint states.

Lockhart says that Binance’s failure and refusal to comply with federal and state securities laws allows “bad actors” like Terraform Labs to harm investors. The complaint alleges that Binance’s entire business model is built on enabling such “bad actors” as Binance only profits from the scheme.

“From Binance U.S.’s perspective, the less disclosure, the better, as more disclosure about the riskiness of crypto-assets will predictably lead investors to trade certain assets less and reduce transaction volume and Binance U.S.’s astonishing profits,” the complaint states.

Lockhart seeks declaratory and injunctive relief, damage, attorney fees and a jury trial.

In a statement to Law360, Lockhart’s counsel said they would do everything possible to help those who suffered losses get their money back.

“Binance and other exchanges were critical enablers of this devastating failure to comply with the securities laws. Crypto exchanges made massive profits by flouting securities laws and causing real harm to real people,” said Tibor L. Nagy Jr. of Dontzin Nagy & Fleissig LLP.

Binance did not immediately respond to requests for comment on Monday.

Lockhart’s suit is one of the first over the collapse of TerraUSD and Luna. There has also been a growing push from lawmakers and regulators for greater stablecoin regulation.

In early May, shortly after the initial collapse, U.S. Department of the Treasury Secretary Janet Yellen told senators that the crash was a further warning sign of how cryptocurrency can present a risk to financial stability.

Yellen used TerraUSD’s woes to call for a legislative and regulatory framework for stablecoins, saying it would be “highly appropriate” to get something in place this year.

“I think [this episode] simply illustrates that this is a rapidly growing product and that there are risks to financial stability, and we need a framework that’s appropriate,” Yellen told the Senate Banking Committee in a livestreamed hearing on financial stability.

And last week, a bipartisan duo of U.S. senators unveiled legislation that seeks to bring clarity to cryptocurrency regulation, introducing a wide-ranging proposal that would define most digital assets as commodities and enact rules governing stablecoins.

The Responsible Financial Innovation Act, co-sponsored by Sens. Cynthia Lummis, R-Wyo., and Kirsten Gillibrand, D-N.Y., would establish the federal government’s recognition of the booming but often volatile cryptocurrency industry if it becomes law.

Specifically, the bill would require that any stablecoin issuer hold sufficient reserves so that they can always redeem the asset in exchange for its equivalent dollar value. The proposal also requires certain disclosure obligations among stablecoin issuers.

Additionally, the proposal sets forth an optional framework that would authorize banks and credit unions to issue stablecoins. However, the Lummis-Gillibrand legislation does not require all stablecoin issuers to become depository institutions, meaning they would come under less regulation than full-fledged banks or saving associations.

The SEC under Chair Gary Gensler is also seeking more oversight of cryptocurrencies. The commission has recently focused on exchanges that provide trading venues for such assets, arguing that more regulation is needed because most tokens trading on digital platforms are, in fact, securities.

And Gensler has emphasized that cracking down on cryptocurrency’s “Wild West” is a priority. In May, the agency said it was nearly doubling the size of its cryptocurrency and cybersecurity enforcement unit to help crack down on fraud and noncompliance.

The SEC is also no stranger to Terraform Labs. The agency has been investigating another of Terraform’s initiatives called Mirror Protocol, which purportedly allowed users to create and trade digital assets that “mirror” the price of U.S. securities.

The agency served investigative subpoenas on Terraform Labs CEO Do Kwon at a cryptocurrency summit last year, although Kwon has contested whether the agency acted properly.

Lockhart is represented by Tibor L. Nagy Jr., Gregory N. Wolfe, William LaGrange, Heidi R. Schumann and Susan S. Hu of Dontzin Nagy & Fleissig LLP and by Kyle Roche, Edward Normand, Joseph Delich, Alex Potter and Ivy T. Ngo of Roche Freedman LLP.

Counsel information for Binance and Shroder was not immediately available.

The case is Lockhart v. BAM Trading Services Inc. et al., case number 3:22-cv-03461, in the U.S. District Court for the Northern District of California.

–Additional reporting by Elise Hansen and Tom Zanki. Editing by Andrew Cohen.